Decisions about when and how much to invest in new equipment, property, or software systems, also known as capital expenditures or ‘CapEx,’ are a critical aspect of running a business. CapEx often determines whether production schedules are met, or workers are waiting around for repairs to be made to outdated equipment. Well-planned CapEx allows a business to pursue larger orders instead of missing out due to a lack of capacity.
The dilemma is “when, what and how much” – is “now” the right time? Is this the right equipment to buy? 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 manufacturing business 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 at all. New equipment and 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. This can cause a liquidity crisis that may require deep cost-cutting, which can lead to other problems for the business. 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 debt was used to help make the purchase. Overspending on CapEx often fails to deliver an adequate return on investment.
How to Make Smart CapEx Choices
How can business owners make wise choices for CapEx, making investments in the business that are effective and financially sound? In this post, we describe six steps to improving your capital budgeting process so that you can balance the goals of staying competitive while keeping the business cash flow positive. Let’s get started.
- Decide what types of things to include in your CapEx budget by focusing on long-term goals. This is a different process than creating an operating budget that addresses monthly expenses. Envision where you want your business to be in two to three years, then list the types of equipment and technology you need to help you get there. That could be new equipment to expand capacity, or a software system to better manage inventory, or automation tools.
- Justify each item with specific metrics. Defend each item based on longer-term but realistic objectives, not just your needs for the next 12 months or so. Are you considering buying new equipment to double capacity, even if your market is only growing 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.” CapEx may also be linked to improving customer satisfaction and retention but again, this should be based on quantifiable goals, e.g. “we will reduce defects by X% so that we can reduce customer complaints by Y% and curtail refunds by Z%.”
- Include all associated costs and benefits. The cost of a CapEx budget item is 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 is never pain-free. There may also be knock-on benefits – a CapEx item intended to reduce product defects and improving customer service may also increase employee satisfaction and reduce turnover.
- Go back to the principles of corporate finance – 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 new piece of equipment or other 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 into 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. Know your cost of capital – that includes the ROI you, as the business owner, expect.
- Analyze alternatives. There is usually more than one way to accomplish a goal. Before you emotionally commit to a specific piece of equipment, put down the glossy brochures from the trade shows and brainstorm at least one alternative to what you currently 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 what you originally thought.
- Measure success after the fact. Make sure your management team is held accountable for monitoring the effectiveness of a new piece of equipment or system. Analyze whether or not the item is delivering the benefits you had included in your cost-benefit analysis. If not, 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?
Capital expenditures should not just be limited to replacing old equipment that cannot be repaired – that point of view limits growth opportunities. New equipment should do more than maintain your business “as is”. Capex should lead the way to reducing labor costs through automation, expanding your product offerings, addressing regulatory requirements and/or improving product quality. 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.
If you’re not sure how best to approach these analyses, that’s where G-Squared’s outsourced CFO services come in. Contact us for a no-obligation discussion about how we can help your business take these six important steps.