The Joy of Capital BudgetsOct 26, 2023
Today we’re talking about capital budgets.
Joy, I know? Every business owner loves some capex.
Not… Today we’ll break down:
- Types of capital spend
- 5 variables to consider
- 5 ways to calculate the cost
- Mistakes to avoid
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THE JOY OF CAPITAL BUDGETS
Who wakes up in the morning excited about putting together a capital budget? You? Wait, you are? No... you're lying.
No one likes a capital budget. They're hard, tedious, and frustrating. And because of that, a ton of people get them wrong.
Not because they can't get them right, but because they're afraid of the process.
Today, I hope I can help make them a little less "scary."
And before we dive in, let me throw this out there: It’s easy to make mistakes in this process. They're hard and take work and coordination. But they don't have to be anger-inducing.
The biggest unlock I had was getting the people needing the “capital” to do the budget request. As a finance person, it always felt great to control it. But I was often too far from the action to get all the variables.
Now, I have the person “request” it and do their best to get a complete picture before cleaning it up and normalizing it to the format that is consistent for all capital requests.
The size of your business will determine what your approach is here, but complete buy-in is the biggest element to having a successful capital budgeting cycle.
When people don’t know why their request wasn’t approved, they feel like they’re on an island. By allowing them partway in the process and then communicating decisions, you have a better chance of buy-in.
Today we’re going to talk about:
- Types of capital spend
- 5 variables to consider
- 5 ways to calculate the cost
- Mistakes to avoid
Types of Capital Spend
2 types of capital spend: new strategic objectives and growth or replacement of old equipment. Let’s talk about these first.
New Strategic Objectives
Since we broke down how to rate them and narrow the list in the previous post, today we’ll focus on estimating the cost and mistakes made.
A big overarching question to understand with strategic objectives is: Do we have the necessary talent and skill to carry out this objective? If not, do we need to bring in a consultant, train current employees, or hire new staff?
While we’ll address other things to consider in the mistakes section, understanding this first can completely change the calculus.
Growth or replacement of old equipment
You could ask 10 companies in the same business what their policy for replacement is and they’d all have a different answer. So, I’ll say it upfront: there is no right or perfect answer.
Everyone has their preferences, which means the reality is I’m just sharing mine.
But, a few questions to consider:
- What is old and breaking? If you’re hearing about it from employees, it’s definitely time to do a deeper dive.
- What “new” could improve the business? New stuff comes out all the time, but keep your ear to the ground for big advancements. You don’t want to be the guinea pig for version one, but maybe version two.
Similar to the strategic objectives, we want to create a list of these items and prioritize them.
The same analysis for new objectives works for replacement/growth with some tweaks:
- List the positives and negatives of each
- Identify the potential risks associated with not replacing it now.
- Rate them on a scale of 1-10:
- Mission alignment
- Upside potential
- Downside potential
- Feasibility of replacement
- “Want to do” score
Once we’ve highlighted our top few growth or replacement ideas, it’s time to determine the cost of them.
5 Cost Analysis Variables
When looking at new strategic objectives or replacement equipment, the kind of cost analysis you’ll do depends on the type of objective it is. Instead of trying to tell you which method to use, I’m going to show you a number of methods at a high level so you can determine for yourself (and your business) what’s best.
At a high level, I like to think about the cost in 5 ways:
- Upfront cost: identify how you will finance the objective.
- Total cost: assures you don’t miss pesky ongoing costs.
- Potential benefits (revenue/cost reduction): We want to make sure we capture any benefit from the spend. If it increases revenue, we want to make sure we understand how much. If it reduces cost, we want to know the mechanism by which it reduces it. This is wide-ranging, so we’ll address some of these items in the mistakes sections.
- Variability of outcome: Asking for worst-case and best-case scenarios can swing outcomes wildly. We have a tendency to paint a rosy picture in cost analysis, so this makes it less likely for us to lie to ourselves. If the business is in a lean phase, the one with the lowest variability can quickly become the favorite.
- Certainty of outcome: This is similar to variability, but different. Sometimes the variability can be minimal, but the likelihood can be low. We want to discount potential outcomes by their likelihood of being true to get a “true cost” for each objective.
Methods for Analyzing Costs
Return on Investment (ROI): ROI divides the return on investment by the cost of the investment. The higher the ratio, the greater the benefit earned. If this happens over multiple years, we not only want to look at total return but average annual return.
Net Present Value (NPV) & Internal Rate of Return (IRR): This identifies current value (in today’s dollars) of the investment you’ve made after inflation and returns of the investment. Positive NPV signifies it’s a good investment. IRR takes into account the NPV and gives you a return percentage, similar to ROI.
I’ve said it before but I’ll say it again… I’m not a huge value of NPV. It’s not a real number and can be hard for laypeople to navigate. But, when comparing multiple options, it gives you one number of truth to look at. This is a method used to calculate the value of a dollar today compared to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a project or investment is positive, it’s considered a good investment.
