Major Purchases and Projects
When you consider expanding or purchasing expensive equipment, you may put your business in jeopardy or pave the road for expansion. Do the math before you dole out the cash.
From time to time, every business owner wrestles with the question of whether it's time to make a major purchase, or to undertake an expensive, lengthy project. Depending on the size and type of business you own, you might have to decide things like whether to purchase a new car or truck, upgrade your computer system, hire a new employee, redecorate your retail store, undertake a major expansion or even buy another related or unrelated business.
You can, of course, make this kind of decision based on your gut feeling that the time is right and that it will be "good for business." In some cases, such as when you're replacing essential equipment that is no longer functional, it's probably appropriate to go with your gut-level feeling.
But in many other cases, when the purchase or project costs a significant amount of money or will serve you for more than a year, it's worthwhile to take the time to evaluate the costs and benefits of the project, and even do a little number-crunching (perhaps with the aid of your accountant).
Deciding to Make a Major Purchase
What do we mean by a "major purchase," you ask? Among financial types (like your banker or accountant), the main consideration is usually that the item or project will have a service period of more than a year. If so, you'd want to spend at least some time studying the issue, and doing what is known as "capital budgeting." If the item will last for less than a year, it's probably not worth a detailed analysis—you might decide to just "get it if you need it."
Some business owners also like to draw the line at a certain dollar amount—depending on the size of your operation, this can be $1,000, $10,000, or any other amount that makes sense. Anything below that amount would be treated as a normal budget expense, but anything above it would deserve separate, careful study.
Clearly, the bigger the project, the more formal analysis you'll want to go through. The fact that your business is small does not mean you can avoid this process—in fact, smaller businesses usually have a smaller margin for error, making careful analysis even more important. Overspending on an expansion or new equipment can sink a small business, where a larger one would be likely to have deeper pockets and be able to recover.
If your project will require major financing, a fairly detailed analysis is often necessary because the bank or financing company will probably want to see your cash flow projections, and maybe even a full-blown business plan. If you're doing something as ambitious as purchasing or starting another business, you'll definitely want to involve your accountant and go through some serious number-crunching, before you make a firm commitment to the project.
Don't Look for Absolute Answers
The reason for doing capital budgeting and analysis is to allow you to take calculated risks. Of course, there is no way to foresee the future. Analyzing a major purchase decision involves making many predictions and estimates about things like interest rates, local economic conditions, consumer tastes and trends, technological developments, etc. It's likely that some, or even many, of your expectations may not pan out. Nevertheless, going through the process of examining the costs, benefits and risks involved with a major purchase should help you weed out the projects and ideas that have little chance of success. Then, you can concentrate on those with the least risk, combined with the greatest potential payoff for your business.
Deciding Between Competing Projects
Sometimes, the question is, "Should we do X?" Other times, the question boils down to, "We only have so many dollars—should we do X, Y, or Z this year?" Major purchase analysis or capital budgeting can help you answer either question. However, the answer becomes less certain when you're looking at more than one project, because the number of unknowns multiplies as the number of projects under consideration goes up.
Projects Without a Financial Payoff
Most capital projects are intended to either increase your revenues or decrease your costs. For example, opening another location should put your name in front of a new group of customers, resulting in increased sales. Getting a new, more efficient machine might reduce your power bill and your maintenance costs. However, in some cases a project is necessary just to keep you in business. Replacing a leaky roof, or installing some required pollution-abatement or safety equipment, would fall into this category. Such projects are often subjected to capital budgeting techniques anyway, since usually there are several possible solutions and it's still necessary to work out the issues of cost, payment method and timing.
In making your decision about a major purchase or project, you should:
- Consider all the benefits of the project.
- Consider all the costs.
- Create a projected cash flow statement that quantifies costs and benefits, and places them in the correct time frame.
- Use financial analysis tools to determine whether the project makes sense.
Considering the Costs of Project
Once you've identified what your major purchase or project should accomplish for you and fleshed out your requirements for the project, the next step is to evaluate the costs. In doing so, you'll also be making more decisions about what features you absolutely need, and which you can live without, in view of their respective price tags.
For example, if you're thinking of buying an office building, you'd need to talk to real estate brokers or agents about the types of properties available, their features and their price range. If it turns out that the type of building you want is far beyond your borrowing ability, you may have to set your sights lower by choosing one with less square footage, or in a less desirable location.
If you're thinking of buying a piece of industrial equipment, you'll need to talk to suppliers or agents to see what's available to fill the needs of your production system, and to do some comparison shopping. You may find that you'll need customized equipment that costs more. Or, you may find that you can live with standard, used equipment that costs significantly less.
Salespeople can be invaluable sources of information. Just remember that, at this point, you're not buying, just collecting data. Salespeople are particularly adept at selling you on the features of whatever product they happen to be pushing that month. You can't rely on them to say that you might be able to meet your goals with an older model, or with some modifications to your existing equipment.
Identifying All Procurement Activities
As you scope out the costs of the project, don't forget that there are many ways to skin a cat. Depending on the type of project, you may have the choice of buying, leasing or constructing some or all of the item yourself. You may decide to pay cash or to finance the project. If you will be financing the item, a variety of lending alternatives may be available. At this point, it would be wise to consider the costs under all reasonable alternatives. You might wind up with several sets of figures, showing the total costs under a number of different scenarios.
If the project involves construction, either by your employees or through outside contractors, the ultimate cost will be more difficult to determine. Many contractors and suppliers will give bids that are estimates on your project, but not guarantees of the final price. The contractors will want to pass any unexpected material or labor costs on to you. Unfortunately, it's much more likely that the ultimate cost will be higher than the bid, rather than lower.
