Use Payback to Justify Equipment Purchases

admin August 7, 2016 Comments Off on Use Payback to Justify Equipment Purchases

Most business owners buy like consumers, not like businesses. They focus on wants, not needs and they don’t use the common payback method to justify equipment purchases.

Justify EquipmentLeast that’s what I was told by a major printing supplier late one night as we discussed the printing industry around a bar at a trade show. His point was we owners make investments based on feelings, not facts and we shouldn’t. I agree. That’s where we can get into really big trouble, for many times these major investments leave us cash poor.

As consumers we buy based largely on what we WANT; rather than what we NEED. We might want a new house but we need a dependable vehicle to get us to work which will allow us to make the money to pay for the house we really want.

Consumers focus on the payment. We use the Joe Girard theory. He was the world’s greatest car salesman. Seriously, Google him. His theory was that buyers didn’t care what the car cost; it was simply how much their payments would be. If I have a $1,000 payment “dropping off” and I haven’t gone bankrupt so far, then I can “afford” something else as long as the payment is less than $1,000. Wrong. You’ll never build real wealth that way.

Consumers justify in isolation. Our business version of that is we justify a new digital press or a delivery truck or a new building in isolation. That’s the most common mistake. Ours is a choice among alternatives, not just whether we can “make money” on one piece of equipment or the other. We should look at everything we “need” once or twice a year and choose among alternatives. There is never such a thing as an emergency equipment purchase.

Consumers can be stampeded. In sales, this is giving the customer a reason to buy largely by offering a deadline. This deal is good only until the end of the month. In business, my favorite is when we self-impose a deadline based on the salesperson’s needs. Deal ends on the 15th because the salesperson is in a contest and has to have the signed contract by then in order to get the trip to Hawaii. Just because it’s the salesperson’s problem, doesn’t make it our problem.

Most important to us:

We often rely on sellers to tell us what we need. I’ve often been hit with an “emergency equipment purchases.” I learned to ask how the need for the purchase was identified. Did the business owner study all their needs at one time and then decide on it? Or, more commonly, did a salesperson bring them this deal which solves a need they may not have realized they needed in the first place? Often business owners are stampeded if we’re told our competitor is going to buy a thingamajig and get a competitive advantage over us.

On the flip side justifying purchases can be too complex

Some make this justification thing too complicated. If you don’t believe me, look up the DuPont Theory of Return on Investment also known as the DuPont Analysis. Or take a peek at present and future values.

http://www.investopedia.com/exam-guide/cfa-level-1/financial-ratios/return-equity-dupont-system.asp

So, what should we do?

1. Determine if you can afford to invest in equipment

This is a Balance Sheet calculation. The biggest need of any business is to maintain a 2:1 current ratio and 30 days’ cash on hand. After all, businesses go out of business when their current ratio drops too low. So, regardless of how much an equipment investment could make you; it will do you no good if you go out of business before you can make it.

Calculate the Current Ratio by dividing the Current Assets on your Balance Sheet (cash and other assets that will turn into cash within the next 12 months) and dividing it by your Current Liabilities (stuff that will require cash in the next 12 months such as accounts payable, taxes as well as the next 12 months’ worth of payments) which will give you a number such as 2:1, 1:1 or, worse, 0.5:1. If it’s less than 2:1 then you shouldn’t be worried about making additional equipment investments, rather you should focus on building your working capital (current assets – current liabilities). But that’s another article.

For more information on Cash on Hand, see http://cprint.com/how-much-cash/

Okay, assume your current ratio and cash on hand is good.

NOW USE PAYBACK

The Payback Method is most useful for those who have little rather than a lot of money to invest, which is most of us. It’s also less complex from a math standpoint and is more easily understood.

2. List all of your NEEDS

Review all your needs at one sitting. Go ahead. Develop a wish list. A well-disciplined owner would do this at set times, say January and July. Focus on your NEEDS, not your WANTS. Also, while you could use the process in deciding whether or not you need to purchase fire extinguishers, focus on larger dollar items. Fire extinguishers and such are in the “no brainer” category.

Complete the sentence, “I NEED to have the following things in order to make more money.”

Then list your needs which can include software, buildings or even other things such as hiring more people. Investing in hiring people using payback is an advanced topic beyond this article so we’ll focus on more mundane things here. Just know that it can be used once you have these concepts down.

If it’s a WANT, then seriously consider not ever getting it. I want a bigger press, an impressive building or to hire more people because it will make me look better among my fellow printers whom I’m trying to impress. You can live without all that.

Don’t overlook existing equipment! A common misstep is to focus only on NEW investments. Look around and place any existing equipment (software, etc.) on the list as well. I’ll show you how to factor that a little further down.

Okay, cut your list down to a practical three or four choices right now. The ones that are obvious to you. Remember, you’re doing this every six months or so therefore you can come back to those that aren’t as immediate later.

BTW it is because you sit down in a calm environment and review your needs twice a year or so that gives rise to my claim that’s there’s not such a thing as “emergency equipment purchases.”

Then continue the following steps with each of the items on your slimmed down list.

