TABLE OF CONTENT
1.Introduction - Capital Equipment (SK) (09/12/2000)
2.Types of CE (SK) (09/09/2000)
2.2.1 Stationary CE
2.2.2 Portable CE
3. Forecasting, Assessment and Replacement (SK) (09/30/2000)
4. Overview of CE purchasing
4.1CE: When to buy? (NG) (09/12/2000)
4.2CE: What to buy? (NG) (09/09/2000)
4.3CE: How to buy? (MR) (09/09/2000)
5.Financing options (MR) (09/15/2000)
6.Metrics (SK,NG,MR) (09/16/2000)
7.Conclusion (SK,NG,MR) (09/30/2000)
The principal challenge facing business is to make possible to achieve the rising standards of living, which the people have a right to expect. Mass production will continue to be the basic tool in achieving this objective, but we must accelerate our capital investment to obtain greater productivity at lower unit cost. Research, on which large sum is been spend, acts as a stimulant to capital investment and will result in the replacement of much existing machinery. Through technological progress, improved as well as new products will compel change.
There has been a decided shift away from the theory that a capital investment program consists only of replacing worn-out machinery. No longer are we preoccupied primarily with the physical life span of equipment in considering capital investment. Today the basic consideration must be the optimum economic life span of plant and machine. " We opt for modern machinery and equipment capable of producing a higher-quality product at lower cost with less waste ".
To reach intelligent decisions on capital investments, it is necessary to consider long-range objectives, future technology changes, the need for additional products and other factors individual to each company. These considerations must indicate the effect on dilution of equity, reduced earning from heavy amortization in the early years, and the length of time it will take for earnings to justify the new facilities.
Capital Equipment (CE):
" Capital Equipment is what financial people call a noncurrent asset, meaning it is capitalized and depreciated over the length of its productive life ". Capital Equipment is also considered as an investment that is directly related to the generation of profit. There is a direct correlation between Capital Equipment and the cost of production.
This is a sample how "Capital Equipment" is defined in a project :
b. Supply items are neither assigned UWM property numbers nor inventoried by Purchasing.
B. The acquisition cost of capital equipment includes the cost of transportation, installation, modification and attachments.
2. Capital Equipment is equipment, having a useful life of more than two years and an acquisition cost of $500 or more per unit.
3. Capital Equipment- Any movable asset (each item)
2.Types of Capital Equipment
Fixed Capital Equipment (FCE)
Examples of fixed capital equipment items are: plumbing fixtures, heating and electrical equipment, built-in shelves and cabinets, and inlaid carpeting.
Movable Capital Equipment (MCE)
1.Movable capital equipment is defined as capital equipment, which is not permanently attached to a building or a structure.
2. Movable capital equipment is not an integral part of its surroundings. Its removal does not affect the value of the item or the value of the real property.
3. MCE items are issued inventory numbers and are carried in the Generalized Inventory file. change in status, i.e., moved, sold, surplusage, stolen, traded-in, etc., must be reported to Purchasing.
4. Movable capital equipment is further defined as stationary or portable.
A. Stationary Capital Equipment (SCE)
1. Many items of movable capital equipment are generally housed in the same location because of size and/or application.
2. Such items are classified as stationary and their locations are a permanent part of the inventory record.
B. Portable Capital Equipment (PCE)
1. Many items of movable capital equipment because of size, use, or application may constantly be moved from place to place.
2. Examples include audio-visual equipment, dictating machines, test meters, etc.
3. Items in this category are designated portable capital equipment.
4.PCE must be assigned a "home" location. At the "home" location, a record should be kept of the PCE's current location including the name of the person to whom it is issued. Also, Home locations must be reported to Purchasing so that they can be recorded on inventory records.
