Every day, senior management must evaluate investment opportunities (such as an opportunity to build a new plant or to purchase new equipment). Big decisions require information, and information is based on planning. This is capital budgeting. Cash is always sacred so every project requires a thorough analysis to see if it is feasible, and ultimately profitable to the company.
Generally an investment in new equipment or a new plant will result in a net cash flow (through a decrease in annual operating costs). The payback period is the time it takes to recover the initial investment through this net cash flow.
|Cost of machine||$16 000|
|Annual net cash flow||$3,500|
Over a period of 4.6 years this machine will have paid for itself. This is based on the budgeted annual operating costs being accurate and shows how important an accurate budget is. In choosing investment opportunities, a short payback period is desirable. The shorter period also reduces the risk of premature obsolescence as well as changes in the business environment that may reduce the usefulness of the purchase.
Identifying the break-even point for a particular project is a good way to evaluate whether or not a new idea has the ability to make money. The formula is:
Fixed costs are those that remain the same regardless of the level of production, like rent or office equipment. Variable costs encompass the materials and labor required for the product. These items are used more or less depending on how much product is produced.
Let’s say that you want to make a new kind of gadget. The fixed cost for each gadget will be $50. The variable costs will be $5.56 for each gadget. The break-even sales point, therefore, is $55.56. Selling your product for any less than this would result in a loss.
Another type of analysis that can be as simple or complex as required is cost-benefit analysis. This allows you to compare what an opportunity will cost versus the expected payoff.
Let’s say that you’re trying to decide between two robots to help you make widgets.
|Robbie the Robot||Rachel the Robot|
|Widgets Produced Per Hour||75||60|
|Value of Widgets Produced Per Hour|
($5 sale price each)
|75 x 5 = 375||60 x 5 = 300|
|Cost of Units Produced||75 x 1.5 = 112.50||60 x .25 = 15|
|Total Value – Total Cost =|
|375 – 112.50 = 262.50||300 – 15 = 285.00|
Initially, Robbie seems like the better choice if we just look at how many widgets produced per hour. However, Rachel has an overall better benefit, and therefore seems to be the better buy.
Return on Investment
This calculation enables you to see what a particular investment has returned, giving you a percentage that easily allows you to see how this investment has performed. The basic equation is:
The result is then expressed as a percentage, which gives you the return on investment.
Let’s say that you put $100 into a savings account. Over a period of 20 years, you got $10 back in interest.
|110 – 100|
Your return on investment, then, is 10%. Please note that when performing this calculation in the real world, there can be many other factors affecting it and therefore complicating it. This is only the basic formula.