Four Points to Ponder When Justifying the Purchase of Equipment
written by: N Nayab
• edited by: Jean Scheid
• updated: 7/27/2011
Those looking at how to write an equipment justification need to substantiate the need for the equipment, make a cost benefit analysis, list out any indirect benefits, and justify the selection of the particular equipment over alternatives.
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1. Substantiate the Need
Lean manufacturing advocates elimination of anything unnecessary. Otherwise, no business would spend needed cash on anything not absolutely required, even if such an investment might lead to a notional profit.
To justify the new equipment purchase, prove in clear-cut terms:
The circumstances for making the new equipment request. The requirement for new equipment may be owing to change of process or nature of work, increased workload on a sustainable basis, complete breakdown of existing equipment, or increased maintenance costs of existing equipment.
How not having the new equipment leads to inefficiency, waste, bottlenecks, poor quality, or other drawbacks.
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2. Perform a Cost Benefit Analysis
A cost benefit analysis is used to substantiate how investment in the new equipment will result in an overall cost savings. For instance, if old equipment rakes up too much maintenance costs, compare the cost of the new equipment to the monthly maintenance cost of the old equipment, to demonstrate the cost savings.
Business owners and managers consider the hurdle rate, or the minimum acceptable rate of return that the equipment would generate, in return for the risks and opportunity cost of the money invested. The hurdle rate depends on the source of the money. If the money comes from a bank loan, the hurdle rate factors in the rate of interest. If the money comes from internal accruals, the hurdle rate factors in the rate of return of an alternative investment. If the money comes from investors or stakeholders, the hurdle rate factors in a rate of return higher than what another project may offer.
When determining the cost benefit analysis factors, do so for both direct and indirect costs. For instance, when replacing equipment, consider direct costs such as cost of parts, labor, power, fuel, and maintenance time, vis-à-vis the same factors related to new equipment plus costs and interest rate for the investment made. Also, consider indirect costs such as the lost opportunity for more profits when the production halts as the old equipment is in maintenance.
When purchasing new equipment, consider the profits resultant from enhanced production or productivity per day or month with the new equipment against the purchase price and interest rate of the investment for the new equipment. Substantiate all cost analysis with evidence such as actual bills or invoices, estimates from suppliers or contractors, historical cost and time data, and more.
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3. Consider Indirect Benefits
A cost benefit analysis allows making a financial justification for the new equipment. At times, the benefits resultant from the new equipment may not easily be quantifiable or even apparent. For instance, performing a task manually or using equipment might not have much difference in time, cost, or quality. Equipment may, however, lead to less worker fatigue, leading to indirect benefits such as lesser HR costs, and lower costs related to absenteeism.
Include such indirect benefits in the new equipment justification. Such indirect benefits may very well act as a distorter and substantiate the purchase of equipment even when quantifiable or direct cost benefit analysis does not support the purchase.
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4. Run Down the Alternatives
Many equipment brands or models invariably provide the same benefits. In such scenarios, how do you write an equipment justification in favor of a particular brand of model?. Make a life cycle cost analysis of competing alternatives. A Life Cycle Cost Analysis is a subset of a cost-benefit analysis, and compares alternative equipment that fulfill the same requirements but have different upfront and operational costs.
Determine the following popular ratios for the alternatives:
Payback Period, or the time to recoup the cost of the equipment. This is cost of equipment divided by net annual savings resultant from using the equipment less annual operating expenses for the equipment. Payback period = cost of the equipment / (net savings resultant from using the equipment – operating and maintenance costs of the equipment for the period).
Simple Rate of Return, or the estimated saving as a percentage of the cost of the replacement. For instance, if equipment costs $1,000 and resultant annual savings is $250, the simple rate of return is 25 percent.
Net Present Value, or calculating the future savings in current value and deducting the same from the equipment cost price. This requires discounting interest and inflation from the cash flow savings resultant from the purchase of new equipment, and deducting the same from the purchase cost.
At times, some alternatives may actually cost less than the proposed equipment. Substantiate the reasons for selecting equipment that cost more. Possible reasons are:
Lower operating costs such as lower cost of supplies, low energy consumption and lower annual maintenance charges.
Lower Replacement Asset Value, the annual cost of maintenance expressed as a percentage of the total equipment value.
Reputed and reliable manufacturers to guarantee a trustworthy product.
Longer warranty period, and better after-service support that would ensure reliability and easy recovery from breakdowns.
Ready availability of the equipment, which may allow the company to make a head start in launching a new product.
Easy availability of equipment, or easy availability of spares in the eventuality of breakdown.
Ease of operating, allowing for better productivity or savings on training costs.
Special cases, such as the equipment manufacturer by one of the company’s subsidiaries, or the business owner holding considerable stocks in the equipment manufacturer’s stock.
Include comprehensive details of all alternatives, such as the equipment specifications, cost price, operating costs, purchase and service terms, maintenance schedules, and more. This provides clarity to the decision maker, allowing them to make a decision without referring to other sources for more complete information.
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"How to present a winning financially justification for new and replacement equipment." http://www.complianceonline.com/images/supportpages/500630/sample_03%20AssetMaintenanceSystems-Methods-Rev2.pdf. Retrieved July 24, 2011.
British Columbia Ministry of Children and Family Development. "Guidelines for Writing Justification Letters for Medical Equipment." http://www.mcf.gov.bc.ca/at_home/pdf/guidelines_writing_med_equip.pdf. Retrieved July 24, 2011.