3.Forecasting, Assessment and Replacement
Forecasting Returns from Investments in Capital Equipment:
How should a capital budget analyst go about forecasting the future cash returns from a prospective investment in Capital Equipment? From the standpoint of practicing Capital Budget Analysis, the preparation of accurate forecasts of future returns from investment in Capital Equipment represents a key element in any successful capital investment program. In other words, the forecast of the future returns from a capital Equipment must start with a forecast of the future rate of return, which the firm will realize on the cash, receivables, inventories and fixed assets in the line of activity to which the Capital Equipment relates. This will be true regardless of how the CE will be classified by the firm
In the case of proposed expenditures for cost reduction equipment, the future rate of return, which the firm will realize on the entire asset investment in the product line, needs to be forecast. Lets consider the case of cost-reduction equipment as an illustration. Here the forecasting appears simple and clear cut. Here the forecast of future investment returns involves estimating the future savings that will be realized in labor, material and other costs for some forecasted level of future output.
If a firm is to avoid ‘pouring money down the drain’ on cost reduction equipment, the present and future decisions to continue the activity must be explicitly considered first. In cases where the decision to continue the use of the Capital Equipment ‘goes without saying’ the cost savings will suffice to reach an intelligent decision on the equipment.
Assessment and Replacement of Existing Capital Equipment:
The great strides made in increased output per man-hour and output per dollar of investment have come to a significant extent through the installation of better tools and machines. If we are to continue to improve productivity it is necessary to replace obsolete plant and equipment. The replacement of obsolete CE should almost invariably make possible increased production as well as higher productivity.
The methods available for analysis of replacement investments are:
- Uniform Annual Cost
- Comparative Annual Cost
- MAPI (Machinery and Allied Products Institute)
- Incremental Cost
- Cost Flow
- Dynamic Programming
The Incremental cost, Cost-Flow and Dynamic Programming method are different from the other methods mentioned in that they compute the optimal year of replacement of the existing equipment rather than comparing costs of the existing and the new equipment to determine whether replacement is needed or premature. In terms of reliability and simplicity the Comparative Annual Cost Method is preferred to Uniform Annual Cost method and MAPI method.
Comparative Annual Cost Method (CAC):
Present equipment or the old asset is denoted as ‘defender’ and the equipment proposed for replacing the defender is called the ‘challenger’. The CAC method has been suggested by Foster and Norton. It recognizes three major components of replacement cost: capital, operating, and deterioration and obsolescence (D&O) costs. Capital cost refers to cost associated with the use of money, which is fundamental to the time value of money concept.
D&O cost reflects the annual machine depreciation and increased operating costs due to obsolescence.
CAC = (P-S)(ACPG r%, n) + Si + D
CAC = comparative annual cost P = Purchasing price of challenger or current market value of defender depending on whether this equation relates to challenger or defender. S = Salvage value ACPG = Annual Cost Plus Gradient r = annual rate of interest n = expected life service in years (for challenger) or remaining expected life service in years (for defender) i = interest rate per year D = net annual operating costs
4.Overview of Capital Equipment Purchasing
CE: When to Buy?
Most business owners will tell you the most complex, excruciating decisions that they must ponder are those involved with the purchasing of new capital equipment. " Will the market support it? ", " Will the economy stay good? " , "Can I afford to add more debt? " " Should I sell existing equipment? " These questions, and many more, go through the minds of trade finishing operations on a daily basis. Next section will explore the ins and outs of adding that new piece of equipment, and the type of questions you should ask before making a purchasing decision.
" Analyze the Need Carefully "
Before time is wasted in researching the specific model or manufacturer of the type of equipment they think they need, he or she should first do a " careful analysis " on the feasibility of adding new equipment. As many know, you can end up spending a great deal of time attending trade shows or talking with salespeople when you might think you are in the market for a new machine. This can be wasted time if you later find out you cannot afford the equipment or your particular market won't support it.
