Evaluating Capital Budgeting Proposals (#144)
/In this podcast episode, we discuss a number of ways to reduce the investment in new fixed assets. Key points made are noted below.
This episode is about evaluating capital budgeting proposals. This is when someone wants to spend a lot of money on a fixed asset, like production equipment. The traditional way to do this is to make a guess at the cash flows that relate to a proposed purchase – both cash in and cash out. And then you discount all of those cash flows to the current period, and you buy it if the net present value is positive. I have some issues with net present value analysis, and that may be a topic for another episode. But for now, I’m going to talk about some other ways to evaluate these proposals.
The Bottleneck Analysis
One of them I talked about way back in Episode 45. That was about focusing your investments on bottleneck operations, so that you increase capacity only where it’s really needed. It’s a good topic, and I encourage you to go back and listen to that episode. But there are some other issues to consider, too.
Before I start in on these items, please keep in mind that what I’m going to suggest might be considered somewhat intrusive to the person submitting the proposal – because you’re going to essentially be suggesting that they reconsider what they want to buy.
Avoid Customization
For example, you can try to avoid asset customization. This means someone wants to buy equipment that been heavily customized. And they have a good reason, which is that custom equipment will be more efficient for the company. But that also means you may have to pay extra for custom spare parts, and it may be more difficult to maintain, and there may be no aftermarket for it if you want to sell it someday. This can be a tough battle, but you need to have managers look at the total life cycle cost of customized assets.
Reduce Features
As another example, what about reducing the number of features that come with a new asset? People love to buy the latest and greatest, but the greatest, with all of those extra features, is also more expensive. So if there’s old equipment being replaced by the latest and greatest, you could talk to the users and find out which features they’re actually using. Chances are, you don’t need everything, and you might be able to buy the next version down. Now, what if the manufacturer only offers one model? If it’s expensive equipment, you could call them up and see if they’ll strip off some accessories in exchange for a lower price. They might say no, but they also might say yes.
Buy Used Equipment
Here’s a third item. I just mentioned buying the latest and greatest, and was a little disparaging about buying the greatest assets. Now – let’s also be disparaging about buying the latest assets. There’s quite a good secondary market for all kinds of fixed assets, so you may spend a lot less buying second hand, and still get a lot of use out of what you buy. Some companies even ramp up their fixed asset purchases during a downturn in the economy, because they know that’s the best time to buy used equipment. In short, you might want to have a mindset that’s not to buy the latest and greatest, but instead to buy the oldest and least.
Buy in Bulk
OK, here’s a fourth item. What about always buying the same piece of equipment? Not just the same general type of asset, but the same asset. This means you can buy equipment in volume to save money, and you can stock fewer spare parts, because they’re all for the same equipment. And on top of that, the maintenance staff becomes very good at repairing the same machine all over the company. Of course, competitive bidding goes away, but there really are a lot of benefits to standardization.
Avoid Monument Assets
Next up is the monument. Other than the Washington monument or the pyramids, what I’m talking about is a large and expensive asset – usually pretty heavily automated – that everything else in the production area is designed to support. These things are super efficient, but the trouble is that there’s usually only one of them, so when it goes down, the entire facility stops working.
Even if engineering managers the world over are in love with their monuments, it’s worthwhile to talk about buying a couple of smaller and less efficient machines instead. That way, if one goes down, the company can still operate through the other one – or two, or three. And also, smaller units tend to be less complex, and so they break down less.
Extend the Asset Life
And my final point is to see if existing equipment can be extended a little longer. Sometimes the industrial engineering staff wants to replace equipment just because the manufacturer’s recommended life span has now been reached. But what if the machine is still operational most of the time, and it operates within specs, and its maintenance records look pretty good? Chances are, you can delay a replacement purchase for a while.
Parting Thoughts
Now, all of these suggestions are really pretty logical, but it’s surprising how much of a buzz saw you can run into in the way of resistance. I think the main trouble is that the administrative people are expected to just look at the numbers, run their calculations, and either say yes or no.
By asking these extra questions and really digging into a purchase proposal, it’s almost like you’re calling their competence into question. And that’s just not the case. What you are doing is exploring all of the options, so the business spends less money on equipment, or at least it spends the money more intelligently.
Still, it can take some smooth talking to get someone to seriously reconsider what they want to buy. But given the amount of money involved, it could be worth a try.