Mass production continues to be the basic manufacturing tool for discrete product assemblers. Today's business environment requires accelerating capital investment to obtain greater productivity at lower unit cost, but it also requires that capital investments satisfy increasingly stringent demands for a profitable return.

There has been a decided shift away from the theory that a capital investment program consists only of replacing worn-out machinery. No longer are we preoccupied primarily with only the physical life span of equipment in considering capital investments. Today we opt for modern machinery and equipment capable of producing high-quality products at lower cost with less waste.

To budget for capital equipment investments intelligently, it is necessary to consider long-range objectives, future advancements in manufacturing technology and plans for new product introductions, as well as any other factors unique to the individual company. These considerations must include the effects on dilution of equity, reduced earning from heavy amortization in the early years and the length of time it will take for earnings to justify the new equipment. It should not be overlooked that product research and development programs stimulate capital investment, both to replace existing machinery and to acquire new and more productive machinery.

Forecasting Returns

Capital equipment is what financial people call a noncurrent asset, meaning it is capitalized and depreciated over the length of its productive life. Capital equipment is also considered an investment that is directly related to the generation of profit. There is a direct correlation between capital equipment and the cost of production.

Capital equipment is typically defined as an individual piece of equipment with a useful life of more than 2 years and, in the case of state or federally funded projects, with an acquisition cost of $5,000 or more. Equipment costing less than $5,000 for state or federally funded projects is considered a supply item.

How should a capital budget analyst go about forecasting the future cash returns from a prospective investment in capital equipment? From the standpoint of practicing capital budget analysis, the preparation of accurate forecasts of future returns from investment in capital equipment represents a key element in any successful capital investment program.

Forecasting the future returns from a capital equipment investment must begin with a forecast of the future rate of return that the firm will realize on the cash, receivables, inventories and fixed assets in the line of activity to which the capital equipment relates. For example, in the case of proposed expenditures for cost reduction equipment, one needs to forecast the future rate of return, which the firm will realize on the entire asset investment in the product line. This forecast involves estimating the future savings that will be realized in labor, material and other costs for some forecasted level of future output.

When to Buy?

Budgeting for new capital equipment involves pondering questions ranging from whether the company can afford to add debt, whether existing equipment should be sold to offset part of the cost, whether the market served will support the acquisition, and even whether the economy itself will remain strong. So examining the feasibility of adding new equipment is a prerequisite to setting a budget for the equipment.

The bottom-line requirement is to ensure a positive return on the capital equipment investment. Probably the most favorable situation is where serving the current customer base requires the additional capacity. Expanding the market served, either locally or farther out geographically, typically requires additional capacity and, managed properly, the resultant market growth offers a positive return on the investment. Analyzing the growth of various revenue channels from the existing customer base, and the potential for additional growth from new customers, yields valuable information to help decide the timing of capital equipment investments.

For contract manufacturers, a new contract will often determine the timing of a capital equipment acquisition. Contract work can justify new equipment, but there are other factors to consider. First and foremost is the duration of the contract. It is extremely difficult to justify new capital equipment if the contract work does not cross over into the main business focus, especially if the contract is for only 1 to 2 years. If the contract is set up for multiple years with options to extend it even further, then it becomes easier to justify the capital expenditure.

How to Buy

Purchasing capital equipment is different from other types of purchasing undertaken in an organization. There is a direct correlation between capital equipment and the costs of production.

It is crucial to remember that the total cost of a piece of capital equipment includes the costs of operating and maintaining the machine during its productive life. This lifetime cost may be much greater than the purchase price. That is why the purchasing of capital equipment requires the skillful estimation of future operation and maintenance costs.

Companies buy capital equipment much less frequently than expensed items. Major capital equipment items typically have long lead times and are expensive to design and build. While there are some off-the-shelf capital equipment items, these are the exception. A long lead-time puts a premium on the ability of a purchasing department to select suppliers and negotiate mutually advantageous partnerships with them. Another critical issue is spare parts, their cost and lead times.

Once the feasibility of the capital equipment acquisition is determined, it's time to research potential equipment vendors. The process is straightforward, beginning with specifications of need, proceeding to requests for quotations, identifying and visiting the vendors with quotes that match your needs, negotiating terms, and ending by awarding a contract. Don't overlook the importance of conducting production tests in the vendor's plant, using your parts, before accepting the equipment and authorizing shipment.

Financing Options

The most used option for financing capital equipment is probably borrowing the funds from a bank or other financial institution, preferably one familiar with the manufacturing industry. And aside from financing, the most common alternative to writing a check from the company treasury is to lease the equipment, with or without an option to ultimately buy the equipment outright.

If equipment is financed with a standard loan through a bank unfamiliar with the industry, the lending institution may expect the borrower to secure the loan with other assets within the company. On the other hand, a financial institution familiar with the industry will usually use the equipment itself as collateral. This is possible because of their knowledge of the industry and the network available to them to help sell used equipment.

Another advantage of working with an industry finance company is the flexibility of looking at other financing options that may not be available with a bank. These include a loan that has step-up payments over the first few months as the business increases on the new equipment. This is especially helpful if you are expanding your business with services you never have offered in the past. It will take a while to educate your customers that you now have this service available if you have never offered it in the past. You can also negotiate a balloon payment at the end of the loan that, again, can help keep the payments down as you increase the work on the new equipment.

Leasing is an often overlooked but quite viable option for acquiring new capital equipment. Leasing provides an enormous amount of flexibility, with options such as low initial payments that increase throughout the term of the lease, balloon payments, and even seasonal payments where you pay more during the time period when the equipment is being used the most. This may apply with contract work that hits one or two times during the year. Leasing also allows acquiring new capital equipment with a very small cash outlay. In most cases, there is no down payment necessary as there is with a loan. In addition, if the lease is structured properly, you may be able to deduct the lease payment as a current operating expense for income tax purposes.

The major disadvantage of equipment leasing is that in the long run the overall cost of a lease can be more expensive than other types of financing. And, because you are basically renting the equipment, you do not build equity in the asset as you would by purchasing the equipment outright unless an option to buy is included as part of the lease agreement.

This article is condensed from a paper written by the author while he was a candidate for a master's degree in industrial engineering at the University of Houston. The complete paper can be found at www.uh.edu/~mrana/definition1.htm.