" The bottom line is that you must analyze the market and make sure you can get a return on investment,". How do you do this? Asking yourself if your current customer base will support the additional capacity. If not, you must decide if you will have the capability to expand your market either locally or farther out geographically. Find out if your competition offers this service already. If so, you must decide if the machine you purchase will produce better product or run at faster speeds. If they do not offer the service, it may make your decision easy, based on a belief that there is a market for the additional equipment.
Some companies analyze customer base by looking at the growth of various revenue channels and determine how much potential growth can achieve from them and then how much growth can be achieved from any new customers at a target during the next year." Companies also looks at the overall economy when considering new equipment as well, and looks even more specifically at the economic projections for the related industry both regionally and nationally.
Many times companies look at purchasing new equipment when they receive a specific contract for a specified amount of time. Contract work can justify new equipment, but there are many factors to consider. First and foremost is the duration of the contract. It is extremely difficult to justify new capital equipment if the contract work does not cross over into your main business focus, especially if the contract is for only one to two years. If the contract is set up for multiple years with options to extend it even further, then it becomes easier to justify the capital expenditure.
The marketability of the equipment is another important factor when considering a new machine. This can be especially true if you are looking at new equipment for a specific contract or if you are looking at entering a new market altogether.
"It is always worthwhile to check the resale value of the machines you are considering, Some equipment will historically depreciate rapidly while other machines can hold their value quite nicely." Checking with some of the used equipment dealers on their thoughts of the resale value is a good idea as well. If the new equipment that you are considering fits well with the current services you offer, and you do not predict a need to resell it at all, then the long-term marketability of the machine may not be as strong a factor.
Following are some more considerations
1) Of first importance are replacements, which give continuity of operation. Mobile mining and quarry machinery, for example, has an average life of five years. In cases of excessive use, it is frequently found that it is more economical to replace pieces of equipment after shorter periods, particularly when the cost of repair becomes high. In this type of equipment, there is little obsolescence. Extremely close watch is kept over the repair costs and when point is reached where uneconomical operation occurs, machine is ready to go off and to be replaced. Equally important is the plants where raw materials are processed. Here the depreciation period is about 20 years, but again, repair costs are the major factor in replacement. To prevent a complete breakdown, the maintenance staff watches each machine and as it approaches the end of its economically useful life, replacement is ordered.
2) A second category of appropriation requests is the replacement of existing machines to improve quality. Continuous research directed towards the improvement of both product and process repeatedly shows that changes in equipment are needed and that obsolescence in this area may become important.
3) Another category is the acquisition of new machinery designed to reduce costs.
CE: What to Buy?
Once you have determined that you are definitely in the market for a new press, folder/gluer, coater, etc., you now must take the second step and decide which particular machine to buy. Researching the potential equipment vendors for the type of machine you are considering and then identify what you need-fast make ready times, running speeds, registration accuracy, etc is recommended . "Create a list of what you are looking for and specific questions to ask your sales representative,".
Once you have narrowed your choices to machines that look to be the best on the surface, the next step is to get a list of installations and references. "Always check as many references as possible, ask questions on equipment reliability, service, parts availability, warranty issues, etc."
It is also recommended to visit the handful of manufacturing facilities that you have narrowed your choice to. "This is a step that a lot of people don't pursue, trade shows can disguise how professional a company really is, and parts inventory is the one area that can be easily misrepresented," An on-site visit can clear up any gray areas or last questions you might have. If the equipment manufacturer hesitates, then this might be a red flag before going any further. Lastly, a pre-delivery inspection of the equipment you are purchasing is always wise.
Before the machine leaves the factory, an actual production test of the type of product(s) should be done. It is recommended to use the actual stock, dies, glues, coatings, etc., that you know will be used in your plant to verify that the machine functions to your satisfaction. "This will allow you and the manufacturer to have peace of mind that the guarantees that are being made are realistic and can be met long term,".
How to Buy?
Purchasing capital equipment is different from other types of purchasing, which occur in an organization. " There is a direct correlation between capital equipment and the costs of production ".
