The Hostway Blog

Deciding to Make a Major Purchase

First of all, what do we mean by a "major purchase?" Among financial types (like your banker or accountant), the main consideration is usually that the item or project will have a service period of more than a year. If so, you'd want to spend at least some time studying the issue, and doing what is known as "capital budgeting." If the item will last for less than a year, it's probably not worth a detailed analysis — you might decide to just "get it if you need it."

Some business owners also like to draw the line at a certain dollar amount — depending on the size of your operation, this can be $1,000, $10,000, or any other amount that makes sense. Anything below that amount would be treated as a normal budget expense, but anything above it would deserve separate, careful study.

Clearly, the bigger the project, the more formal analysis you'll want to go through. The fact that your business is small does not mean you can avoid this process — in fact, smaller businesses usually have a smaller margin for error, making careful analysis even more important. Overspending on an expansion or new equipment can sink a small business, where a larger one would be likely to have deeper pockets and be able to recover.

If your project will require major financing, a fairly detailed analysis is often necessary because the bank or financing company will probably want to see your cash flow projections, and maybe even a full-blown business plan. If you're doing something as ambitious as purchasing or starting another business, you'll definitely want to involve your accountant and go through some serious number-crunching, before you make a firm commitment to the project.

No absolute answers. The reason for doing capital budgeting and analysis is to allow you to take calculated risks. Of course, there is no way to foresee the future. Analyzing a major purchase decision involves making many predictions and estimates about things like interest rates, local economic conditions, consumer tastes and trends, technological developments, etc. It's likely that some, or even many, of your expectations may not pan out. Nevertheless, going through the process of examining the costs, benefits and risks involved with a major purchase should help you weed out the projects and ideas that have little chance of success. Then, you can concentrate on those with the least risk, combined with the greatest potential payoff for your business.

Deciding between competing projects. Sometimes, the question is, "Should we do X?" Other times, the question is, "We only have so many dollars — should we do X, Y or Z this year?" Major-purchase analysis or capital budgeting can help you answer either question. However, the answer becomes less certain when you're looking at more than one project, because the number of unknowns multiplies as the number of projects under consideration goes up.

Projects without a financial payoff. Most capital projects are intended to either increase your revenues, or decrease your costs. For example, opening another location should put your name in front of a new group of customers, resulting in increased sales. Getting a new, more efficient machine might reduce your power bill and your maintenance costs. However, in some cases a project is necessary just to keep you in business. Replacing a leaky roof, or installing some required pollution-abatement or safety equipment, would fall into this category. Such projects are often subjected to capital budgeting techniques anyway, since usually there are several possible solutions and it's still necessary to work out the issues of cost, payment method and timing.

Steps to making your decision. In making your decision about a major purchase or project, you should:

  • Consider all the benefits of the project.
  • Consider all the costs.
  • Create a projected cash flow statement that quantifies costs and benefits and places them in the correct time frame.
  • Use financial analysis tools to determine whether the project makes sense.