This is a reprint of a special series of letters to our customers written by Ron Mager, MSI President & CFO in 2002.  This is the first in the series. 

Our experience has shown that many customers justify their machine tool purchases by intuition, gut feel, “got a new job,” capacity need, process improvement, etc.  Some customers use a more formalized approach and take the justification process a bit deeper looking at things like labor cost reduction, scrap elimination, reduction in tooling expenditures, etc.  Both of these justification methods have worked for many successful companies; however, in these difficult manufacturing times, we believe the only accurate means to justify a major capital expenditure is to perform what is known as a “Net Present Value” analysis or “NPV.”  This method is also sometimes called a “Discounted Cash Flow” analysis.

Net Present Value can be a difficult concept to understand; however, it is clearly the most fact-based method.  Perhaps the easiest way to understand the theory behind NPV is that a dollar today is worth more than a dollar tomorrow.  Why?  Because of what is known as the time value of money.  Still confused?  Think of it this way: if you had your choice of receiving $10,000 today or $10,000 in one year, which would you choose?  Of course, you would choose $10,000 today because you could invest it and in one year have more than $10,000.  This is what is known as the time value of money.

So what in the world does this have to do with justifying a machine tool purchase? A NPV analysis requires that you compare the investment you would make today to the future monetary benefits that will result from that investment.  Since benefits will be in the future and a dollar today is worth more than a dollar tomorrow, these future benefits must be discounted.

Prior to joining MSI, I spent twelve years in manufacturing with duties ranging from purchasing capital equipment to improving processes on the shop floor.  Subsequently, I received my Masters Degree with a specialization in Finance. Based on this background and experience, here are the steps I recommend.

First, establish the total cost of the investment.  Not only does this include the cost of the capital expenditure, but all those costs associated with it like freight and rigging, work-holding and tooling, etc.  In my example (below) a 10 CNC machine job shop with annual revenues of $3,500,000 has just decided to invest $1,000,000 in Mazak Multi-tasking machines.
 

Second, determine how long you expect to reap benefit from the investment. Customers typically use seven years in this portion of the analysis for machine tools because that’s what the IRS allows.  However, some customers might use three years because that is the length of the contract they are about to win.  Others might use ten or twelve years because that’s how long they typically hang on to machine tools. In my example, I will use seven years.

Third, estimate your “salvage value” (this might also be known as resale value or residual value) at the end of your project.  Obviously a three-year old machine tool will be worth more than a seven-year old machine tool.  Since I am using a seven-year life in my example, I am going to choose a conservative estimate of salvage value of 20%.  This value could easily be 30% to 40% depending on factors like machine condition, market demand, etc.

Fourth, determine all the benefits your investment will bring and the timing of reaping those benefits.  In the case of a machine tool purchase, a NPV analysis requires that you identify every potential cost savings resulting for the purchase and the timing of those benefits — things like set-up reduction, elimination of scrap and rework, maintenance costs, reductions in finished goods and WIP inventory, labor cost reduction, tooling and fixturing reductions, etc.  The simplest way is to determine how much will be saved in each year of the life of the investment.  Following is the list of cost savings used in my example.  This data is not “pie-in-the-sky”; we have spent years gathering this data from our customers.

Fifth, determine what is called the “discount rate.”  This is how I do it.  First, find out how much interest you would pay if you borrowed money from a bank.  Since the prime rate is about 4.75% today, I will simply use 5%. Second, I add on a factor for risk.  This could be as little as 3% or as high as 7%.  I will be conservative and use a 5% risk factor, so my discount rate is a total of 10% (5% + 5%).  The more confident you are in the success of the investment, the lower the rate you use.  For example, Mazak machine tools tend to be less risky and have lower discount rates in analyses such as this because their technology is proven, there is a tremendous support infrastructure in place and resale values tend to be high.

Finally, crunch all this data in an NPV formula.  Your accountant or financial advisor probably knows how to do this, or, ask us and we will be glad to help.

What kind of conclusion can you draw from this?  Well, the decision rule for NPV analysis is to accept any investment with a positive NPV.  In our case there’s a significantly positive Net Present Value and unless there is an alternative investment with a better NPV, you should make the investment.  If you wish to look at this from a Return on Investment perspective, the average annual return is 83.2%

The savings in my example may seem incredible, but Mazak’s Multi-tasking technology has actually provided these types of results.  Feel free to plug your own values into the model.  If you have questions, please send an e-mail to ronm@machsys.com.