Asset Purchases - When to Upgrade?

Here we consider the following:
Payback Period, Return on Investment (ROI) and Break-Even Analysis.
As a business owner, committing to new plant and equipment or vehicles can be a significant cost. The above calculations provide some structure to making purchasing decisions.
As an example, let’s say that a new item of plant will cost $100,000 (less $10,000 from sale of old plant) -resulting in a net cost of $90,000.
The plant will be more efficient in fuel/power saving $8,000 in costs per year.
Additionally repair and servicing costs will reduce from $9,000 down to $3,000 per year – an annual saving of $6,000.
Improved output from the new plant will contribute a further $10,000 to gross profit each year.
All up these savings/contributions will total $24,000 per year- excluding any financing costs.

Payback Period – This calculates the time in years that it takes the savings to repay the cost. This equates to 3.75 years. Calculated as $90,000 / $24,000. At the end of 4 years the new plant will have effectively paid for itself.

Return on Investment (ROI) - this looks at the percentage return that will be provided on the investment cost. Using the above example an annual return of $24,000 on a net cost of $90,000 is a ROI of 27%. If the cost to finance the asset purchase was 10% per annum, then the ROI in this case is higher/better than the interest cost.
This calculation can also be modified to account for depreciation so that the gradual reduction in the value of the plant is accounted for.

Break-Even – this considers what the return needs to be to cover costs. If the business took out a loan for $90,000 over a 4-year period at 10% interest, the annual loan repayment would be $27,400 (Interest & Principal).
In this example the annual savings/income increase of $24,000 is less than the breakeven requirement. But its close! – and might be close enough to proceed.
Using the above calculations the business owner can get a feel for whether to proceed to invest in new plant – or maybe they have already made up their mind and are looking to confirm their decision making.
The above calculations can be used when considering any additional outlay for a business and useful when comparing investment options.
If you ever need to discuss business/investment decisions – get in touch