Justifying Capital Expenditure For Manufacturing Businesses
By James Nicholson-Smith
For many capitally intensive businesses, 2010 will be an interesting year especially if they were forced to reduce their capacity during 2009 because of cashflow pressures. Capital expenditure falls into 3 broad categories:-
• Replacement capacity
• Additional Capacity within current offering
• Additional Capacity which broadens the offering
Replacement capacity is always the hardest to justify. The reason for this is that the payback for the investment is generally too long. The cost of repairing an existing machine which is fully depreciated and the extra cost of labour cost to run it will be small in comparison to the purchase of a new machine. It’s possible the old machine will be slower and possibly less accurate than a new machine — but the job still gets done.
The cost differential frequently means that the effective payback period could be 5-10 years or more. As a stand-alone decision, other projects will always rank ahead of these from a financial perspective and that makes the chance of justifying it almost non-existent.
As a finance director (offering part-time FD services through www.the fdcentre.co.uk), I am looking for efficiency savings elsewhere in the manufacturing process to justify replacement projects. For example old machinery frequently works slower than other machinery and therefore this can produce a bottle neck in the production flow. Breakdowns can lead to downtime in other parts of the factory which need to be quantified. Therefore, justifying replacement machinery is better rolled into the justification for additional capacity across the planet.
Additional Capacity within the current offering is the easiest project to justify. Unfortunately many manufacturing businesses do so, on the back of increasing the capacity or earning potential of the business without looking at where the additional business will come from. Therefore, as an FD I tend to focus my attention on the risks relating to the additional demand rather than the additional capacity.
The quality of the sales pipeline should be of critical importance to the Finance Director. The reason for this is that the business will be using an uncertain revenue flow to pay the certain costs of increased capacity. The critical question is how uncertain is the revenue flow? To measure this, one needs to look at current customer growth and new potential customer wins. Furthermore one needs to consider whether the additional demand is within the current core capability.
The last category is always the most exciting because it’s new on all fronts. The entrepreneur is buzzing but the Finance Director probably has his bucket of cold water ready. The process that needs to be considered is as follows:-
• Is the New Capacity within the scope of the long term vision?
• Is the new capacity within the core competence of the business?
• Is the demand for the new capacity certain and if not what are the risks?
• At what level will the new capacity be utilised?
• What alternatives to this project, does the business have?
• Does the business have the funding available to see the project through if demand is at the lowest level? A really good topical example of this is the new waste to airline fuel plant that is being proposed in East London. BA has agreed to purchase 100% of the output — as long as the fuel is approved for use by the airline. In this particular example, it looks exciting, however what happens if BA goes into liquidation or the fuel is not approved for airline use? What happens if the cost of product is higher than the sale price received?
In summary, capital expenditure justifications are planned and should not be reactionary. Entrepreneurs need to consider the certainty of the predicted demand for the additional capacity rather than expecting additional business to come because the extra capacity is now available.
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