A primer on maintenance capex: what is it and how to calculate itMay 18, 2023
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A PRIMER ON MAINTENANCE CAPEX: WHAT IS IT & HOW TO CALCULATE IT
As an early CFO, capital expenditures always seemed to sneak up.
The situation I went into during my first CFO job was a rapidly growing business in which I had an unqualified predecessor.
I didn't know this before going in, of course. But once in, it was obvious.
There were no procedures of any kind and I'd never been a CFO before!
Slowly but surely I started implementing new things.
Then, about a year or two in, some vehicles we owned were having maintenance issues. I had to figure out what we could buy and when we should replace them.
While simple compared to some equipment, it was no simple task at that time.
I made some mistakes, but I learned A LOT. A LOT.
Soon, I'd established the procedures we'd needed and the fear and anxiety that first came with the problem became a faint memory.
That is... until I started this post. I rolled around in the bed wondering "how was I so bad?!?"
Ok, I'm kidding... but I share to say you're not alone in being fearful to approach this topic.
Today, we break down capex, maintenance capex, and how to calculate it.
We leave more unanswered than I'd like, but the hope is this will be enough a primer to get you moving.
Let's dive in.
What is CapEx?
Last email we didn’t really answer what CapEx was, so I wanted to break it down a bit in this one.
Capital cost are things that have a life longer than one year.
If the life is less than one year, they’ll be expensed on the Income Statement.
Capital expenditures fall into the Fixed Asset section of the Balance Sheet and some common language used is “Property, Plant, and Equipment.” Common accounts you’ll see are:
- Property: Buildings, Land
- Equipment: Vehicles, Machinery
- Furniture & Fixtures: Office furniture
- Hardware: Computers, Laptops, Phones
- Software: CRM, ERP, Cybersecurity
With the one year life rule, reporting can get extremely complicated. Imagine having to record a $120 phone to your asset schedule and track it!
So, many small businesses follow the IRS tax rules. They used to require reporting of items more than $500, but in recent years has increased it to $2,500 and up. Any item greater than the IRS minimum value has to be depreciated, meaning the expense has to be taken over multiple years.
Companies following the IRS rule used to have to depreciate computers over 5 years, but are now getting to take the whole expense on their taxes in year one.
For our purposes of replacement, we’re not going to worry about the $120 phone. We’re only going to worry about bigger ticket items at or above the $2,500 mark.
Assess your current equipment
It’s wild to me how often I’ve gone into situations and there is no real tracking of equipment.
While you shouldn’t go overboard tracking every mouse (real or not, get it?) that comes in the building, keeping a record of major fixed assets is important to assessing what you have and what you need.
You need to have a sense of:
- What you have
- How long you’ve had it
- What the estimated life is
What you have
Don’t overcomplicate this. For many businesses, especially ones that aren’t depending on large amounts of equipment, a simple tracking spreadsheet can do.
Record as much information as you might want and don’t be shy. It’s easy to cut back later as you better understand your needs.
For example, with computers I like to track:
- Asset Tag ID
- Serial Number
- Computer Name
- Purchase Date
- In Service Date
- Make & Model
- Specific specs (Hard drive size & type, RAM, processor, etc)
- Estimated Replacement date (3 to 5 years, depending on the purpose of the machine)
Asset Tags give you an internal identifier (number) and put something visual to identify the machine as yours.
Estimated life of the equipment (Useful life)
When reporting equipment to your accountant, they’ll assign it a “useful life.” This is just a fancy name for deciding how long they’ll depreciate the expense over.
If you buy a $5,000 widget that is depreciated over 5 years, you’d get $1,000 counted as an expense each year for 5 years.
But useful life is very rarely “useful” when determining the actual lifespan. Sure it should be close, but it shouldn’t determine when you’ll make replacements.
Instead, talk to people in your industry or assess how long that equipment has lasted in the past.
Industry-specific data is important because one industry could be really hard on a vehicle, for example, which means estimated life is shorter.
Instead of measuring in years, estimate usage (miles, hours, units, etc). Then, convert that usage into years. This helps assure you’re closer to the specific time you’ll need the money.
Start tracking it
Asset Tags should be added immediately when purchasing, so it makes sense to update the sheet as you buy things.
Then, at least annually, you should review the sheet to make sure it’s up to date and accurate. If you’re recording transactions correctly, this is simple as reviewing entries to Fixed Assets for the year and confirming purchases have been added and sales of assets have been removed.
Should you replace it?
Now, what everyone is here for… how do we determine if something should be replaced?
I’m not going to lie: this isn’t an easy question to answer (especially since I’m not speaking to a single industry).
The key when it comes to this analysis is to figure out what works in your industry and “stick” to this rule. I put stick in parenthesis because the rule isn’t meant to say “o, the spreadsheet says to replace, so we’re going to replace.”
The spreadsheet gives you a rough plan. Your eyes on the equipment, plus your good analysis skills, will determine what and when you actually replace something.
Below I address some rough rules that could work to identify when you should replace equipment.
Percent of replacement value rule
When looking at a repair, divide the repair by the ERV (estimated replacement cost). If the repair costs more than X% of the ERV, buy the new equipment instead.
A common number is 2%, but it can vary widely by industry. Some could even be up to 50%. So, get a better understanding of norms in your industry and create a rule for yourself.
Look at past replacements and ask: was it too early or too late?
Look at competitors and guess what they have done.
Talk to industry professionals and ask their opinion.
Percentage of revenue
Go back through your history and determine how much repair cost is a percentage of revenue.
We want to see both maintenance and CapEx going down as a percentage of revenue when you grow.
