Prioritizing Capital Expenditures
Most small businesses own fixed assets, which include items like land, buildings, equipment, and automobiles. The investments of adding, replacing, or improving upon fixed assets is called capital expenditures (capex).
It seems like there is never enough money for all the capital expenditures that need to be done in a business. To make the best spending decisions, the business owner needs to put processes in place for capex activities.
The first step is to make a list of all the capital projects you want to do. Here are some examples:
- Buy an additional truck for deliveries.
- Expand the warehouse space.
- Purchase a piece of equipment for the manufacturing line.
- Redo the dock area to improve loading efficiency.
Once you’ve made your list, you can begin to formalize your capital expenditure process. Each project should be detailed and estimated, with bids from vendors so that you have a very good idea of the cost.
The next step is the most important. What are the estimated savings for each project? In other words, what will your return on investment be? In capital expenditure spending, this answer is crucial. For each project, estimate the expected savings in time, money, and intangible benefits, and what the breakeven time will be.
This step can be extremely difficult because the savings might not be concrete. It could be that the benefit is improved customer service, which should result in future sales. In this case, you still need to estimate future sales. In most cases, it can take years for a capital expenditure to start paying off from a cash flow standpoint.
Now, make a summary table of your results.
|Truck||$40,000||Increases sales by $1,000 per week.
Marketing spending (non-capex) increases by $3,000/year.
Assume cash sale – if loan, figure interest expense.
|First year: $9,000 savings.
Second year savings: $49,000. Breakeven comes in second year.
|Increases sales capacity and reduces delivery times.|
|Redo the dock area||$20,000||Time saved – payroll costs decrease by 1/2 headcount. Savings of $27,000. If attrition used, defer savings.||First year savings: -$7,000. Second year savings: $27,000. Breakeven comes at end of second year.||Employee happiness, reduced turnover are intangibles.|
When deciding which project to do, return on investment is only one factor to consider. You must also consider employee satisfaction and turnover issues, customer service, capacity management, tax breaks, breakeven time, cash flow, lending limits and financial ratios, and other factors that might be specific to your industry.
The key is to have a process. If you don’t, you might off the top of your head say “let’s do the cheapest project first.” But it might not be the one with the highest return, which can cause cash flow and profitability issues down the road.
Taxes need to be considered, which have been left off of the above example. Especially if it’s just before year-end and you have high profits, December could be the best timing for a higher return on investment.
Another consideration is if you will need a loan to make these improvements. Interest rates have been rising, and these costs, plus your cash flow impact, need to be evaluated. As your debt increases, your financial ratios also need to be evaluated. You have to be careful not to go into too much debt overall.
Once you have documented all of these considerations, you can make a much better-informed decision on your capex spending and which project to do first. You might consider creating a capex committee to help you make a decision. Be sure to include your accounting advisor on the committee!
Three Processes for Capital Expenditures
You need three processes to properly evaluate capital projects:
- Initiation, estimating, and evaluating return on investment for each capex project.
- Prioritization – what gets done first?
- Managing and monitoring the projects once they have started.
We’ve talked about the first two; let’s talk about managing the project. You’ll want to appoint a project manager that can oversee the project’s progress and make any course corrections needed. Once the project is complete, set milestones so that you can see how accurate the estimates were of both costs and benefits. You might need to set milestones every year for several years in order to accurately measure actual return. Doing this will make you a better estimator in the future.
Spending at the right time on capex projects is surely still more art than science. Putting formal processes in place will improve your chances for a better return, smoother cash flow, and improved profits. And, since this is an incredibly complicated area, we are happy to step in and help with any of these capex processes, so feel free to give us a call.