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The economics of investing in coffee equipment.

Fred McKinney covers several of the most common approaches to evaluating investment decisions.

Take a quick peak through the latest edition of Ukers' International Directory and you will find glossy pictures and descriptions illustrating the full range of coffee equipment, from augers to vacuum packagers. Equipment in every business is indispensable. Roasters as well as retailers have to choose what to buy, when to buy, and how to pay for all of these different types of equipment.

Companies of all sizes use some type of analysis to answer these questions. In general, the larger the company the more rigorous the decision making process. Over the years financial analysts have developed techniques to assist managers and owners with decisions regarding expenditures for capital equipment. And recently, software companies such as Microsoft and Lotus and financial calculators such as the Hewlett-Packard 17BII have introduced tools that make capital budgeting analysis relatively painless. Now the approaches used by the largest companies are and can be used by even the smallest coffee retailer.

Reasons Why Companies Purchase Equipment

Why companies purchase equipment might appear so obvious that it may seem unnecessary to delineate the reasons. However, there is value in categorizing the reasons for your equipment decisions because these decisions define your strategy. For instance, if your company is spending its limited resources replacing outdated equipment, there may not be sufficient resources left to pursue new business opportunities. Alternatively, if your company is investing heavily in equipment to pursue new markets, there may be little left over to patch up and replace outmoded and inefficient equipment in other parts of your business.

Replacing Obsolete Equipment

As much as we don't like to admit it, we as individuals are not that different from the equipment we use in our businesses: we both break down. Sooner or later all of the equipment we use will need to be replaced because it simply will not work anymore. Replacing obsolete equipment in many respects is a decision that many managers/owners make without doing any detailed analysis. Simply, it broke, we need it, buy another one. My advice is not to be too hasty when this occurs. When things breakdown because of use and real depreciation beyond repairs, here is an opportunity to review changes in technologies. There may be a new type of equipment that does more than your old clunker ever did, something that is faster and more efficient. In addition, when things break down, this is a good opportunity to review how essential this part of the business is to your bottom line. For example, your company uses large trucks to pick up and deliver coffee and one of these trucks breaks down. The best thing to do may not be to run out to the nearest truck dealer and buy or lease another truck. A better approach might be to negotiate shipping costs with suppliers and customers, to pay for the shipping to and from your door and not be bothered with the expense and upkeep of an underutilized fleet.

Purchasing New Equipment to Expand Your Market

New market development comes in three general forms: expanding horizontally, expanding vertically, and expanding in unrelated areas. Horizontal expansion involves increasing the geographic scope or market scope of an existing line of business. So if you are a retailer who decides it is time to open another shop one town over, there will be capital expenditures required for this type of expansion. A decision to expand your business horizontally needs to take into account the impact this type of expansion places on existing resources as well as a full understanding and analysis of the new types of equipment needed for success.

Vertical expansions are characterized by taking on new types of products and businesses that are part what Michael Porter of the Harvard Business School calls the "value chain." For instance, a wholesale roaster might decide to add some chairs and a bar in order to sell fresh brewed coffee to retail customers. In order to take advantage of this market, expenditures for new types of equipment will be necessary. Whether this investment in new equipment is good or bad for the bottom line can be determined from an analysis of the net cash flows associated with the investment. Vertical integration can also go back towards the goods and services your supplier sells you. Under the right market conditions, it is appropriate to consider making investments of this nature.

Expansions into unrelated areas also require analysis. For example, coffee roasters may discover that there is a growing demand for high quality bulk teas among their customer base that is not being serviced now. This market has its own unique equipment requirements, not to mention product knowledge skills. These new markets can be treacherous because the skill base required for success takes time to develop. This information directly impacts and can be considered in the capital budgeting process.

Purchasing New Equipment to Lower Cost

Lowering costs is one of the most important reasons for purchasing new equipment. Much attention is paid to the effect improvements in information technology have had for firms of all sizes and in all industries. Everyone is familiar with stories of how the internet has allowed companies to expand their marketing reach beyond their historic market boundaries. But the internet and computer technologies do not have a monopoly on reducing costs. Roasting, grinding, packaging, brewing, and dispensing equipment have all demonstrated improvements in productive efficiency. A dollar saved drops right to the bottom line, making it actually better than an additional dollar's worth of sales. Deciding whether to purchase equipment that promises to lower costs is a common use of capital budgeting analysis. The equipment our company makes, the bean machine, has demonstrated significant reductions in operating cost in comparison to traditional acrylic bins. A capital budgeting analysis requires that these savings be documented and compared to equipment costs differentials.

Other Reasons to Invest in New Equipment

Companies in all industries make investment decisions occasionally because government requires them to. Roasters are well aware of environmental legislation defining the amount of effluence permitted. To stay in line with environmental regulations frequently requires investment in different types of equipment. Even here there are choices, and anytime there are choices, there is an opportunity to analyze what is best.

Other reasons for capital investment are quality improvement, research and development, and competitive forces. Each of these reasons also require managers to analyze the bottom line consequences of their capital expenditures.

Approaches to Capital Budgeting Decision Making

There are three commonly used methods of evaluating capital expenditures: the payback method (PB), the internal rate of return method (IRR), and the net present value approach (NPV). In addition, I will next define two terms that are common to most capital budgeting analyses.

