Buy that Hummer and write 69% off this year!!! Don’t need a Hummer? Buy that $100,000 computer-operated saw you always wanted. Heck, it doesn’t really matter what you buy, just buy that equipment now!
Have you recently heard statements like those above? If you have a CPA, chances are you’ve at least been advised to purchase fixed assets just before year-end. If you were in the oil and gas exploration business twenty years ago, chances are you heard the “it doesn’t matter” part.
For that matter, if you look at our year-end planning techniques you’ll see some of the foregoing advice there. You’ll also see our opinion that you should never, repeat never, do anything simply for tax savings. If a venture doesn’t make business sense, there’s no reason to do it.
In our tax article this month, we told a story about a business owner who put a lot of money into a new plant. Do you think this person was just looking for a write-off? Of course not, he built the new plant because he expected to make money off of it. He employed a decision making process that made him conclude his investment would pay off, but what steps did he take? For that matter, what steps do you take when you decide to purchase fixed assets?
Are you an impulsive buyer? Come on, you can be honest with yourself. Do you decide today that you need that new computer or drill press and order it tomorrow? Are you the planning type? If so, you probably start from projected demand for your service or product and work backwards to figure out how you will meet that demand.
Chances are, you’re a little of both, depending on the cost and use of the equipment you are buying. Unfortunately, we can’t tell you how to make a “wise” impulse purchase, but we can give you a road map for making the best decision you can when you plan your purchase.
Your first step should be an assessment of your needs and your wants. Needs are generally determined based on objective factors like projected future demand for your product or your organization’s needs for controlling the business. Wants are more subjective being based on your own personal preferences and not necessarily functionality.
Assuming the equipment you need is production equipment, you should start with taking a look at past sales trends and, combined with current industry and economic conditions, project future demand. When you do this, though, don’t just look at expected unit demand, but look at your expected sales price and production cost – including the per unit cost of equipment. Your best bet is to prepare a mini-income statement that projects the net income generated by your proposed expansion. Don’t forget the operating costs of the new equipment versus old equipment, additional property taxes, added repair costs and any other operational costs associated with the new equipment. If this is an expansion of capability, your resulting net income will simply be an increase to past income. If you are replacing equipment, don’t forget to remove the costs of the old equipment. What you are looking for is the net increase in your company’s income.
So, how do you decide whether the dollars make sense? If the net result is a $1 increase in the bottom line, does this justify the effort you will put out in executing your plan?
Of course not, you need some measure to tell you if you are getting a good return. Probably the best option here is to calculate the project’s internal rate of return or IRR. Simply put, the IRR is the percentage rate that will allow you to reduce the present value of net income to be generated off of an investment in equipment to an amount that will offset the entire cost of the project.
For example, if you produce a net income of $100,000 per year off of a $1 million investment for 20 years, what is the rate of return on your investment? Don’t worry if you forgot the formula to solve the problem, there are numerous programs that will assist you in calculating IRR. You only need to estimate the future cash flows and cost of the project.
In our example, the actual return works out to be approximately 7.75%. Is this a good enough return for your investment and risk? If so, then you go to the next step, which is locating the necessary equipment and, if necessary, financing. If 7.75% isn’t sufficient, you put off the expansion until it makes more sense.
Assuming you move forward with the project, first you search for the facilities and equipment you need. This can be the most time consuming part of the project. If you have only one supplier for the equipment, determining timing and availability of the equipment you need is simple. You tell the manufacturer what you need and when you need it, they tell you what they can do and you settle for what they can do.
If there are multiple suppliers for the equipment and/or facilities that you need, plan on spending a great deal of time. To minimize the time, we suggest you prepare a detailed set of specifications for the project components and ask each supplier for a quote. Not only does this have the advantage of maximizing comparison of the proposals, but it also keeps you from enduring long telephone calls with salespersons.
Once you have received the quotes from potential suppliers, you should be in a good position to make the best possible choice in purchasing your new equipment. There will, of course, be many other steps such as making the decision to buy or lease, how you will finance the deal and a million other details, but you will have the most important part of the project on firm footing – you will know that you are acquiring the best possible facilities and equipment for your business.
Are you having trouble keeping up with demand? Does it seem that business is slipping through your fingers because you can’t supply the customer? Are you paying too much overtime to produce your product? If you have any of these questions, why not give us a call. The trained professionals in our firm can assist you in making the right decision for your business. We’re here to help, give us a call.
Have a great March!