Capital Expenditures and Competitiveness

31 Jan, 2007 By: Jeffrey Rowe

Use actual costs to show ROI numbers

Even though it's still relatively early in the year, many of you already know what and where you'll see funds allotted for hardware and software technology acquisitions. It's tough when all of an organization's projects and departments vie for the same finite pool of capital dollars. When attempting to persuade and influence the powers that hold the purse strings, one of the most challenging aspects in pleading your case is justifying an expense.

Historically, ROI (return on investment) analysis of the past has been used to justify expenses that will benefit the company and improve its ROI in the future. However, I don't believe that looking at the past adequately represents productivity gains that can be realized in the future if new and better technologies are employed in design, engineering and manufacturing.

I think the biggest fault in this history-based prediction of future gains is in relying on what is known as standard costing, an accounting practice used to estimate the overall cost of production.

Different Accounting Practices

Not to get into a boring accounting lesson, but let's do a little background on different accounting methods in order to better understand how to justify technology expenditures.

Standard costing is a type of cost accounting where standard costs are usually associated with a manufacturing company's costs of direct material, direct labor and manufacturing overhead (including a variety of technologies).

Rather than assigning the actual costs of direct material, direct labor and manufacturing overhead to a product, many manufacturers assign the expected or standard cost. This means that a manufacturer's inventories and cost of products sold will begin with amounts reflecting the standard costs, not the actual costs, incurred when designing and manufacturing a product. Manufacturers, of course, still have to pay the actual costs. As a result there are almost always differences between the actual costs and the standard costs, and those differences are known as variances.

Standard costing and the related variances are valuable management tools. If a variance arises, management knows that manufacturing costs have differed from the standard (or planned, expected) costs. If actual costs are greater than standard costs, the variance is unfavorable. An unfavorable variance tells management that if everything else stays constant, the company's actual profit will be less than planned. If actual costs are less than standard costs the variance is favorable. A favorable variance tells management that if everything else stays constant and the actual profit will likely exceed the planned profit. In theory, the sooner an accounting system reports a variance, the sooner management can direct its attention to the difference from the planned amounts.

Actual cost. An alternative to standard cost accounting is a method known as actual cost, allowing you to assign the costs incurred in a given period directly to materials and equipment. The main advantage of the actual cost method vs. the standard cost method is that the former can accurately measure the impact and benefits of technologies used for design, engineering and manufacturing. The two most distinct advantages of using the actual cost model include:

• Cost is based on a predicted future level of productivity, not on past performance.
• Cost per production part is known at different levels of productivity for both people and technologies employed.

All right, that's enough about different accounting methods. They do, however, provide a basis for speaking the language of the decision-makers you approach for funding new technologies.

Using actual costs could help you justify technology expenditures for future productivity gains and competitiveness.

Continuous Improvement

It's all about continuous improvement, and in manufacturing companies, this can take many forms -- whether it's improved design and engineering methods, lower cycle times, improved quality or many other things. Digital technologies are crucial to continuous improvement because they don't only lower costs, but can also overcome shortages of skilled and qualified personnel. To determine the potential impact of technologies and activities that enhance productivity, don't be too concerned about the past, but measure the state of your current processes to establish a baseline for future process improvements.

What to Know

Knowing how and why you do what you do now will help you justify technologies aimed at future competitiveness. Things you need to know to present your case to the financial types include:

• actual costs of current processes,
• actual cost of proposed processes and
• comparisons of actual costs at different levels of performance.

Ideally, properly implemented, newer technologies will increase productivity, lower your costs and might even pass along cost savings to your customers.
Don't base your case on past problems and inefficiencies -- who wants to be reminded of bad decisions made in the past? Present what you're doing today and a plan for better future competitiveness based on purchasing and implementing advanced technologies.

In the Future

In a future installment, I'll talk about some of the most common mistakes that companies make when considering and purchasing new technologies -- and how to avoid them. Just because you've been granted funding, doesn't always make it easy to make the right decisions when purchasing and implementing new technologies to help you become more productive and competitive.