Capital Justification
I’ve worked in manufacturing plants for over 35 years and over my career, I’ve been involved with 100+ capital projects that averaged over $1,000,000 each. These capital projects were of all scopes and types. Most were extremely successful, but a few did unfortunately fail. The failures that occurred came at the hands of either overly optimistic sales forecasts or poorly designed equipment. Both causes are preventable of course but project success is a topic for a future article.
In this article, we’ll focus on factory capital investment justifications and ROI hurdles.
The Slam Dunk: Revenue Justified Projects
Most capital projects in a plant are initiated in support of new product launches and factory capacity expansion whereas forecasted revenue growth can cover the capital expenditure and provide a solid Return on Investment (ROI). These types of revenue based projects involve the purchase of new and typically expensive production machines. When a sales team has an opportunity to increase company revenue then, capital expenditure justification is usually a slam dunk. Margin dollars and improved plant overhead absorption provide the leverage. These are straight forward calculations for an accountant and with solid ROI’s, approvals happen quickly. It's a slam dunk!
The Frog: Cost Savings Projects
Spending money to save money feels like kissing a frog. Nobody wants to do it, but later everyone appreciates the prince that it becomes. The conversations that surround savings-type of investments often go around and around. It all starts with your good cost savings idea. Then someone tells you to complete a capital request form to purchase the equipment. You write it. The ROI isn’t great, but you submit it anyway. It gets rejected. You sharpen your pencil and look to reduce the expenditure and increase the return. You resubmit it. It gets rejected. You sharpen your pencil and resubmit. Now it looks good, but you’re told it is not in this year’s capital plan. You're told, "submit it next year". You do. It gets approved. The project gets implemented. It saves money. The plant operates favorable to budget. The frog turned into a prince and you’re the damsel that kissed the frog. Anyway, nice job. These are tough justifications but stick with it. Cost savings projects look bad on paper, but they deliver the bacon. Kiss that frog!
The Shunned: Machine Replacement Projects
I’m sorry to say that I’ve never seen a capital project that involved a simple machine replacement. Unfortunately, in the US, replacing outdated and worn-out production equipment isn’t much of a thing because there is no ROI to it. Hence no justification for it. Our inability to upgrade factories and outdated production equipment is causing the US to fall behind in the global manufacturing sector. Over 35 years, I’ve never seen a large-scale investment of say $250,000 to be used to replace a worn-out machine. You see, if you have a 25-year-old production machine that is paid off and fully depreciated, still operating but beyond its expected life, you can’t financially justify spending money to replace it. Does it make sense to replace it? Absolutely. Can you convince others that it should be replaced? Yes. Can you get anyone to approve it? No. There is no financial return on the investment for replacement equipment. It is unfortunate and I don’t see a work around for this problem. Due to the ROI requirements, the strategy for aging capital equipment comes down to repair, repair and repair. Meanwhile, maintenance managers scramble to find obsolete parts on eBay to keep our old production machines up and running.
ROI Expectations
In every business, ROI expectations are high. When an approving manager is asked to approve a capital expenditure, they are taking on the responsibility of putting shareholders’ money at risk with the goal of providing a great ROI. Approvers need to look at not only the bottom-line ROI, but also understand the risk-level that is baked into the commitment. For example, is the sales forecast overly optimistic? Did an operations manager include soft savings instead of only hard savings in a capital justification? Soft savings can't be used to justify capital investment. Approvers need to be on the lookout for it before approving a capital spend.
The Bottom Line
If you have ideas for capital investments at your plant, don’t get frustrated and don’t give up. Just educate yourself in the process and align with the ROI expectations. This makes for a keen investment eye. You can then prioritize your business proposals and effectively present proper justification to your management team.
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