How to Figure Out a Necessary Capital Expenditure
Capital expenditures are purchases a company makes to bring about a long-term benefit to the organization, such as reducing operating costs or expanding its marketing capability. Acquiring manufacturing capacity, expanding office space and upgrading information technology systems are other examples. Capital expenditures are sometimes referred to as projects and are distinguished from day-to-day operational costs such as purchasing office supplies. Companies have limited funds to allocate to capital expenditures, so the issue becomes which expenditures are truly necessary -- those that will have the greatest long-term benefit and further the company’s goals.
Other People Are Reading
Instructions
-
-
1
Complete a three-to-five year strategic plan for the business and develop a list of projects to be funded that will contribute to the company’s overall goals. The owner of a retail clothing business may set a goal of opening five additional locations within the three-year period. The projects could include acquiring land, construction of the new stores, and upgrading the company’s point-of-sale systems so the accounting function can be integrated across all six locations.
-
2
Ask department managers or key employees to assess their needs and submit capital expenditure requests. Top management should solicit advice from those below them in the organization--these individuals often have a greater understanding of the company’s operations and know which upgrades need to be done to make the company more efficient and competitive.
-
-
3
In consultation with finance staff or the company’s outside CPA, calculate and weigh the cost vs. benefit of each proposed expenditure. Business owners often use the concept of payback period, calculating the annual cost savings or revenue increases from the project and then computing how many years it will take for the project to pay for its initial cost.
-
4
Compare the relative merits of each expenditure. Look at the most important goals established in the strategic plan and evaluate which capital expenditures contribute the most to reaching these goals, particularly those that will help the company remain competitive. These are the most necessary capital expenditures. Consider non-quantifiable benefits as well. A law firm deciding whether to modernize its offices will evaluate the productivity gains from having more efficient computer systems, but there may also be a positive impact from having the office better present an image of success to prospective clients who visit.
-
5
Factor in budgetary limitations or available capital. Some projects may be funded out of current cash flow, whereas others are of such a magnitude that they will require additional capital being brought in, such as from a bank loan or obtaining equity capital. Secure the capital before scheduling the project.
-
1
Tips & Warnings
The vendors or contractors whom you are considering for the project will likely have financial data about the benefits, based on the experience of other customers they have worked with who have undertaken similar projects.
Make sure the capital expenditures do not have the potential to jeopardize the company’s financial stability--causing it to fall into a cash-deficit position. Large-scale projects such as constructing new manufacturing facilities often face delays or unexpected increases in the prices of materials, thus causing the project to go over budget. Allow for these contingencies in your cost estimates. Include contingency funds for unforeseen events to avoid compromising your company’s cash position.
