Capital Expenditure Viability Analysis for Small Businesses

Published on Monday, 4 November 2013 09:13:23    Written by Marc
Most large businesses have processes in place to do a uniform cost and benefit analysis of proposed capital expenditures. This is often performed at the level of the initiating entity and then again at the approval level. Small businesses; however, often lack procedures and processes to deal with what they would consider major capital expenditures. Let us look at some of the factors that small businesses should take into consideration when determining the viability of a capital expenditure project.

small-business-300x280Let us take a practical real-world example of a mom-and-pop printing company. This printing company has about three presses of varying sizes, about four computers, five full-time employees, two part-time employees, two closed offices, an open office area (that also contains the equipment), and a waiting area for customers that is within the same heating/cooling zone but is otherwise isolated from the production area. In total, the area covers about 2,000 square feet (185 square meters).

During the period of the last three months, the employees noticed that the air conditioning unit (chiller) was starting to under-perform. The owner noticed that to maintain a temperature of 70?F (21?C) the compressor on the air conditioner would have to run for longer periods. At the end of this period, the owner noticed that his electricity bill had increased by about $73/month.

The owner contacted three contractors who told him that he would have to replace the air conditioning unit. Accounting for temperature and eight hours of operation, the unit is supposed to draw about 80kWh, but is in actuality drawing about 115.2kWh leaving an efficiency gap of about 4.4kW. The lowest price that he could find for the unit is $1,820, plus $100 for installation charges.

A lot of small business owners might only do a simple payback period calculation for this amount, which would tell them that it would take about 25 months to make back their money factoring in only the amount recouped from the amount lost each month.

What many small businesses do not take into account; however, is that money has value over time, and money that is allocated for a capital expenditure has to be weighted to account for the lost opportunity that the money could have been used on if it were spent today. If we were to use a Net Present Value (NPV) calculation, it would show that we would have to recoup $98 each month for the 25-month period for the project to be worth it financially. This puts the value of the lost opportunity at around $625.

It is important to note; however, that businesses should not always rely on an NPV calculation when determining if a capital expenditure is worth it. In our previous example, we assume that the price of electricity is a constant throughout the 25-month period; however, if the price of electricity were to increase by $0.025/kWh, then the cost of electricity lost each month would jump to $100 making the project viable since the cost of the lost opportunity drops to zero. If the business were to consider those with a probability analysis, they might decide that this project is worth it.

In conclusion, it is important to consider the value of the money over time and/or the value of the project over time when determining if a capital expenditure project is worth pursuing or not. In some cases, such as if the air conditioning unit gave out altogether, the business would have no other option but to make the purchase. In other cases, a time-series analysis might prove more insightful. It is important to know always these factors when considering a capital expenditure.