It must be remembered, as well, that the total cost of a piece of capital equipment includes the costs of operating and maintaining the machine during its productive life. This cost may be much greater than the initial cost. That is why the purchasing of capital equipment requires the skillful estimation of future operation and maintenance costs unlike items which are used much more quickly.
Companies buy capital equipment much less frequently than most items needed to run a business. Sometimes, the frequency can be in terms of five to twenty years between the purchase of large items like chemical fertilizer plants, printing presses, welding machines or specialized materials-handling equipment. The reason being, that most of these items have long lead times and are expensive to design and build. Thus, they often take a long time to produce as well. This is of particular importance to the purchasing and engineering departments since lead times are most often quite long, sometimes months or even years. While there are some off-the-shelf capital equipment items, these are the exception. A long lead-time puts a premium on the ability of a purchasing department to select suppliers and negotiate mutually advantageous partnerships with them. Another issue is capital spare parts, their cost and lead times.
For the most part, the process of procuring capital equipment begins with a capital requisition form and approval process. A department in the company, usually Engineering or Maintenance, identifies a need for new equipment. Most often, this is not an immediate need but one that can be fulfilled in the near, or even long-term, future. Perhaps the company records indicate that a current machine is approaching the end of its life cycle and needs replacement. In many cases, the manufacturing manager has budgeted, as part of the company's strategic goals, the need for a new machine to replace an old one in order to make products of higher quality, lower total cost and higher profitability. Whatever the case, it is often true that this initial request for proposal is made to gather information about possible suppliers, prices and delivery schedules.
1) The requestor studies the proposals, to determine whether or not it is feasible to procure this piece of capital equipment. Perhaps information about alternative solutions needs to be gathered to explore more effective solutions.
2) If the decision has been made to continue forward with the original request, the requesting department works with a team consisting of people from Purchasing, Finance, Engineering and Maintenance to write up a capital appropriation request and detailed specifications. These specifications must cover performance, design and operating characteristics and features. It is often advisable to include a sales engineer (or engineers) from one or more of the suppliers during various stages in this step. They can supply alternatives (based on their expertise) which will lower costs or improve efficiency and quality.
3) When your company has drawn up these specifications, you then request proposals from suppliers. These suppliers should be certified.
4) Concurrent to the request for proposals, the company must prepare a financial analysis of all the alternatives.
5) Armed with the financial analysis and suppliers' responses to the request for proposals, the company evaluates the information, and makes a recommendation. This recommendation includes a description of the capital equipment, how it is used and why it is needed.All the metrics are carefully considered while making the decision. It also includes financial information such as estimated operating and maintenance costs for the equipment's life as well as the expected rate of return on the investment.
6) Since many purchases of capital equipment are expensive, top management's final approval is required. The written recommendation prepared in the previous step is submitted to management for review and sign off.
The last step is to finance it. There are several options involved with financing new equipment. Are you going to borrow money from your bank? Will you use a financial company familiar with the industry? Are you going to buy or lease the equipment? These are some of the basic questions you must consider.
If you have decided to borrow the money with a standard loan, you are most likely going to finance the equipment with your local banker or a finance company . This is certainly a personal choice. However, in many situations, a bank is not familiar with the graphics arts industry and will expect you to secure the loan with other assets within the company. A finance company within the industry will usually use the machine itself as collateral. This is possible because of their knowledge of the industry and the network available to them to help them sell used equipment.
Another advantage of working with a separate finance company is the flexibility of looking at other financing options that may not be available with a bank. These include a loan that has step up payments over the first few months as the business increases on the new equipment. This is especially helpful if you are expanding your business with services you never have offered in the past, like the addition of a new UV coating machine. It will take a while to educate your customers that you now have this service available if you have never offered it in the past. You can also negotiate a balloon payment at the end of the loan that, again, can help keep the payments down as you increase the work on the new equipment.
