Case Study:
Case of Equipment
Justification, Part III
By Tom Crouser
Senior Contributing Editor
Tom Crouser is senior contributing
editor, chairman of CPrint
International, and principal of
Crouser & Associates, Inc. You can
reach him at 304/541-3714, connect
on Facebook and LinkedIn and
follow his business tweets on
Twitter @tomcrouser.
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Last month we reviewed developing the
total costs of an equipment purchase as
well being able to consider the change in
income because of the purchase. Now, let’s
pickup on identifying the change in costs that go
along with it. Here we go.
Change in costs
Th ere are three elements of cost. Direct materials,
wages walking out the door, and overhead.
In a sales increase scenario, we must consider
the change in costs to produce the sales. Start with
direct materials. Either identify the direct material
cost specifi cally or use your historic cost of direct
materials from your fi nancials. Usually it will be
25% of the selling price.
Now, what about the changes in wages walking
out the door? Th at’s wages you pay to other people,
not wages paid to you, your spouse, and unemancipated
children. I’m not saying calculate how
much of their wage will be spend producing the
new sales. I am asking will you have to add a worker
and/or increase wages? Will your current workers
have to work overtime? Or will you terminate
someone if your get the equipment? Calculate the
change and add the percentage for payroll taxes
and benefi ts based on your historic percentage
from your fi nancials.
Now, consider changes in overhead. Any increase
in equipment maintenance and/or repair?
Ignore depreciation as we’re doing this on a cash
basis.
What if the new equipment allows me produces
20% faster so that will mean I can have more
sales? It’s not a factor. Why? For many it only
means we’ve invested in equipment to allow our
workers more break time. So, unless there is a
change in the checkbook, ignore this.
On the other hand, tell me you can nail down a
weekly contract to produce a job you can’t do now,
and you’re getting the idea. Say it’s $1,500 a week.
Fine, that puts $1,500 a week or $75,000 a year (50
weeks) into our checkbook.
Calculate the marginal
contribution
Again, think of this as your checkbook balance.
Add your change in income and then deduct the
increase in direct materials, wages paid to others
and overhead. Th e positive or negative result is
your marginal (change in) income.
If it’s positive, keep going. If it’s negative, stop
since the equipment purchase won’t ever pay
for itself. For our purposes, let’s assume that the
marginal contribution (change) is $10,000 positive
per year.
Calculate payback time
Th is is the easy part. We know the total cost is
$72,700. We also know that if we do the deal, then
our marginal (change) in income is $10,000 per
year. So, the question is how much time does it
take for us to get our money back?
$72,700 divided by $10,000 per year gives us 7.2
years or some seven years and two months. Problem
is we can’t tell if this is a good or bad investment
until we compare it with an alternative.
Remember, there is no such thing as an emergency
equipment purchase. We should review
our needs once, twice, or even three times a year
if we have the money. Get the practical options on
the table and follow the payback process for each.
Th en choose among alternatives.
Choose among alternatives
Th is one deal is a $72,700 investment with a
7.2-year payback period. What if another gizmo is
$160,000 with an eight-year payback? And another
is $50,000 with a two-year payback?
Rule one is to choose the one with the fastest
payback. You’re taking the money out of your
checkbook and putting it into equipment. Payback
tells you how long it takes to get it back. So, go with
the fastest and you’ll replenish the money fastest
and then you’ll be able to make another purchase
decision.
Continued on page 31
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