09 Aug 2011 | Jeremy Walker, The FD Centre
FOR MANY capital intensive businesses, 2011 will be an interesting year, especially if they were forced to reduce their capacity during previous years because of cashflow pressures.
Capital expenditure falls into three broad categories:
• Replacement capacity
• Additional capacity within current offering
• Additional capacity that 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 that is fully depreciated, and the extra cost of labour 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 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 above these from a financial perspective and that makes the possibility of justifying it almost non-existent.
As a finance director, I am looking for efficiency savings elsewhere in the manufacturing process to justify replacement projects. For example, old machinery frequently works more slowly than other machinery and this can produce a bottleneck in the production flow. Breakdowns can lead to downtime in other parts of the factory, which needs to be quantified. Therefore, the task of justifying replacement machinery is better accomplished by rolling it into the justification for additional capacity across the plant.
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, 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, as 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, you need to look at current customer growth and new potential customer wins. And you need 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 a 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?
In summary, capital expenditure justifications are planned and should not be reactionary. Rather than expecting additional business to come because the extra capacity is now available, entrepreneurs need to consider the certainty of the predicted demand for the additional capacity.
Jeremy Walker is regional director for The FD Centre, west country and south coast
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