Is Your Investment Worth It?
Businesses must constantly strive to save costs.
Because of their size, small businesses are frequently at a cost disadvantage compared to large businesses but they must understand the nature of costs in order to compete.
Most do understand what we call direct, variable costs. Theses are the straightforward, ongoing costs that are part of the normal business operation. These include supplies and raw materials regularly consumed, normal items that you buy month to month, and most cost of goods sold. Examples could include office supplies, packaging, some utilities, and labor.
Sometimes, small businesses can save costs and approach the buying power of larger businesses by using trade, associations, partnering for cooperative advertising, and joining large buying groups specifically designed for this purpose.
However there is one area of costs that small businesses don’t understand as well as large businesses. That is capital budgeting.
This occurs when you make an initial, capital investment up front to save costs later. It involves the calculation of a stream of future cost savings which is then compared to your initial investment to see if it is worth it. It could be as simple as replacing a cheap incandescent light bulb with a more expensive fluorescent unit that uses one-quarter as much electricity. It could also be a major capital decision like installing an expensive computer system or production machine that saves money in the future.
The main concept in this analysis is recognizing that money saved in the future is not worth as much as money saved in the present. It is the concept of net present value. You must discount these future monies. The farther out in the future they are the more they need to be discounted and the less they are worth.
Setting up the stream of monies is generally straightforward. If you are going to buy this computer system or machine you usually know how much it costs. This is the outflow at the beginning. Then you usually know how much you are going to save per year for a given number of years in the future. This is the inflow in the future.
Here’s where it gets a little more complicated. You need to decide what “discount rate” you will use. Typically these are related to what is known as the Cost of Capital” and it depends on the interest rate you pay when you borrow money, and your goal for your return on your equity. For simplicity let’s call it 15%. If you save $100 one year later, it would be worth about $87 today and 2 years late it would be worth $76 today, and so on. In this way you measure whether the discounted in flows add up to more than your initial investment. If they do it’s a good investment. If not, it’s not.
Another important consideration is obsolescence. It seems today that things get obsolete quicker than they used to. We are always throwing stuff away, especially technology items. Even rummage sales are getting picky. Because of this concern of your capital items becoming obsolete, it is better to be conservative in your estimate of how long these future money streams will last.
Your accountant or someone with a financial background can help so don’t give up. It’s a common, straightforward calculation for those that do it.
This way you can make good capital budgeting decisions just like big businesses.
This article was written by Seattle SCORE Chapter member Fred Parkinson for the Kitsap Sun in Bremerton.