Last article we reviewed developing the total costs in payback of an equipment purchase as well being able to consider the change in income because of the purchase. Now, let’s pickup on identifying the change in costs that go along with it. Here we go.
Change in Costs Using Payback
There are three elements of cost. Direct materials, wages walking out the door, and overhead.
In a sales increase scenario, we must consider the change in costs to produce the sales. Start with direct materials. Either identify the direct material cost specifically or use your historic cost of direct materials from your financials. Commonly it will be 25% of the selling price.
Now, what about the changes in wages walking out the door? That’s wages you pay to other people, not wages paid to you, your spouse and unemancipated children. I’m NOT saying calculate how much of their wage will be spend producing the new sales. I am asking will you have to add a worker and/or increase wages? Will your current workers have to work overtime? Or will you terminate someone if your get the equipment? Calculate the change and add the percentage for payroll taxes and benefits based on your historic percentage from your financials.
Now consider changes in overhead. Will insurance premiums go up? Do you have to rent more space? Any increase in equipment maintenance and/or repair? Ignore depreciation as we’re doing this on a cash basis.
What if the new equipment allows me produces 20% faster so that will mean I can have more sales? It’s not a factor. Why? For many it only means we’ve invested in equipment to allow our workers more break time. So, unless there is a change in the checkbook, ignore this.
On the other hand, tell me you can nail down a weekly contract to produce a job you can’t do now, and you’re getting the idea. Say it’s $1,500 a week. Fine, that puts $1,500 a week or $75,000 a year (50 weeks) into our checkbook.
Calculate the Marginal Contribution Using Payback
Now, again, think of this as your checkbook balance. Add your change in income and then deduct the increase in direct materials, wages paid to others and overhead. The positive or negative result is your marginal (change in) income.
If it’s positive, keep going. If it’s negative, stop since the equipment purchase won’t ever pay for itself. For our purposes, let’s assume that the marginal contribution (change) is $10,000 positive per year.
Calculate Payback Time
This is the easy part. We know the total cost is $72,700. We also know that if we do the deal, then our marginal (change) in income is $10,000 per year. So, the question is how much time does it take for us to get our money back?
$72,700 divided by $10,000 per year gives us 7.2 years or some 7 years and 2 months. Problem is we can’t tell if this is a good or bad investment until we compare it with an alternative.
Remember, there is no such thing as an emergency equipment purchase. We should review our needs once, twice or even three times a year if we have the money. Get the practical options on the table and follow the payback process for each. Then choose among alternatives.
Choose Among Alternatives
This one deal is a $72,700 investment with a 7.2-year payback period. What if another gizmo is $160,000 with an 8-year payback? And another is $50,000 with a 2-year payback?
Rule one is to choose the one with the fastest payback. You’re taking the money out of your checkbook and putting it into equipment. Payback tells you how long it takes to get it back. So, go with the fastest and you’ll replenish the money fastest and then you’ll be able to make another purchase decision.
Ah, but rule number two is to choose the one with the lowest amount of cash out as it’s least risky. So, choose the one with the lowest cost first.
And that brings up rule number three. Choose the one with the lowest cost and the fastest payback and, if that’s not clear, do the one that appears to be closest.
That’s all there is to it. Yes, but I know you have some “yeah butta” questions. We’ll deal with those next month.
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Message Tom Crouser at email@example.com for more information on how CPrint International can be of help to you in your business or call his cell (304) 541-3714. No cost or obligation.