Evaluating the purchase of new equipment can be a complicated process. There are many stakeholders to consider, vendors are aggressively bombarding you with information and you have limited time to make a decision. It is easy to miss some key questions during the evaluation process which can prove costly later on. Before committing your company to an expensive investment in equipment or systems, make sure you add these questions to your checklist:
1. Have we talked with our employees, suppliers and clients about this?
When evaluating equipment purchases, owners, managers and vendors tend to be the strongest voices heard. While they play an important role, it is a mistake to leave out the input of other stakeholders. Employees can provide practical insight from hands on experience with regard to how different equipment truly performs in real-world conditions. Suppliers can provide insight on the ease of integration with their own systems.
Imagine if two months after acquiring and installing new equipment to automate your plant floor, a key supplier announces a significant change to the design of an important part which is not compatible with your new equipment. Had you discussed it with your supplier, they would have informed you about the upcoming changes. Clients can provide feedback on specific changes they would like to see with your product or service so you can evaluate whether or not the new equipment can execute them.
2. Have we looked at both custom and off-the-shelf solutions?
There is a direct trade-off between cost and flexibility. Off-the-shelf solutions tend to have limited abilities for personalization to your specific company’s needs. In fact, you may need to adapt your processes to accommodate the limitations of off-the-shelf equipment.
But the cost savings can be significant, future maintenance and repairs can be performed in less time and updates obtained more frequently. Custom designed solutions can meet all of your existing needs, but are significantly more expensive to purchase, maintain and repair and may require expensive retrofits to update them. It is important to carefully consider both options.
3. “How have we taken into account the timing of the costs and benefits?”
Like most things in life, timing is everything when it comes to investments in new equipment. Typically, equipment requires a large upfront investment and the benefits in the form of cost savings are earned over time. When taken into account, the timing can have a material impact on the comparison of costs and benefits.
Let’s take a look at a simplified example to illustrate the point.
Simplified equipment purchase analysis
How long it lasts
- Useful life: 5 years, afterwards it will be worthless
What it costs
- Purchase price: $120,000 paid upfront in cash
- Service contract: $5,000 per year and it covers all service and maintenance
- Total cost is the sum of the purchase price and the 5 years of service: $120,000 + $5,000 + $5,000 + $5,000 + $5,000 + $5,000 = $145,000
What you’ll get out of it
- Estimated cost savings in…
- year one: $10,000
- year two: $25,000
- year three: $25,000
- year four: $40,000
- year five: $50,000
- Total estimated cost savings: $10,000 + $25,000 + $25,000 + $40,000 + $50,000 = $150,000
In this example the value of the benefits is $150,000. On the surface, a $145,000 investment that generates $150,000 in benefits yields a positive return of $5,000.
However, the costs and benefits are spread out over 5 years at different amounts. Because of inflation, the longer you have to wait to generate the cost savings, the less valuable they are when measured in today’s dollars. In order to make an accurate “apples to apples” comparison of the costs and benefits, we have to measure everything in today’s dollars. To measure “future dollars” in “today’s dollars” we divide them by the appropriate discount factor for each year.
Calculating the discount factor
Assuming 4 percent annual inflation, the discount factors would be as follows:
- For year one the factor is 1 (since it is the present)
- For year two the factor is 1.04 (1 x 1.04)
- For year three, the factor is 1.082 (1 x 1.04 x 1.04)
- For year four, the factor is 1.125 (1 x 1.04 x 1.04 x 1.04)
- For year five, the factor is 1.170 (1 x 1.04 x 1.04 x 1.04 x 1.04)
Costs adjusted for inflation
- Year 1 costs in today’s dollars: $125,000 / 1 = $125,000
- Year 2 costs in today’s dollars: $5,000 / 1.040 = $4,807.69
- Year 3 costs in today’s dollars: $5,000 / 1.082 = $4,622.78
- Year 4 costs in today’s dollars: $5,000 / 1.125 = $4,444.98
- Year 5 costs in today’s dollars: $5,000 / 1.170 = $4,274.02
- Total costs in today’s dollars: $125,000 + $4,807.69 + $4,622.78 + $4,444.98 + $4,274.02 = $143,498.48
Benefits adjusted for inflation
- Year 1 benefits in today’s dollars: $10,000 / 1 = $10,000
- Year 2 benefits in today’s dollars: $25,000 / 1.040 = $24,038.46
- Year 3 benefits in today’s dollars: $25,000 / 1.082 = $23,113.91
- Year 4 benefits in today’s dollars: $40,000 / 1.125 = $35,559.85
- Year 5 benefits in today’s dollars: $50,000 / 1.170 = $42,740.21
- Total benefits in today’s dollars: $10,000 + $24,038.46 + $23,113.91 + $35,559.85 + $42,740.21 = $135,452.43
After adjusting for inflation, the cost of the equipment measured in today’s dollars is $143,150 while the value of the benefits measured in today’s dollars is only $135,452.
After taking into account the timing of the costs and benefits, the return on the equipment is negative.
Simple questions lead to complex answers.
Evaluating equipment purchases can be a long and involved process. Sometimes the costs are unknown and some benefits are intangible. Other times it may be difficult to obtain the necessary input from everyone involved. Asking the right questions up front will help you make the best decision possible.
Want to learn more? Leave a question for me in the comments section.
Mike Periu is the founder of EcoFin Media, LLC an independent producer of financial, economic and entrepreneurial content for television, radio, print and the internet. Over the past ten years he has started three companies and advised over 50 companies on financial strategies including fundraising. Mike also hosts regular small business webinars on a range of topics relevant to business owners.