In an ongoing operation of a plant it may necessitate the addition of a new machine or process equipment due to demand or Line extension for the products. /before procuring and commissioning the capital goods a thorough financial analysis has to be undertaken considering addition of positive factors and subtraction of negative ones. If the difference is positive then it justifies the planned action of installation of a new machine as the company benefits from the action.
A financial analysis also termed as cost benefit analysis finds, quantifies, and adds all the beneficial parameters. These are the benefits. Then it identifies, quantifies, and subtracts all the negative parameters or the costs that are likely to be incurred. The difference between the two indicates whether the planned action is advisable. The analysis must include all the costs and all the benefits and properly quantify them to know the correct profitable or losing proposition.
The expenses must include even items like hiring an additional sales person or assigning overtime. It may also be taken into consideration whether investing the money in a new machine is a good idea or it is better off putting the available free cash flow into securities rather than investing in additional capital equipment. Each of these questions can be answered by doing a proper cost benefit analysis.
Given below is an example for an investment justification Analysis:
The V.P (operations) is proposing the purchase of Rs 50 lakhs Power Press line to increase the output based on demand consideration from assembly shops and marketing groups. He has to submit the proposal to the Board of Directors through the CEO.
Here the V.Pâ€™s proposal to the Board must incorporate some facts to support the suggestion. The numbers determined after a cost benefit analysis justify or support the recommendation to the higher management. The benefits must be indicated item wise and production increase in terms of output per shift with the new machine should be precisely highlighted.
The three workers currently doing some press operations by hand presses can be replaced. The new power presses will be higher quality because they will be more uniform. These benefits should outweigh the costs.
Now the costs are, cost to purchase the machine, interest on capital utilized for procurement of the machines and it will consume some electricity and operating supplies like lubricants and additives used for smooth operation of dies etc.,. Any other costs would be insignificant.
On the beneficial side calculate the selling price of the additional units per shift multiplied by the number of shifts per day and the number of working days per year. Add to that two percent for the units that aren’t rejected because of the quality of the machine output. The monthly salaries of the three workers who were earlier operating hand presses and are replaced by the automatic power presses can also be added. The total benefit is thus worked out.
The expenses and the costs are already indicated in the above paragraph. [Benefits â€“ Costs] indicate the net benefit to the company. These projections presented to the higher management in a understandable and simple format will easily get the approval of top bosses. A proper analysis of costs and benefits will lead to a sound proposal.