Decisions about when and how much to invest in new equipment, property, vehicles, land, or technology, also known as capital expenditures or ‘CapEx,’ are critical aspects of running a business.
Capital-intensive industries like manufacturing, utilities, and telecommunications often have higher capital expenditures, hence the need for a thoughtful CapEx budget.
Ultimately, well-planned CapEx allows a business to pursue larger orders instead of missing out due to a lack of capacity or investment.
The dilemma is “when what and how much” – is “now” the right time? Is this the right equipment to buy? Does it make sense to purchase a new plant this year? Can the business afford it, and what happens if you don’t make the purchase now?
Investing in new equipment and updated technology can make a capital-intensive organization more efficient and profitable and may help to gain a competitive edge in a market over businesses that operate with older, slower systems.
On the other hand, capital expenditures are a source of risk and may not produce an immediate payoff or generate a return. New equipment or software tools require training, and additional capacity is a waste of money if the business doesn’t achieve an increase in orders.
Manufacturing executives that lack a robust process for analyzing their cash needs to support ongoing operations may overspend on CapEx, causing a liquidity crisis that may require deep cost-cutting, leading to other business problems.
And, if the economy slows, it may become difficult to pay for the new equipment with internally generated cash flow or to service a loan if the debt was used to help make the purchase. Overspending on CapEx often fails to deliver an adequate return on investment.
How can business owners make wise choices for CapEx, making investments in the business that is effective and financially sound?
In this post, we describe six steps to improving your CapEx budget process so that you can balance the goals of staying competitive while keeping the business cash flow positive. Let’s get started.
1. Decide what assets to include in your CapEx budget by focusing on long-term goals
To help focus on long-term planning, begin by envisioning where your business will be in two to three years, then list the types of assets required to help you get there. Remember, this is a different process than creating an operating budget that addresses monthly (or operating) expenses.
There are several areas to consider when planning your long-term CapEx budget. CapEx assets can be anything from new equipment to expand capacity to a new software system to better manage inventory.
Types of CapEx can include:
- Equipment and Machinery
- Buildings or Storage Space
- Computers and Servers
2. Justify each item with specific metrics
After you've determined what CapEx assets you will need to reach your long-term business goals, the next step is to defend each item based on longer-term (yet realistic) objectives, not just your needs for the next 12 months.
For example- are you considering buying new equipment to double capacity, even if your market only grows by 7-8% annually?
Link each item on your list with measurable, quantifiable goals. For example: "This new equipment will allow us to increase capacity by x% using our existing workforce," or "we will be able to expand our ABC product Line, increasing revenues by Z% in the mid-Atlantic region."
Remember that in many cases, robust deployment of CapEx assets can lead to improved customer satisfaction and retention.
Assessing each expense with tangible KPIs will also help your organization thrive in the long run, e.g., "we will reduce defects by x% so that we can reduce customer complaints by y% and reduce refunds by z%.
3. Include all associated costs and benefits
Building on steps one and two of your CapEx budget is the long-term cost of your CapEx budget item- as the actual cost of the asset is always more than the purchase price of the item itself.
There are indirect costs (perhaps a yearly maintenance contract, new training requirements for employees, or expanded IT needs), as well as opportunity costs – you may have to suspend production while new equipment is being installed and switching to a new software platform or ERP may result in disruptive downtime.
On the positive side, many CapEx assets may have knock-on benefits – a CapEx item intended to reduce product defects and improve customer service may also increase employee satisfaction, reduce turnover, and improve customer acquisition.
4. Go back to the principles of corporate finance
As the CEO, you should always know the true cost and ROI of your capital. CapEx is an investment you make in your business, and it should offer a positive “net present value,” or it doesn’t make sense to go forward.
While many businesses use a simple concept of a payback period (how long it will take for this investment to generate net cash flow that equals its costs), a more defendable approach is to assess whether a capital expenditure item offers a positive net present value to your business.
In other words, you should expect to earn a return on your CapEx, taking into account the new cash flows it generates in the future minus the cash outflows (upfront and ongoing) associated with the item, discounted at the cost of the capital you use to buy it.
5. Analyze alternatives
Remember that there is always more than one way to accomplish a goal. Before you emotionally commit to a specific piece of equipment or new software package, put down the glossy brochures from the trade shows and brainstorm at least one alternative to what you think is the best approach to achieve the objective.
Remember, 'Business As Usual' is almost always an alternative – what would be the cost of continuing what you’ve been doing? That may be so “expensive” in terms of lost business, inefficiencies, and repairs that spending on CapEx becomes less “expensive” than initially thought.
6. Measure success after the fact
Lastly, don’t invest in CapEx just because you can. Take the time to do a thorough analysis that shows your capital expenditures will generate an adequate ROI for your business.
Capex should lead the way in reducing labor costs through automation, expanding your product offerings, addressing regulatory requirements, and improving product quality. Therefore, it is critical to analyze whether or not the item is delivering the benefits you had included in your cost-benefit analysis.
Make sure your management team is held accountable for monitoring the effectiveness of a new piece of equipment or system.
If the CapEx asset is not performing as intended, find out why – do your employees need more training? Is there a feature you need the vendor to modify to make it work for your particular situation?
Remember that capital expenditures should not just be limited to replacing irreparable equipment– that point of view limits growth opportunities. New equipment and capital expenditures should do more than maintain your business “as is”; they should be used strategically to elevate your business.
If you’re not sure how best to approach these analyses, G-Squared Partners can help.
Contact us for a no-obligation discussion about how we can help your business take these six important steps.