Tuesday, January 4, 2011

Questions to Answer When Evaluating a Fixed Asset Purchase

Because a fixed asset requires such a large investment that will impact the operation well into the future, before making the purchasing decision, careful consideration should be given to its long-term usefulness, the business that will be generated from its use and the return on that business.  Although quite different from company to company, the capacity for accumulating fixed assets is limited.  Therefore, it is important to make your choices wisely when evaluating a capital expenditure.  Here are a few questions to consider when making those decisions.

•             What other opportunities will be eliminated or delayed significantly by the use of cash (or debt) for this expenditure?  Are there other items that would provide a higher or faster return on the investment?  Would a different decision facilitate increased operating efficiency more quickly or more effectively?  Remember, there are opportunity costs with every decision.  You can only spend the cash once and then it must be replenished.

•             How does this item support the future objectives of the organization?  It is important to be certain of the company’s strategic plan and the areas in which that plan will require the application of resources.  Capital expenditure decisions will have an impact on the operation for years into the future.

•             What is the possibility that an item will become obsolete before it has reached its useful life?  Obsolescence is the loss of usefulness of an asset occurring through progress of technology or by changing laws or social customs.  It is a reduction in the value of the item resulting from revolutionary inventions, unusual growth or development, radical economic changes or other factors that force retirement before the end of its useful life.  The last thing you want to do is invest a large amount of cash in an asset only to find that a few years later (long before its 5-7 year life) its effectiveness has been significantly diminished because of the evolving needs of the company or business in general.  Electronic equipment such as computers, telephone systems, copy machines, etc. is especially susceptible to this phenomenon.

There should be a periodic review of the company’s fixed assets to determine if there are under-performing items.  Action should be taken as soon as it is feasible to dispose of any assets that are determined to be under-performing, or even worse, non-performing.  Unless there is a probable future use for an asset, there is no logical reason to retain it in the company.  Holding items that have no useful purpose causes the operation to be impacted by consuming otherwise usable floor space, increasing maintenance costs unnecessarily, and having cash tied up in assets that are not useful to the business.