Working On My Business: Evaluating New Machine Purchases In Terms of Impact On Operations

My experience tells me that most executives, however, never really evaluate the true cost of these modern marvels in terms of total impact on operations

It's hard to believe that IMTS is here again. It seems like only yesterday that I was rubbing elbows with the 120,000 plus professionals that pack into McCormick Place every two years to find and buy the latest technology for their shop. One of my clients purchased eight machines at the '98 show at about a quarter million dollars each. Big business! Big stakes.

My experience tells me that most executives, however, never really evaluate the true cost of these modern marvels in terms of total impact on operations. Those that do, tend to lead the pack in their industry and their shop's order flow is continuous, above industry average, reasonably stable and growing.

Let's look at some of the parameters that the management team must evaluate when considering the purchase or lease of a new machine for their company. Note that the machine can be new or used - the same principles and analysis apply.

Normally a manager will evaluate the cost of the equipment, the financing available and options, the delivery, and the bells and whistles that the machine offers. They take a cursory look at the jobs that will or can run on this machine and a rose colored view of the potential for adding more revenue to the company's income statement. Then comes the moment of truth - they decide if it feels right, make an educated guess and move forward with the deal. This seems pretty straightforward. Happens everyday! There are times when the deal-cycle has a short fuse - i.e., when someone wants to sell a used machine at about 60 percent of its value.

The first question that I ask a client is: Are you concerned about profit and equity for the next seven years? Sounds like a stupid question, but in fact it sets the tone for the analysis.

Why seven years? It's the normal tax depreciation cycle for capital equipment. As an example, let's look at a company that has $5,000,000 in annual sales and earns 15 percent PBT (Profit-Before-Tax). To facilitate its growth strategy, the company's management has decided that new technology in the form of a new machine must be acquired for operations. They have decided to buy a new hi-tech machine as their first step.

Assume that the machine they want to buy costs $210,000 and they are going to purchase the machine on January first and capitalize it. The company puts up $10,000 as the down payment and arranges a loan for $200,000 for five years at 10 percent interest APR. The first year they can expense-out approximately $30,000 ($210,000 divided by 7) in depreciation plus the $20,000 in interest - total of $50,000.

The tangible cash outlay is greater however:

Down payment: $10,000
Principle and Interest payments: $51,000 (approximately $4,250/mo.)
Subtotal: $61,000

For companies other than "C" type corporations, the difference is at least partially offset in reduced taxes payable. Thus, it appears to be a wash.

Maybe!

Now back to the question. The balance sheet at the end of the first year will show very little net change. The income statement will reflect the decrease of $50,000 in allocated profit. This translates to a lower equity transfer for the second year as well as future years. Any extra money that is generated as a result of new sales will increase profitability for the company in the current year and thus improve the net income (and equity transfer).

What if they don't want to sacrifice equity and profitability? How much revenue do they need to offset the $50,000 in profit loss? They must increase the sales in the first year of machine ownership by least $333,333. ($50,000 divided by 15 percent) This assumes that they add no additional staff or tooling and maintain current levels of productivity throughout the shop. Thus sales must increase by 6.67 percent. ($333,333 divided by $5,000,000) That's year one! There's six more years to go.

Let's now inject a bit more reality into the decision process and examine areas of impact on human capital (staffing), structural capital (operations management) and customer capital (sales and marketing).

Here are 25 questions that must be addressed before the actual procurement (purchase or lease) takes place:

    Human Capital

  1. What impact will the new machine have on morale and productivity (positive and negative)?
  2. Do I need more staff to operate this machine?
  3. Who will be assigned to the machine on each shift?
  4. Who will be trained?
  5. How long should the training program run?
  6. Where will the training be done?

    Structural Capital

  7. What impact will the new machine have on workflow? Shop and office requirements? Shop and office processes?
  8. Does this machine open capacity, meet a current need or is it something that I just want to have?
  9. Where will I put the machine and how will I get it into position?
  10. Do I need to make any structural improvements to the facility (e.g., special footings or supports, power, environmental, etc.) to accommodate this new machine?
  11. What service is required? How often? By whom?
  12. Can other assets be eliminated if I buy this machine?
  13. Will I have reduced rework and scrap with this new machine?
  14. How do I continue to meet or exceed current productivity outputs while this new machine is being brought on-line in the production main stream?
  15. What impact does this acquisition have on my QS 9000 or ISO program? What are the required changes and who will make them? How long will it take? When will they be done?

