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Critical Steps & Analysis on a Capital Expenditure

written by: Ian Johnson • edited by: Michele McDonough • updated: 5/22/2011

When companies look to increase their production capacity, it involves analyzing the benefits of a machine or equipment purchase. What's involved and how can a company ensure the decision to move forward on the capital expenditure is the right one?

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    Increase Production Capacity Wtih the Right Equipment

    As companies grow, they often come face to face with the decision of whether or not to move forward on a capital expenditure. In every instance it involves improving efficiency and business capabilities. However, what are the critical steps to analyzing a go/no-go on a machine or equipment purchase?

    Deciding to move forward on a purchase must involve an understanding of the costs to operate the machine itself, its reputation for quality and its resale value. Afterwards, the process involves establishing criteria for evaluation as to the overall benefit of the purchase. To make this example relevant, we’ll analyze it from the perspective of a manufacturer who needs to purchase machinery to increase their production capacity. First, we'll review the importance of establishing the costs of ownership, as well as assessing the quality and resale value of the equipment.

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    Costs to Operate Machinery

    MorgueFile: imelenchon As surprising as it may seem, a number of companies move forward on a capital expenditure without first analyzing the costs to operate the machinery. The costs to operate are relative to upkeep & maintenance. This includes both consumables needed to operate the machine and its spare parts. Each of these plays a vital role in the overall cost of ownership. To make this analysis as complete as possible, we’ll provide these costs below and then use them later in our total assessment of the purchase.

    • Costs of consumables: $6,000.00 per year
    • Costs of spare parts: $3,000.00 per year
    • Additional costs of electricity, miscellaneous costs: $840.00/year
    • Total cost of ownership: $9,840.00/year
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    Review Reputation for Quality & Resale Value

    A company could do everything right in their analysis and still be faced with the need to resell that equipment. Understanding the machinery’s reputation for quality and resale value is an essential step in deciding whether or not to move forward. This information can be gathered from the market itself, competitors and complementary markets using the machinery.

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    What are the Benefits of the Purchase?

    While understanding the machinery’s reputation and resale value is important, it’s far more important to review the benefits of the purchase. In this instance, we’ll continue with our example of a company that needs to purchase machinery to increase production capacity.

    Let’s assume the manufacturer has consistent demand for its products, but has a hard time meeting demand with its current capacity. It is encountering too much overtime and this is eating away at the company’s gross profit. Therefore, it needs the machinery to increase production capacity and to lower its cycle times in manufacturing. So, what are the steps needed to perform the analysis?

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    1. Assess Current Capacity & Summarize Gross Profit

    For any analysis to be relevant, it involves taking an assessment of the current conditions. The company currently has a cycle time in manufacturing of 10 minutes. They produce 6 units every hour and 30 units per 5 hour shift. The product has a gross profit of $9.00/unit and the company generates $270.00 of profit during a given shift (9.00/unit x 30 units).

    • Cycle time: 10 minutes
    • Units per hour: 6 units
    • Total per shift: 30 units
    • Gross profit per unit: $9.00
    • Gross profit per shift: $270.00
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    2. Assess Increase in Capacity & Impact of Lower Cycle Times

    The machinery will allow the company to reduce its cycle times in production by 25%. So, what does this decrease in cycle times mean to the company in terms of additional units produced and additional gross profit? Well, that 25% means the cycle times will go from 10 minutes to 7.5 minutes and will allow the company to produce 2 additional units per hour. Their new total produced per hour will be 8 units. The production increase means the company now manufactures 40 units per shift (8 units x 5 hours). However, the most important aspect of this increase is the increase in gross profit. Producing 2 additional units an hour, at the same labor rate, will increase gross profit. While calculating gross profit can be quite involved, we’ll assume gross profit increases to $9.50 per unit.

    • Cycle time: 7 minutes and 30 seconds
    • Units per hour: 8 units
    • Total per shift: 40
    • Gross profit per unit: $9.50
    • Gross profit per shift: $380.00
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    3. Summarize Net Gross Profit & Capacity Increase

    When it comes to analyzing the merits of a capital expenditure, every comparison needs to have a basis to start from, and taking the current production capacity from step 1 and comparing it to step 2, will provide an overall benefit of the increased production capacity and the net gross profit generated. In this case, it involves taking the new gross profit per shift of $380.00 (from step 2) and deducting from the original gross profit per shift of $270.00 (from step 1). Here are the benefits summarized below in point form.

    • Gross profit per shift increased by $110.00
    • The company lowered its cycle times & increased production throughput
    • They increased their gross profit

    Is this all there is, or is there more?

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    Total Assessment of Purchase

    In order to seal the deal on this purchase, the company must assess the overall benefit of the purchase relative to the cost of ownership. In this example, the company runs 3 shifts a day, 5 days a week. Therefore, they produce an extra 30 units and $330.00 a day in gross profit.

    Was it a good purchase? Well, it’s never as simple as just looking at the increase in gross profit. It amounts to working backwards to ensure it’s the right decision.

    • Establish the yearly increase in production capacity: 30 units/day x 260 days = 7,800 additional units

    • Establish the yearly additional gross profit: $330.00/day x 260 production days = $85,800.00

    • Deduct yearly cost of ownership from gross profit: $85,800.00 - $9,840.00/year = $75,960.00

    • Determine new gross profit per unit by taking above total and dividing it by increased capacity: $75,960.00 / 7,800 = $9.73 gross profit per unit

    While there are plenty of numbers and calculations in this article, it's important to remember that the approach is fairly simple. Analyzing the pros and cons on a capital expenditure for production involves understanding the current production capacity with its cycle times and gross profit, and determining what the increase in production capacity will be from purchasing the equipment. Start with assessing current production levels and determining future production levels. Afterwards, it's simply a case of making sure it all makes sense.

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