Too often the equipment selection process is based on the �gut feeling� of the purchaser�s personnel, rather than a rational justification study. Unfortunately, too many operations do not conduct such studies. Companies have selected equipment that was easily 20% slower than their competitors, putting themselves at a competitive disadvantage that stretched into the future � while making a serious financial commitment.
 
Granted, equipment justification studies are challenging but well worth the effort. They are also an exciting discovery process. They can not only change the way an owner or management team sees and understands its operation, but such studies can also lead to significant changes in performance.
 
Starting the Process
Equipment justification studies should help a management team accomplish its objectives through a better understanding of how �all the pieces fit together.� It should cover items such as improved cash flow, potentially improved productivity per employee, changes in workflow speed and improvements in contracted work that is won and produced. In competitive environments, you�ll want to emphasize how the new equipment will lead to elevated customer satisfaction, improved employee morale and retention and, certainly, improved support from your target constituencies (e.g., parent company, senior management, customers).
 
Start your process by taking a conservative position at each step in assembling and interpreting information. Carefully document the choices of interpretation of information that were available, which choice you made and why. Keep in mind the impact of your work on the people in front of you, on the operation for which you are conducting the study and on throughout the entire process.
 
Begin by outlining the issues you believe need to be reviewed. Include estimating and financial performance, potential impact on depreciation, revenues, material and labor costs and cash flow. Then conduct interviews with key personnel who are involved with company direction. Discuss current business, potential business not being produced and opportunities (bids and inquiries) that are not being captured but could be if certain conditions existed. �Certain conditions� means your potential new piece of equipment as well as workflow changes that fit the organization�s needs.
 
Now create a �story� or picture that has numerical and financial values. It�s your job to tell the story to your readers who might include your production team, the company owner or division manager or even your banker.
 
Managing Cash Flow
Remember, cash flow is often more important than profits. And your responsibility is to improve your operation�s performance through creative management of all resources. This requires fact-finding, analysis and piecing together a plan that from a conservative perspective makes sense.
 
There are a lot of different items to consider, depending on your operation. Among others, there�s
� potential for more work to be won or brought in to the operation
� changes in productivity (what�s the value in dollars?)
� any potential changes in personnel turnover and associated costs of training
� changes in material usage
� changes in production times and overtime incurred
� changes in floor space or support resources (e.g., electrical service, additional support equipment, flooring supports)
� changes in supplier price levels
� changes in product mix
� changes in spoilage
� resale value of your equipment
� changes in personnel pay levels
 
From this background, you�re now ready to examine your new equipment�s potential installed cost, start-up cost, depreciation and potential trade-in values.
 
Start-up costs to be incorporated into your model might include lost production (and revenues) from installation, training and low productivity from personnel on a learning curve and site preparation costs. These are the types of issues that need to be considered as you negotiate a purchase price, down payment and payment schedule, interest rate, services provided from your supplier after installation and sometimes even trade-in value of equipment you�re about to buy.
 
Finally, you will want to make an expressed assumption for �cost of capital.� What this means is, as we calculate cash flow, future dollars in two, three and more years in the future are worth less than current dollars, and we need to calculate their �present value.� I generally use 10%, but some people prefer a lower (or in a for-profit environment, a higher) number.
 
This information follows detailed explanations of how you got the information you plan to use and becomes important for �where you end up.� For myself, I prefer a schedule that shows:
 Equipment Model:.............$
 Less Down Payment:...........$
 Balance of Payments Due:.....$
 Fixed Monthly Interest Rate: X%
 No. of Monthly Payments of: $
 Discount Rate for Present Value:
 
From this beginning schedule, you need to calculate each year�s contributions for:
� all cost reductions
� depreciation for the investment in equipment (this is a positive cash flow issue, and the number of years to depreciate varies by the type of equipment and its expected life)
� conservatively, what additional value-added contributions you believe you will enjoy (in dollars) as a result of the installation of the equipment.
 
From this total, for each year, factor in a deduction for payments; the discount rate for capital; and the state and federal tax rates for profits the company is experiencing.
 
If you make these calculations for each year of equipment payments and depreciation, you should be able to understand financially and mathematically the impact of such an equipment investment on your operation and, perhaps most importantly, when the equipment will generate a positive cash flow.
 
Your creation of an equipment justification study should provide professional challenges, insights and dividends to your organization. Meanwhile, the process is contributing to your management competence and understanding of what�s really required to improve company performance.
 
Over time, after one or two studies, you�ll understand that such analyses should be conducted regularly to insure your organization�s future. And your equipment suppliers should participate in the development of such studies.
 
Sid Chadwick is president of Chadwick Consulting, Inc. He can be reached by e-mail at sidchadwick@cs.com. For more information, visit www.chadwickconsulting.com.