To be on the safe side, many business owners mentally tack on an extra 10 percent or more to every bid they receive. Be sure that you've thoroughly explained your needs to the contractor(s)—you don't want that extra 10 percent to turn into 20 percent because you didn't fully describe all the work you wanted done.
Identifying Hidden Costs
Along with the cost of the project itself, don't forget to include costs like installation, training sessions, maintenance and repairs, insurance, utilities, supplies, taxes, payroll and benefits costs for new employees needed to operate the equipment, or any other incidental costs that relate to acquiring or maintaining your particular project. Consider also the time your employees will devote to the project instead of their regular work (and make sure the regular workload is covered).
Also consider the nonfinancial aspects of the project—like the time you'll need to devote to gathering bids, supervising installation and managing the project once it goes on-line. Depending on what you're doing, this time may be negligible, or it may be so great that your attention will be fully occupied and the rest of your business may languish for a while.
Consider, too, your own strengths and weaknesses. For instance, if the project you're considering is an expansion from one store to two, you'll probably have to delegate more decisions to managers instead of handling all the details yourself. For some business owners, this is a plus. For others, a great frustration.
Branching out into different lines of business is often problematic if you lack familiarity with the market or day-to-day operations in the new area, but such experience can be "acquired" by hiring or consulting with the right people beforehand.
Develop a Cash Flow Statement
If you want to finance your major purchase or project with a bank loan, your lender is likely to want to see a cash flow budget showing the effect of the project on your revenues, and proving that you can make the anticipated loan payments.
Even if you're not financing the purchase, you should consider creating such a budget (or, more likely, having your accountant do it for you). It's a way of systematically comparing the costs and financial benefits of your project over a period of time, and will enable you to get a good handle on how the project will affect your business.
If done correctly for each project you consider, cash flow budgets should also point out projects that are financially unfeasible or only marginally feasible, thus saving you the trouble of finding that out the hard way.
Your cash flow projection should show estimated cash inflows and outflows for the project, by month, for at least the first year. As a starting point you can use the cash flow projections you've already done for your business, simply adding in the changes that you expect the project to bring. Then you can compare your original statement (without the project) to your new statement (with the project), to gauge the likely results of moving forward with your plans.
You can find a cash flow budget worksheet in our Business Tools section. The worksheet is an Excel spreadsheet you can use over and over after you download the original.
The worksheet is set up to be used for projecting your cash flow for six months at a time. We've formatted the worksheet and put in most of the cash inflow and outflow categories for you. All you have to do is put in your numbers and print it.
Once you've downloaded the worksheet, feel free to modify it to fit your own needs.
Ideally, you would also create a simplified projection that extends for the length of the asset's useful life, or at least for the length of the loan or lease used to finance it. You might also like to project your cash flow out to the date when the project's costs will be paid back by the benefits it generates.
Recognize, however, that the farther out in time you go, the less certain your figures will be. Don't forget the increased chances that there will be unexpected changes in interest rates, technological developments, consumer tastes and habits or other factors that can affect your business.
At this point, your simplified, long-range cash flow projection for the project should include only those inflows and outflows that are directly related to the project itself. Don't include overhead costs that you would have regardless of whether you did the project or not.
Example of a Simplified Cash Flow Projection
For example, you are thinking of purchasing a new machine that will allow you to offer a new product to your customers. The machine will cost $100,000 to purchase and install, and after five years (when you plan to sell it) the machine will be worth about $10,000. Your facility has plenty of room, so you won't have any additional rental costs for space, and you can piggyback advertising for the new product on to your existing advertising budget. You will, however, have to pay for insurance, personal property taxes and a part-time employee to operate the machinery (these items are included in your fixed costs which will total $12,000 in the first year). Also, there will be costs for materials, supplies and electricity that will vary depending on the volume of production. These variable costs will amount to about 60 percent of the sales revenues.
The following is a simplified example of a projected cash flow statement for the project:
|Current ||Year 1 ||Year 2 ||Year 3 ||Year 4 ||Year 5 |
|Price/Unit || |
|$80 ||$84 ||$88 ||$93 ||$97 |
|Multiplied by: |
|1000 ||1150 ||1323 ||1521 ||1749 |
|Net Sales || |
|$80,000 ||$96,600 ||$116,424 ||$141,453 ||$169,653 |
|Variable Costs || |
|$48,000 ||$57,960 ||$69,854 ||$84,872 ||$101,792 |
|Fixed Costs || |
|$12,000 ||$12,600 ||$13,230 ||$13,892 ||$14,586 |
|Depreciation || |
|$14,290 ||$24,490 ||$17,490 ||$12,490 ||$ 8,930 |
|Gain/Loss - Equip. Sale || |
|Pre-tax Income || |
|$ 5,710 ||$ 1,550 ||$15,850 ||$29,591 ||$32,034 |
|Tax Expense || |
|$ 1,941 ||$527 ||$5,389 ||$10,060 ||$10,892 |
|Net Income || |
|$3,769 ||$1,023 ||$10,461 ||$19,531 ||$21,142 |
|Add Back Depreciation || |
|$14,290 ||$24,490 ||$17,490 ||$12,490 ||$ 8,930 |
|Asset Purchase Salvage Value ||$100,000 || |
|Net Cash Flow ||($100,000) ||$18,059 ||$25,513 ||$27,951 ||$32,021 ||$40,072 |
Remember, though, that this table makes a number of assumptions:
- The average price of the product will increase by 5 percent a year, while the volume sold will increase by 15 percent a year.
- Depreciation is computed using the IRS's tables for 7-year property, using the half-year convention under MACRS. Tax depreciation is used because it affects the outflow of cash in the form of tax payments.
- Fixed costs will increase by an inflation factor of 5 percent a year.
- The tax rate is calculated at 34 percent.
Once you've created a projected cash flow statement for your project, you can use some financial analysis tools to see whether the project makes sense for your business.
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