Business Investment Analysis – Preface
It is a sales axiom that people buy things based on emotion and seek out facts to justify their decision. I wish I could say that the axiom were true ONLY for personal decisions, but my experience has shown that it is frequently true in the business realm as well. Perhaps we accountants are guilty of scaring off the novice with our intimidating terminology such as “time value of money” and “discounted cash flow” or acronyms such as NPV and IRR%. The purpose of this Part 1 article is to present a simple approach to evaluating investment decisions. Part 2 will present an example.
The ultimate goal of the investment analysis process is to organize everything that is known about the potential investment. You are simply comparing the costs you will incur (initial investment and costs of operation) against the benefits (revenue opportunities) that are reasonably assured to be available to you. Keep it simple and don’t over analyze the investment decision. As the saying goes, eat the elephant one bite at a time. I suggest that your break the analysis into bite size parts. The following categories can serve as an example:
Business Investment Analysis – The Opportunity
When someone is contemplating purchase of a piece of equipment, building or purchasing a building or other investment they are doing so because of an expectation that such a purchase will enhance the profitability of their business. A clearly defined opportunity with accurate estimates of revenues and costs is essential to making a wise business decision.
Business Investment Analysis – Investment
The purchase price for a piece of equipment is likely just part of the total cost. Other costs may include shipping, building alterations, electrical hookup, employee training, and similar costs.
Business Investment Analysis – Manufacturing costs
Manufacturing costs are essentially the variable costs of a product. There are at least five aspects of costs related to the manufacturing of a product:
Performance capacity: This is the production capability of the equipment you are contemplating purchasing. What will the equipment do for you? How much can it produce?
Set up: In order to begin using the machine, there is a certain amount of preparation and set up. There might be tools or dies, specific formatting or other preparation. These all come at a cost.
Material cost: This is the cost of material used each time an item is produced. It might be metal, plastic, wood or virtually any kind of material.
Labor Cost: Seldom can any thing be accomplished without people participation. For the purposes of the investment analysis we are only concerned with any additional people that will be necessary as a result of the equipment purchase.
Overhead: Often referred to as “Burden”, overhead costs include a wide range of factors such as electricity, building rent, janitorial services, indirect labor, indirect materials and a host of other cost categories. For the purposes of the investment analysis, we are only concerned with additional overhead costs.
Business Investment Analysis – Revenue
The dollar amount of additional sales income that is expected as a result of the investment must be determined. Making your estimates based on unit sales price times the anticipated quantity in units will enable you to easily determine the impact of changes in either price or quantity.
Business Investment Analysis – Sensitivity of Analysis
This simply means the degree to which the results are sensitive to fluctuations in revenue expectations and cost estimates.
Business Investment Analysis – Risks
Perhaps the most difficult part of the analysis is quantifying the risks that are invariably part of any investment. If you purchase that new machine, how confident are you that you will actually achieve your revenue expectations and how good are your estimates of costs. Are you 100% confident, 50%. The lower your confidence, the greater the risk.
Business Investment Analysis – Present Value Rate
Sometimes referred to a the “cost of capital”, “opportunity rate” or “minimum rate of return” this is a method of recognizing that a dollar today is worth more that a dollar next year, if for no other reason, inflation devalues the dollar. A higher present value rate will result in future dollars having a lower present value in today’s dollars.
Business Investment Analysis – Comparison
The comparison is a matter of comparing estimated costs against anticipated revenues, adjusted to consider the time value of money. If the result is positive (money left over after expenses are subtracted from costs,) it would suggest the investment is a good decision. The application of a little sensitivity analysis would help determine how good is the decision.
This article is focused on organizing the information that is known or is a best guess of things that will impact the desirability of purchasing a new capital equipment item. The next article will present an example of the actual analysis.
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