In the latest issue of Woodworking Magazine, Sepp Gmeiner teaches you how to calculate a financial justification for your capital investment – be it a CNC router, plasma, waterjet, or any other piece of equipment.
You have been to the trade show and visited with potential equipment suppliers. Your staff says they need the machine and you have received detailed proposals from different suppliers. Let’s say you have done your homework and you know what kind of machine you want. Good practice is to calculate a financial justification.
The textbooks are full of different methods with which financial professionals can calculate if the investment is financially sound.
- Payback method
- Return on investment
- Break-even time
However, based on manufacturers’ feedback, the minority did no, or only limited, financial calculations. Of the companies that did the calculations, the “payback method” was the most common. Years of payback = (total investment) divided by (total average benefits per year). Very seldom do I see companies going to the lengths of do9ing detailed “return-on-investment” (ROI) calculations. All these calculation methods have common elements:
- Initial costs: capital and expenses
Compiling the initial costs (capital and expenses) is relatively easy. The purchase price, freight and rigging, connection to utilities, and building modifications are the basic costs. Additionally, there is a long list of related costs and expenses:
- Travel expenses
- Spare parts
- Research and development
- Training courses
- Engineering and consulting costs
- Material for testing and training
- Dismantling and disposal of existing equipment
Depending on local tax law and company policy, these costs can be capitalized or expensed. Your finance department will give you the direction on this. On the benefit side, we have different categories:
- Cost savings
- Inventory reduction
- Flexibility increase
- Volume increase
The cost savings can be material, labor, overhead cost, or any combination of these. A practical approach is to look at all the line items on the profit & loss statement and think through all of them. What will change by how much if this investment is made? Some costs can go up, but others will go down. All the cost savings can be accumulated over the projected life of the machine per year. The projected life of the machine can be much longer than the depreciation time that the tax law allows. Companies might also decide the payback time needs to be a much shorter time. I have worked with companies allowing investments only if the payback period is two years or shorter. Most companies state that they would invest up to three to maximum four years of payback. It is important that the projected cost savings can be linked to the investment. Be aware and avoid inflated cost savings. For example, like the punch line of a favorite joke: If you decide to walk instead of taking the bus, you save the $3 fare. However, running behind a taxi doesn’t save you a $25 fare. The savings are still only $3. You must always compare it to the logical alternative. Cost savings calculations are relatively easy and often focused on the machine(s) being purchased.
If the investment directly allows for the reduction of inventory, then the amount of reduction can be deducted from the investment. For example, of the installation of a $120,000 CNC machine allows one-piece-flow, and this in turn allows the reduction of work-in-process (WIP) and finished goods inventory by $500,000, the the initial cost ($120K) is immediately offset by the $50K reduction in working capital. The remaining $70K needs to be justified by other benefits. Be sure this inventory reduction cannot be achieved without the investment.
On the path to LEAN manufacturing, you are most often held back by inflexible machines with long set-up times. Long set-up times cause big batch manufacturing, narrow product lines, long lead times, and so on. It is quite challenging to calculate the benefits of short lead time, flexible manufacturing, and the ability to increase the product variation. In my opinion the long-term benefits of flexibility on machines are most often underestimated, and scratched off the purchasing list for ‘being too expensive’.
If the investment allows the (sales) volume to increase (removing the bottleneck), then the benefit is the ‘gross profit’ of the incremental sales increase. Again, do not count what could be produced, instead count what is expected to be additionally produced and sold. The machine could be more costly to run than the existing equipment, but the benefit is realized by the entire plant or department being more productive.
Inspired by Sepp Gmeiner’s article in Woodworking Magazine”Capital Investment: Financial Justification”.