The other option available to you is the possibility of leasing the machine. Leasing provides an enormous amount of flexibility. You can look at options as we discussed above that include low payments at the beginning which increase throughout the term of the lease, balloon payments, and even seasonal payments where you pay more during the time period when the equipment is being used the most. This may apply with contract work that hits one or two times during the year. Leasing also allows a very small amount of cash outlay. In most cases, there is no down payment necessary as there is with a loan. In addition, if the lease is structured properly, you may be able to deduct the lease payment as a current operating expense for income tax purposes.
The major disadvantage of equipment leasing is that in the long run the overall cost of a lease can be more expensive than other types of financing. Secondly, because you are basically renting the machine, you do not build equity with the asset as you would with purchasing the machine outright.
What makes a "good" metric? From a psychometric point of view, metrics must be reliable and valid. Reliability refers to consistency, i.e. if circumstances do not change, the metric should read at a consistent value. Unreliable metrics can be thought of as indicators subject to a large amount of random variation. They may truly assess whatever concept they are supposed to be measuring, but one cannot trust the precision of the assessment. A valid metric is one that actually measures the concept we think it is measuring.
To illustrate, One indicator of the success of an Electronic Commerce trading partner relationship between an "X" and its suppliers may be the number of "expedited purchase orders". The validity question is whether this metric truly indicates the effectiveness of electronic commerce. One could argue in various ways. Part of Electronic commerce is a good planning process supported by technology. Because successful EC implementation requires good planning and efficient communication, one would expect EC to decrease the need for expediting. Or in a contrary manner, Expediting is mostly driven by unexpected changes in the "X"s market, and thus is not an indicator of the effectiveness of "X"/supplier EC. And so on, as many variations, nuances, and partial affects may be considered. The correct answer of course depends on context. If historically, expedited purchase orders in the "X" - supplier relationship came from poor internal planning and data transmission within the "X", then expedited purchase orders are a valid indicator. If the source of uncertainty has been the market, then the metric is not valid. Whether valid or not though, the measurement itself may be reliable, as in both cases one may be able to accurately assess the number of expedited purchase orders
In addition to the "scientific" concerns of validity and reliability, good metrics must also be practical, in the sense that the data can be obtained at reasonable cost and effort; and salient, in that they must mean something to the people who will use the information. To build on the previous example, many companies, for reasons of running their own business, keep good records of the number of expedited purchase orders they receive. Further, managers care about this number because the greater the expediting, the greater the trouble and cost to all involved.
The challenge is to jointly maximize the four characteristics of a good metric - validity, reliability, practicality, and salience. As in any design effort, good metric design requires not only a joint optimization of these characteristics, and also a cross functional design team whose members collectively understand, and have a stake in, all of the desired design parameters.
Metrics for Purchase of Capital Equipment:
1. Input costs
2. Process technology:
4. Economies of Purchase
6. Maintenance and Operational costs
8. Special Costs
Capital Equipment is what financial people call a non-current asset, meaning it is capitalized and depreciated over the length of its productive life.
Why do we go for CE? Basically we opt for modern machinery and equipment capable of producing a higher-quality product at lower cost with less waste.
To reach intelligent decisions on capital investments, it is necessary to consider long-range objectives, future technology changes, the need for additional products and other factors individual to each company. These considerations must indicate the effect on dilution of equity, reduced earning from heavy amortization in the early years, and the length of time it will take for earnings to justify the new facilities. Since the investment in CE is an occasional one, it requires careful analysis and research.
Another important decision to be made is whether to buy or to lease the equipment. If it is to be bought, the resale value of the equipment is to be calculated. The equipment should have a minimum payback period. Different Replacement and assessment methods are used to compute the optimal year of replacement of the existing equipment or to compare costs of the existing and the new equipment to determine whether replacement is needed or premature.
The Metrics for investing in CE are carefully looked into. Once the decision regarding the procurement (or replacement) of the CE is taken by the Engineering or Maintenance Dept, the process begins with a capital requisition form and ends with final approval from management.