When maintenance cost goes up as a percentage of revenue, it could be a sign that your equipment is wearing out.
This doesn’t work well if your business has wild swings up and down, but can be a good rule of thumb for stable but growing companies.
This rule depends on the method you use to depreciate the equipment (straight-line or double-declining), but it’s simple: if the cost to repair is greater than the depreciation for the year, it might be time to replace.
This is great because of how simple it is. Just look at the depreciation schedule and you have your answer.
But simple could mean tooooo simple. One big repair might make the piece of equipment last for many more years without maintenance, so use your best judgement.
Know your industry
With all these rules, know your industry.
I go broad with this newsletter and don’t speak to a specific industry, which means it’s hard to give specific advice.
Seek industry pros in your circles and ask them for how they make the call.
You’ll find that very few think scientifically about replacement. Most go with feel. Feel can work, but feel also makes it hard as you scale.
By reviewing your history and creating some basic rules, it helps you to have a better plan and understanding of upcoming expenses.
Additional factors to consider
Payback period calculations
With this, you take your cash flow from the equipment and ask, “how long will it take for cash flow to exceed the investment?”
You want the shortest payback possible.
You can also compare loan payment against cash flows.
We’ll talk about the payback period concept next week when talking about growth capex, so come back for some more in-depth analysis.
Maintenance cost for remainder of life
When getting equipment, you generally have a sense how much the annual maintenance cost will be. But as you get later in the life the maintenance cost goes up.
Let’s compare it to a personal vehicle. For years, people tried to sell around 100,000 knowing that certain maintenance costs went up after that point.
With certain models, parts would be more likely to fail.
The same goes for business equipment. It can be hard to know this offhand, but you can generally have a sense of what’s wearing down and what has a limited life.
It’s important to seek out experts who can speak from experience.
Anytime an essential piece of equipment goes out, it requires the business and personnel to adapt. If a vehicle or computer goes down and you don’t have a replacement, you could have employees sitting with nothing to do.
In manufacturing, or businesses with heavy equipment, you can’t just simply buy an extra machine. The question then becomes “how long does it take to get it back up?”
If downtime cost is too high, it can make sense to have backup equipment to assure there isn’t any.
For example, for an employee charging $150 per hour, it only takes 15 hours to cost $2,250 in billing, which is likely more than a new computer. When many users have the same computer, it makes sense to have backups.
But when equipment is 10s or 100s of thousands, that isn’t so easy.
Instead, make sure you have a “fast response” maintenance plan in place.
You can also choose to replace items more quickly to avoid downtime.
Impact on operation
If the equipment goes down, does it mean you have to change employee schedules? Rework production? Notify clients?
Only you can determine how catastrophic these impacts are, though client impact is probably always a big thing.
Make sure you take real time to understand and assess these risks before they present themselves.
Difference in operating cost
Newer equipment could run more efficiently, which could reduce cost of ownership. Compare operating cost of the equipment to the new version.
Payback period could be reduced significantly when current equipment has high operating cost.
Add the operating cost differences to the investment cost in the payback period calculation.
Employee happiness cost
This is unmeasurable but important.
Employees who have to deal with the equipment every single day are often the first to see trouble on the horizon.
If you don’t replace equipment that clearly needs it, good employees can turn sour really quickly.
Be sure to keep a close eye on how often employee jobs are made harder because of deferred maintenance and be proactive in addressing it.
Loans on CapEx
As we’ve seen over the last year plus, the cost of loans can vary drastically.
We went from historically low rates to rates that haven’t been seen since 2007.
It’s impossible to actually predict what will happen, but when rates are low it might make sense to replace equipment sooner if you can afford it.
On $100,000 worth of equipment, a 10% interest rate over 5 years costs you $20,000 more than a 3% one. That’s an 18% increase in the price paid with only a 7% increase in rate.
Create a replacement schedule
One of the biggest mistakes businesses make is being surprised by the need to replace equipment.
And by surprised I don’t mean “o no, I forgot.” I mean “dang, it’s time and I have to take a high-interest loan to make it work.”
Once you’ve analyzed all your factors above (plus more I’m sure I’m missing), it’s time to create a schedule.
Earlier, when discussing useful life of the equipment, you should have gotten an idea about when stuff might need to be replaced.
Now, you want look at the other factors:
- Can cash flow support replacement. If not, what financing is available?
- What are the priorities? Which is critical versus which is not?
- How much will it cost? How does it play into the big picture?
This replacement analysis should then be used to set a budget each year.
This is where the rubber meets the road.
In the budget, set aside the amounts you’ll need for the budget year, plus look 3-5 years in the future.
You need to make sure future cash flow can handle future needs.
Honestly, this topic could be a whole post unto itself, so we’ll revisit in the future.
Growth CapEx & Owner’s Distribution Availability
Maintenance CapEx ended up taking more space than I expected, so we’ll discuss growth CapEx and distributions more in-depth next week.
As a primer on Growth CapEx:
- Identify and prioritize growth potential
- Evaluate the possibilities against your goals
- Calculate the cost (Payback, ROI, and my saucy opinions on IRR & NPV)
- Assess your risks and do scenario planning
- Make a choice
Alright, we'll hold the rest till later!
Today I'm going to share 2 "different" types of reads, non-finance related:
- Nathan Barry wrote about "The Creator Flywheel." Creator businesses run right are just a different type of business and so I was fascinated by this application. Seeing how others are running their business and how the flywheel works in so many situations.
- Khe Hy is a former consultant turned writer. He wrote about, and has a course/email sequence on, the idea of $10,000 per hour work. This really made me think and I believe it'll do the same for you personally and professional.
Thank you for reading!
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