Capital Expenditures: A Corporate Freebie?

Many managers believe that because a capital expenditure is initially recorded on the balance sheet and the expense can be spread over a number of years that there is only an incidental effect on the profitability of the company – a kind of corporate “freebie.”  This is true enough when taken as a single event, but over time the cumulative effect of acquired assets can create a very large expense that has to be managed (and explained) for many years to come as a damper on profitability.

The profitability of the company has a direct affect on the perception held by banks, leasing companies, trade vendors and potential investors regarding the relative risk and/or value placed on the business.  This perception, in many cases, will determine your ability to maintain existing financing arrangements or to secure additional funding for the operation going forward. Be very certain the investments you make are necessary and the return is sufficient.  You will live with the results for a very long time.

Scaling the Profit Mentality

As the size of the company increases so does the level of resources made available for developing extensive complex systems and procedures used to “manage” all areas of the business.  In large companies there are operating divisions which have multiple departments and many functional areas within departments.  There are often teams with cross-functional members to address nearly every issue that arises.  And there are a lot of people to do the things that need to be done.  This is all good and, in most cases, completely necessary.

However, the larger the company, the more levels of management there are and the further the operating staff is removed from the development of the financial model that will determine the company’s future.  There is distance between the direct detailed knowledge of the requirements and the ultimate execution of the activities that most often impact the outcome to the greatest degree.  This distance dilutes the message which then blurs the intent of the directive.  The basic assumptions are that there is a certain dilution that occurs as a message is communicated through the various levels of the organization and additional dilution that occurs as it is translated across non-finance functional lines.  There are an infinite number of factors that may determine the degree to which the dilution actually takes place from person to person.

Without a fundamental understanding of the overall objective (which should be making a profit) and an instinctive ability to make the right financial decision at the right time in order to hit the targets, the actual outcome can quite often be very different from the desired outcome.  The development of a “Profit Mentality” across the entire organization will ensure that every decision is undertaken with a common purpose in mind: the true profitability of the company.

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Using Payback Period to Evaluate Purchases

A fairly simple and straightforward concept for evaluating the wisdom of a purchase is to determine the payback period.  The payback period, defined as the time required to recover the initial cash outlay for an item or project, is calculated by determining the hard dollar value that will be realized each month from acquiring the asset then dividing the total purchase price of the item by that number. 

For example, let’s assume you are considering the purchase of an asset that will return $100 per month in reduced expenses (or possibly increased gross margin) through more efficient operations.  If the purchase price for that item is $1,000 the payback period is 10 months (.83 years).  However, if the price is $10,000 the payback period is 100 months (8.3 years).  Considering the fact they each return $100 per month of benefit, which item would you buy?  There are situations when making multiple purchases over time of lower cost items that have a shorter useful life will be a more effective use of cash than the purchase one higher cost item that will last for many years.  You should do the math to determine the payback to make the appropriate decision.

Although the payback period calculation can be complicated by inducing an untold number of complex variables such as inconsistent returns year over year, discounted cash flow considerations, lease vs. purchase options, etc., the very simple approach presented above is as effective in nearly every case.  The more sophisticated the formula, the more opportunity there is for incorrectly determining the assumptions that influence the outcome.

Back to Basics: Inventory Management

Inventory is the amount of goods kept in stock for use in producing the company’s revenue.  These are items that are either consumed during the activity that is undertaken for the sole purpose of making the company’s products available or they are items that are directly incorporated into the products produced.  There are four primary types of inventory.

• Finished goods – completed products that are ready for sale to the customer.
• Work-in-process – products in semi-finished form that require additional material and/or more labor before becoming finished goods.
• Raw materials – items on which no labor has been expended that are to be incorporated into finished goods before completion. 
• Indirect materials – materials and supplies that aid in the production of finished goods but which do not become part of the finished product.  In service or other similar companies where there is no finished goods inventory, these may also be supply type items that are used specifically and directly in the provision of services.

Inventory management will have a direct impact on the profitability of your company.  It can be either a positive impact or a negative impact, but it will have an impact.  The answer to effective inventory management is a well-organized system of planning and control that is consistently followed.  The level of sophistication is not the overriding issue; it is the continuous effort of monitoring the process and executing in accordance with the established management guidelines that will make the effort a success.  A haphazard approach to inventory management is certain to result in a long list of unwanted surprises.  Through the affect on profits, these surprises can dramatically change your expectation for cash flow.  If the magnitude of the change is significant enough, the result can be devastating to the business.

The technical aspects of accounting for inventory management can be extremely complicated and require years of formal training to handle properly.  Although the effect of these different accounting procedures on profitability can be quite significant, it is also relatively short-term in nature.  Over time, the end result is basically the same.  Your ability to manage inventory for maximum profitability is not predicated on understanding the details of these technical issues, that’s why there are accountants in the world. 

The issues that drive true profitability and therefore cash flow (ignoring the accounting stuff) are more operational in nature.  These are associated with the efficient and effective use of the inventory sitting on the shelf.  The kinds of items that might be included in inventory for any particular company will vary widely and could possibly require different methods and techniques for managing each type.  However, the ability to anticipate the correct purchase volumes to be ordered at the right time and to effectively distribute and make use of the various items are the keys to success.