Mastering Capital Expenditure Planning: Key Tips and Techniques
Most small businesses own at least some type of fixed asset, which could include items like land, buildings, equipment, and automobiles. The investments of adding, replacing, or improving upon fixed assets are called capital expenditures (or “capex” for short).
It seems like there is never enough money for all the capital expenditures that are on a business’s wish list. To make the best spending decisions, it’s a good idea to establish a process for capex activities in your organization. There should be three phases of your process:
- Initiation, estimating, and evaluating return on investment for each capex project.
- Prioritization of projects based on ROI
- Managing and monitoring the projects once they have started.
Step 1: Initiate, Estimate, and Evaluate the capex initiatives you’re considering
The first step is to list all the capital projects you’re considering. Here are some examples:
- Buy an additional truck for deliveries.
- Expand the warehouse space.
- Purchase a piece of equipment for the manufacturing line.
- Redo the dock area to improve loading efficiency.
Once you’ve made your list, you can begin to formalize your capital expenditure process. Each project should be detailed and estimated, with bids from vendors, so you have a realistic idea of the cost.
Step 2: Prioritize your capex initiatives
The next step is the most important. What are the estimated savings for each project? In other words, what will your return on investment (ROI) be? In capital expenditure spending, this answer is crucial. For each project, estimate the expected savings in time, money, and intangible benefits, and determine the break-even point.
This step can be challenging because the savings might be more qualitative than quantitative. For example, the benefit could be an improved customer experience, which should result in future sales. In this case, you’ll still want to estimate how you think future sales will be impacted. In many cases, it can take years for an item of capital expenditure to start paying off from a cash flow standpoint.
Next, it’s time to visualize the data you’ve accumulated into something like this:
||First year: $9,000 savings.
Second year savings: $49,000.
(Break-even comes in second year.)
|Increases sales capacity and reduces delivery times.|
|Redo the dock area||$20,000||Time saved – payroll costs decrease by 1/2 headcount. Savings of $27,000. If attrition is used, defer savings.||First year savings: -$7,000.
Second year savings: $27,000.
(Break-even comes at end of second year.)
|Employee happiness, reduced turnover are intangibles.|
When deciding which project to choose, return on investment is only one factor to consider. You must also consider employee satisfaction and turnover issues, customer service, capacity management, tax breaks, break-even time, cash flow, lending limits and financial ratios, and other factors specific to your industry.
The key is to have a process that makes sense for your organization. If you don’t have a process, choosing the cheapest project first could seem like the best decision, but it may not have the highest return on investment. This missing link in insight today could lead to cashflow and profitability issues tomorrow.
Tax implications also need to be considered, and we want to point out that these have been left off of the above example since every business’s tax planning circumstance is unique. Always consult with your tax accountant before making a capex decision and as you approach year-end. They can provide valuable feedback about how certain purchases will affect your tax liability. For example, making a capex investment before year-end when you’ve had high profits could be a strategic way to offset your tax obligations.
Another factor to consider is whether you’ll need a loan to complete these capital improvement(s). Interest rates have been rising in 2023, and these costs, plus your cash flow impact, need to be evaluated. As your debt increases, your financial ratios also need to be assessed. You have to be careful not to go into too much debt overall.
After documenting all considerations, you’ll be poised to make a well-informed decision on which capex project to prioritize next. You might even consider creating a capex committee to help you decide. Be sure to include your accounting advisor on the committee!
Step 3: Manage your capex initiative
You’ve decided on the capex project you want to take on now. Great! You’ll want to appoint a project manager to oversee the project’s progress and take action for any necessary course corrections. Once the project is complete, set milestones so that you can see how accurate your estimates of costs and benefits were. You might need to set milestones every year for several years in order to accurately measure the actual ROI, and taking these measures will make you a more accurate estimator in the future.
Spending at the right time on capex projects is as much an art as a science. However, putting formal processes into place will improve your chances for a better return, smoother cash flow, and improved profits.