3. Identify the Total Cost of each purchase

It’s more than just the list price. How about installation, wiring, training time, or an increase in inventory to support the equipment? Be honest with yourself and list as many costs that you can foresee. Total them up for each of the potential investments.

If it’s heavy equipment, don’t overlook the obvious. Is the flooring strong enough to support it? Have run into three instances where this was a big issue.

4. Identify Marginal Contribution

Marginal means change. Marginal Revenue (sales) minus Marginal Costs equals Marginal Contribution.

Think of your checkbook. If I make this purchase it will put how much cash in your checking account during a period (usually a year, but it could be monthly). Now how much money will go out of my checkbook during this period because I made this purchase? One would be your payment but don’t forget the amount of direct material costs in order to create the sales dollars that will go into the checking account.

The difference between what we anticipate to go into our checkbook (Marginal Revenue) minus what we anticipate to go out (Marginal Costs) equals the amount that adds to our cash (Marginal Revenue).

Now, Marginal Revenue is where we make our worst assumptions. This isn’t just a guess. To whom will you sell the product/service? How do you know? Firm it up by asking the potential customers. Get it down to dollars. Secure it if you can as in getting a contract. Importantly, how will the customers know of the new capacity? If you say, “Of course we will have to sell it,” then how’s your selling performance now? Be honest because it’s your future riding on it.

Now do one thing more. Use a “Committee of Executive Opinion.” That’s a fancy name for explaining what you intend to do to a group of people knowledgeable about you, your performance and the industry. Lay out your plan and ask each one to give you their estimate of how probable this is: from 0% to 100%. Zero means they think you don’t have a chance in doing this and 100%, of course, means that they are completely confident. Their responses will probably be somewhere in between.

Once you get the probabilities, average them. Then multiply the resulting percentage times your original dollar estimate. This is a common and statistically valid technique that will come closer to your eventual revenue. Use that number in your revenue calculation.

Yeah, butta.

What if I’m buying out $5,000 worth of services? If I buy this equipment, then can I use the $5,000 as my Marginal Revenue? Absolutely and this is a much more secure way of justifying equipment than relying on an estimate of increased sales.

However, beware of hard-wiring expenses.

The advantage of buying out products/services for resale is that you only incur the costs when you secure the order. By purchasing the equipment to do the jobs, you may reduce your cost of the outside purchases from $5,000 to $2,000 but the $2,000 is hard-wired.

That means you have the $2,000 worth of expenses every month whether you sell anything or not. So be cautious here that the outside purchases are not just sporadic and that they have staying power.

Existing Equipment

How in the world do you put a Marginal Revenue number on a piece of equipment that’s already in service? Say you want to consider replacing a cutter in your decision mix. This is probably the easiest to identify.

Just answer this question. How much revenue would you lose today (or couldn’t sell) if you didn’t have that piece of equipment now? Very often we find that replacing existing yet potentially.

As an example, an offset shop was putting all their investments into digital do-dads but overlooked the fact that their offset plate making system was on its last legs. Offset revenue at the time was still 70% of total sales and should they have pulled the platemaker out of the mix; 70% of their revenue couldn’t be produced. It was a no-brainer.

5. Identify Payback Period

Divide the Total Cost of the investment by the Marginal Contribution and get the Payback period. If the total cost is $200,000 and our Marginal Contribution is $80,000 per year; then our payback period is 2.5 or two and one-half years or thirty months.

Do this with all of your potential investments identified in step two, above.

BTW don’t be surprised if your investment may have a very SHORT repayment period such as months rather than years. Often this indicates we’ve been focused on expansion or doing what we’ve never done before rather than replacing our aging equipment.

6. Compare Alternatives

Now compare. Let’s say our results look something like the following.

Alternative A: $200,000 total cost, $80,000 contribution; and 2.5 years’ payback

Alternative B: $50,000 total cost, $30,000 contribution; and 1.6 years’ payback (20 months)

Which would you choose? Hopefully it’s Alternative B.

Alternative B has the two things we look for the most when evaluating alternatives. It has the shortest payback period, of course. But there’s also one other thing going for it. It’s the least risky. How do we know? Well, what’s riskier? Risking $200,000 or risking $50,000. It’s $50,000 for, if we lose, we’ve lost less money.

Also, regarding risk, diversification is much riskier than expansion. In other words, buying equipment to do more of what you’re doing now is less risker than buying equipment to do something you’ve never done before.

Finally, one other concept to consider

If you do this analysis periodically, and choose Alternative B, then you pay $50,000 out of your checkbook today but get it back in 1.6 years. Once you’ve done that, you’re ready to make the next choice which maybe Alternative A assuming no other alternatives have come up in the meantime.

And that’s a short version of using Payback to justify equipment purchases.

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We affordably work with numerous printers throughout the United States on a weekly basis to help them improve their business and specifically work on increasing cash where necessary, as well as many other issues such as personnel, business to business sales, organizing so everything gets done and good old “time management.” If you’d like to know more and see if CPrint Gold would be of help to your business, email me at tom@cprint.com and let’s chat.

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Happy Trails,

Tom Crouser

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