    Customer Capital

  16. Do I currently have enough profitable work from my backlog to keep this new machine running full-time?
  17. How many of my current customers have jobs that will match the capabilities of this machine? Can this be leveraged into a new market segment?
  18. Must I add additional sales personnel to accomplish the increased revenue goal?
  19. What impact will this new machine and its inherent technology have on attracting new customers?
  20. Can I acquire enough additional sales for the next seven years to break even on costs? Make money?
  21. How stable is the contract (order) that I currently have for work that will be done in this machine? How long will the contract run?
  22. How stable is the business segment and the customer from whom I received this contract?
  23. What happens if the need for which the machine was procured disappears?
  24. What happens if I lose a key customer in another business area?
  25. What happens if I don't achieve increased sales?

The answer to all of the above questions and associated cost analysis will determine the at-risk basis for the decision. The questions and answers must not be taken lightly or addressed only on the surface, as the repercussions can be rather dramatic. However, with appropriate risk planning and management, the rewards can be quite lucrative.

As the analysis is done, examine the basis of the answers. Some useful queries for yourself: How do I know this to be true? How can I ensure that it remains true? How soon will I know if something changes? How will I recognize the signal? What do I do if something does change?

It's an exciting time when a new machine arrives in a shop. Expectations are high. People have visions of working with this new technology or at least a new machine; something different and challenging; something that is rightly or wrongly attached to self-image and self-worth. Management sees the machine as a way to build onto the legacy, improve market leverage, improve customer service and build strength into the infrastructure. Sales and marketing personnel typically envision new opportunity for getting orders and improving service (Note: The manufacturer's reps also visualize more commission dollars).

There's a lesson here for machine manufacturers and their respective sales forces as well. Know the total extent of your customer's requirements and needs. Use that knowledge to help them make the decision process easier. Help them be successful. You're not selling a machine or even a technology. You are selling solutions - solutions to your customers' needs! Before you make a sales call to a customer, review the aforementioned 25 questions and formulate some ideas.

Let's revisit the example and add some of the dynamics of the impacts. The numbers represented in the example above ($50,000 lost profit, $333,333 in new revenue required) are only the tip of the iceberg. As a guideline, one can expect the following additional impacts in the first year:

Improvements/accessories: $25,000 - $50,000
Support and service: $5,000 - $25,000
Total extras: $30,000 - $75,000

Adding these to the $50,000, the new profit reallocation is between $80,000 and $125,000 and revenue must increase by $533,333 - $833,333 (10.67 percent to 16.67 percent).

Still not done!

What about productivity? What falls into this category?

  • On-the-job training.
  • Operations learning curve associated with the new machine.
  • Lost output due to the curiosity factor.
  • Install and cut-over time.
  • New scheduling and flow issues.
  • Delivery issues.
  • Conflict resolution of operations issues.
  • Politics and fence mending associated with whom will be/was chosen as the guardian of the machine.
  • Changes in processes (e.g., quoting, design, engineering, programming, sampling, etc.).
  • Lost management time.

What is the cost associated with lost productivity? Typically, one can expect at least one full man-year (i.e., $50,000 = 2,000 hours at $25/hr.) and likely more in the first year. Add another $333,333 to the sales goal.

There's more!

If we lose productivity, we obviously aren't able to ship (and invoice) the $5,000,000 in sales. This is the lost opportunity factor! Thus, the basis for computing additional sales has shifted. Thus far, we know that nearly a million dollars in sales must be achieved in the first year if we want to sustain the same level of equity contributions and profit margins. The lost opportunity factor will substantially increase this sales goal.

When you look at that scenario, you might conclude that it's insane to buy new equipment? Not true! All of the costs defined are controllable! All of the risks are manageable! The differentiating factor is whether you assess the impacts thoroughly during the decision-making process and implement an integrated plan with discipline. The example does show, however, that when you are working on your business, there is more to consider than the obvious.

My client who purchased the eight machines at IMTS '98 did so in accordance with a very focused strategy and commitment to a long-term vision. He wanted to take a technology leap forward and did so. As a result of his analysis (using those 25 questions) and his collaboration with stakeholders, he was willing to lower his level of profitability and equity contributions in the near-term in return for making huge gains in the market served (depth and breadth) and profit later. He essentially replaced all of his machines with the new technology in 1997, added the eight purchased at IMTS '98 and bought another two in 1999. Because the company planned for the transformation and then executed the plan diligently, it was able to hold margins and thus retain its profitability even during this massive changeover. Revenue has increased an average of 66 percent per year since 1997.

It can be done!

It's your company, your customers and your money! You must decide if a little time up-front and some disciplined follow-through are worth the effort. Do what makes sense and hopefully cents for your special situation!

As for me, I prefer fewer surprises down the line. I am a strong advocate of creative before capital as a leadership trait. This is one way to protect a company from the inherent risks involved when purchasing machinery.

 

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Editor’s note: Fred Young wrote this article to a colleague outside the gear industry to explain his company’s strategy. He sent it to Production Machining with the hope it would be of interest to our readers.