Present Value

The present value concept takes into account that there is a time value of money. Money received today is worth more than the same amount of money to be received in the future. In order to calculate the present value of some amount of to be received in the future it is necessary to discount that future amount by some discount rate. The formula for a present value is: PVt = CFt/(l+r)t.

CFt is the cash received at the end of year t, and r is the discount rate. For example, the present value of $1,000.00 to be received one year from now assuming a discount rate of 10%, is $909.09. The interpretation is that $909.09 received today is equivalent to $1,000.00 to be received one year from now if the interest rate is 10% and there is no risk.

Net Cash Flows

The Net Cash Flow associated with a capital expenditure is the amount of cash after all expenses an investment generates per period of time. For example, if a coffee roaster can produce coffee for $2.00 per pound and sell that same coffee at $4.00 per pound, the net cash flow per pound is $2.00. If the roaster can now sell an additional 1,000 pounds per month by purchasing the new roaster, the net cash flow equals $2,000.00 per month. It is the net cash flows that need to be estimated into the future when doing capital budgeting.

After the net cash flows are estimated (or "guesstimated"), it is necessary to discount those net cash flows into present values.

The Payback Method (PB)

The PB method is perhaps the oldest method used by managers and owners to assess the profitability of a capital expenditure. The payback method simply divides the cost of the equipment by the amount of net cash flows produced by the equipment over some period of time. For example, take a retailer who is considering purchasing a $1,000.00 grinder. It is estimated that the grinder will increase net cash flows by $75.00 per month because of a reduction in lines and increased sales during the coffee rush period. Under this scenario, the retailer will be able to recoup her investment in 13.3 months. After that 13.3 months is up, the net cash flows continue to be earned as long as the equipment is in service.

The most common mistake made when using the PB method is that of using sales as opposed to net cash flows. Beware of any equipment pitch that asks you to compare the additional cost of their equipment to only the increase in sales. Remember - sales cost money!

The PB approach is widely used because of its ease of calculation. The problem with this approach is the difficulty in comparing projects. All companies have constraints. No company can invest in every possible project. Which project or projects should be selected if increasing the bottom line is the objective? The PB method is not definitive when it comes to ranking alternative projects. The reason for this is the PB approach does not take into consideration the useful life of the equipment and the longevity of the net cash flows associated with the investment.

The Internal Rate of Return (IRR) Approach

The IRR approach is judged by most financial analysts to be superior to the PB approach. The IRR is calculated by solving for the interest rate that equates the present value of the net cash flows to the cost of the equipment responsible for those net cash flows. Calculating the present value of net cash flows has become relatively simple with the advent of financial calculators like the HP 17BII and Excel spreadsheets. In the not too distant past, calculating the IRR was a trial and error process. With financial calculators or with Excel, all you need to do is type in the net cash flows over the life of the investment, including the initial cost of the equipment, and press a button and the IRR is calculated for you. Take the example presented above with the retailer considering the purchase of the $1,000.00 grinder that generates $75.00 per month in net cash flows. The internal rate of return on this project is 81.75%! (This assumes the increase in net cash flow continues for 4 years.)

After calculating the IRR, we simply compare that number to the firm's cost of money. If the IRR is greater than the cost of money, the investment should be made. If the IRR is less than the cost of money, the investment should not be made. The IM analysis suggests that the grinder should be purchased if the cost of money is less than 81% per year.

The Net Present Value Approach

Calculating the NPV of an investment is the preferred way of looking at equipment investments. The NPV compares the PV of the net cash flows to the cost of the equipment. If the PV of the net cash flows exceeds the equipment cost, the investment should be made. If the PV of net cash flows is less than the equipment cost, the investment should not be made. If there are multiple projects to choose from, investments with the greatest NPV should be undertaken first, assuming the firm can finance the equipment. Unlike the IRR approach, where you search for the discount rate, the NPV approach assumes some discount rate. That rate generally is the cost of money (capital) to the firm. In our grinder example, if the cost of money is 10%, the NPV is $1,853.00 (The present value of net cash flows $2,853.00 less the equipment cost of $1,000.00). The interpretation is that purchasing the grinder will generate the equivalent of $1,853.00 in today's dollars net of equipment cost.

Before you decide to purchase that new equipment, do a brief analysis of what that equipment will do for your bottom line. If you make the decision to buy, continue monitoring your investment to check whether your estimates of the net cash flows were realistic. If they are not close to your estimates, redo the analysis to see what the real returns are. Keeping track of your returns on investment is an excellent way to manage your business.

Dr. McKinney is vice president of sales and marketing for Advanced Dispensing Systems (ADS) in West Haven, Connecticut. ADS manufactures and distributes the bean machine. Dr. McKinney is also an adjunct assistant professor at the University of Connecticut School of Business Administration. Dr. McKinney would be happy to answer questions regarding the use of financial calculators or Excel spreadsheets. E-mail: sales@thebeanmachine.com.
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Author:McKinney, Fred
Publication:Tea & Coffee Trade Journal
Date:Aug 1, 1999
Words:2264
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