Let’s consider the math for justifying equipment purchases using the payback method. It’s straightforward as there are only four steps. Calculate the total cost of the purchase. Figure the marginal contribution (change in your checkbook). Use that change to calculate the payback time. Then, choose among alternatives. It’s as straightforward as that. Here’s an example.
Calculate Payback Cost
Assume we buy $60,000 of equipment for cash. If you borrow or lease, you may multiply the payment amount by the monthly payment to get the total plus any upfront deposit or payment at the end, if any, for the total cost. If it’s a fair market value lease with an unspecified ending purchase price, use 10% of the known total as an ending payment and add that.
Now add other costs. There’s electrical work of running 220 across the room and modifications to the work area. And we need to hire a crane to off load the equipment as well as pay freight to get it here. The door width and the ceiling height are okay but we must reinforce the floor to support the weight, so add for that.
What about training? Your operator will need to spend 20 hours of training. Okay, that’s $20 an hour x 20 hours x an additional 25% for employee benefits or $500. Add that also to the cost. BTW, don’t train on live jobs.
Don’t overlook anything including working space and maintenance space; change in plumbing or heating/cooling, insurance, or rent if you need to add space. Now, will this purchase require adding other equipment (larger cutter for instance)? Will it increase the amount of standard inventory required? If so, add those costs into the total.
My total is $12,700 of other stuff, which added to the equipment comes to $72,700, which is the total cost.
Calculate Marginal Contribution using Payback
Marginal means change. Change in what? Change in income and/or change in outgo (cash). Think of it as any change in your checkbook.
Start with income.
Hardest scenario is relying on an increase in sales to justify the purchase. How do you know how many sales? You could guess or, preferably, use a Jury of Executive Opinion. That’s where you choose several people who know you and your business. Explain to them specifically how buying this equipment will increase sales as well as how much sales will increase. You could choose your spouse, your accountant, your consultant, and a key employee. Do not choose the person selling you the equipment, but get three or four.
Point here is they know you and your business well enough that if you claim you will increase sales by making sales calls, they will call your bluff if they know you haven’t made sales calls in years.
Nevertheless, present your jury with the plan. Be specific. What customers? Have you talked with them? Have they given you an indication of how much they will buy? Will they sign a contract? The more specific you can be, the higher the rating each juror will give you.
The rating is on a scale of 0% to 100% with 100% being that your jury believes your plan will absolutely meet the projection and 0% is that they have no faith in the prospect.
Now, take the average of the ratings and multiple it by your projected sales. Use that result for the rest of your analysis. Believe it or not, that’s a valid statistical technique.
The most secure scenario is not to rely on increased sales, rather rely on eliminating costs. For instance, if the equipment will allow us to produce jobs without sending them out, then the cost of past buy outs (not their retail price), becomes the change in income.
We’ll pick up next month with calculating changes in costs.
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