Break-Even Analysis & Payback Period: Break-even analysis tells you how much money you need to make (in revenue and units) to pay for the investment. If one dollar of revenue generates 40 cents of profit, how much revenue do you need to generate enough profit to pay for the investment?
Payback Period is how long it takes to recoup the initial cost of the investment. The quicker you get a return on the investment, the better.
I like these two a lot because it helps me know how long it takes to start generating cash and “paying” for itself.
Total Cost of Ownership (TCO): I mentioned this above in total cost, so you know I like this calculation. It’s so easy to say “It’s only $x.” But the reality is that operating an asset can be expensive. In this calculation, you take in actual hard costs (like maintenance, electricity, etc) and soft costs (additional wages paid for the learning curve).
Everyone makes mistakes. And when it comes to capital expenses, it’s easy to make mistakes even when you do the right analysis.
Mistakes with new strategic objectives
Hidden Costs: With a lot of variables, it’s easy to miss stuff. Don’t forget, maintenance, necessary upgrades, compliance, cost of training, productivity loss, or disposal costs. The best way to uncover these costs is to talk to people who have been there before.
Overly Optimistic Forecasts: Everyone loves an optimistic forecast, but overestimation can result in the wrong decisions being made. This is why I harp on thinking about the downsides. Each downside risk you address forces you to rethink your rosy assumptions. The same goes for cash flow. Optimistic timelines can throw off forecast projections, too.
Risk Assessment: Doing a risk assessment is essential. It’s why I love the SWOT and have previously addressed questions to reflect. Understanding internal and external risks is key.
Long-Term Implications: Does the investment align with your strategic plans? We addressed this before, but it’s important enough to address it again.
Market Trends and External Factors: Sure, you can control you but you can’t control the market. Understanding market trends and uncontrollable factors is important to understand what conditions would have to change (outside your control) that could make the objective a bad one.
Caring about Sunk Costs: Sunk cost is just that… sunk… gone. Ignore it completely when looking at strategic objectives. A wrong decision 2 years ago doesn’t make a wrong decision today right. Focus instead on future costs and benefits.
Supply Chain Factors: This is especially important in construction. Evaluate any impacts on the supply chain, including potential cost increases, availability of materials, or dependency on certain suppliers. Everyone remembers the cost increases of the last few years.
Scalability: If you grow, what additional costs will be incurred? The ability to scale sounds good in a sales pitch for a new piece of equipment, but what additional costs will be incurred? Make sure you account for how the operational structure has to change (people, facilities, etc).
Mistakes with replacement CapEx
End-of-Life Costs: Don’t forget the cost of disposing of an old asset. Some equipment may have environmental or safety costs associated with its disposal.
Opportunity Costs: What can’t you spend the money on as a function of spending it on this? We all have limited resources and want to make sure replacement aligns with your strategic objectives and direction of the business.
Maintenance Costs: Maintenance cost can vary between current equipment and replacement equipment, but also based on the replacement equipment you choose. Make sure you evaluate new and used to see what works out best in the long run. Understanding the quirks of used equipment you’re purchasing can save you from chasing down the not-produced-anymore part.
Also, check if there is a warranty or service agreement available. While you may not typically use one, this can reduce uncertainty related to a switch.
Downtime during replacement: What downtime will you have as a function of replacement or retraining? Knowing how it’ll impact the bottom line is key to know if it’s the right time to make that decision. Maybe you don’t replace during the busy season unless the downtime is already high.
Financing Costs: Pretty obvious, but I’ve seen it missed. Don’t forget to compare cash purchase versus loan or lease costs and everything that goes with that. Also, make sure you check your options. Go to multiple banks and don’t be afraid to look stupid when asking questions. The cost of financing can vary greatly between sources.
Resale or Disposal: Always look into the ability to resale. This is why so many businesses replace equipment early: they’re able to capture some value out of what they’re replacing. Understanding how resale value changes through the life of an asset is helpful in making this decision (maybe I write on this in the future?).
If you can’t resale, see if there are any costs for disposal. Environmental concerns are real and fines can be big if you don’t follow disposal rules.
Supply Chain Interruptions: Sometimes new equipment will require getting parts, supplies, or otherwise from a different supplier. Compare your current buy list to what you’ll need to buy for the new equipment. Then go to your suppliers and ask. If you catch something you have to get somewhere else, you’ll be grateful to not be caught by surprise.
We were never going to be able to address everything in this newsletter.
At some point in the future, I’d like to do issues on each individual cost analysis method, but I’ve saved that for another day.
The key is to test them out and try what you like. Once you’ve settled for one (or two), run the process so that you don’t make big mistakes.
Hopefully, this gave you some good things to think through.
Next week we’ll talk about bringing it together in a forecast.