A Better Understanding Of The Purchase Decision
Despite rising costs in fuel, the sub-prime home mortgage fiasco, and the continued war in Iraq, retail sales in the agriculture/grower sector are up. According to the Association of Equipment Manufacturers monthly “Flash Report,” the sale of all tractors in the U.S. for August 2007 was up slightly compared to the same month last year. For eight months in 2007, a total of 155,541 tractors were sold, compared to 154,730 sold the first eight months of 2006.
As we can see, the number of buyers is up slightly. However, it is still apparent that capital purchase decisions can hinge on hope and are possibly inhibited by fear.
As your grower-customers evaluate what to buy and when, they may face nagging doubts. How long will the good times in agriculture last? Will things continue to get better? Just what are the particular immediate and potential long term effects of this period? Will this current cycle end with disappointment, like the one experienced in the 1980s?
In this environment of shifting expectations, there is much to be gained by understanding how your customers should evaluate capital investments. While customers have their own hopes and fears, you can play a helpful role in exploring more measurable costs and benefits that your products carry into the marketplace. As you gain a better understanding of how customers should properly evaluate purchase decisions with you, you might gain some valuable insights about them and cement your role as a trusted business partner. These insights may also uncover other opportunities to expand your own product and service offerings.
The Best Approach
So how should one approach a capital purchase? Let’s take a look at how America’s corporate community does it. Within the financial control structure of most firms, there is a formal procedure for budgeting and evaluating proposed capital spending. Corporate managers recommending investment in capital goods must demonstrate that the investment will build value for shareholders. There are many analytical approaches ranging from a simple break-even calculation to more robust methods. One of the most widely used and respected techniques is Net Present Value (NPV).
Managers argue that the proposed equipment or machine addition will produce a positive NPV. To arrive at the figure, managers must model (a fancy word for estimate) anticipated cash flows associated with the purchase. These expected revenues are sometimes referred to as incremental cash flows. These flows include incremental revenue brought in by the equipment itself, as well as incremental cost reductions associated with its operation. Examples of cost reduction include reduced labor, savings from fuel use, lower maintenance costs, and many other factors.
When both the positive and negative incremental cash flow have been identified, the impact of the purchase can be tallied. The sum of these future cash flows associated with the life of the equipment is discounted back to its present value. This discounting is done using a discount rate, generally considered to be a firm’s cost of capital. Discount rates vary by business. In the very simplistic example in the accompanying table, we used 10%. Remember, the project cash flows do not depend on where you get the money. Financing costs are reflected in the discount rate.
If the NPV of the project is positive, then it is generally considered worthwhile. If it is negative, the project is usually rejected. In our accompanying example, there was a negative NPV, in spite of some fairly substantial annual cash flows.
Making Right Decisions
The point of this exercise isn’t to turn you into a finance guru or turn your grower-customers into corporate middle managers. Making good capital purchase decisions rides on an understanding of opportunities to increase revenues or reduce costs. These decisions must also recognize the cost of capital. Assumptions need to be grounded in reality. Generating assumptions requires serious thought and analysis. Penciling in $4 per bushel of corn as far as the eye can see probably isn’t a reasonable assumption.
These techniques can be used to enhance learning and evaluation and to overcome fear and uncertainty about the true value of your product offerings. The wrong piece of equipment can put a strain on the business. But working with your customer through a process that critically evaluates the true costs and benefits of a purchase can make you a hero.