From: TomCrouser@aol.com
Date: Mon, 5 Aug 1996 22:59:13 -0400
Subject: Opportunity Knocking To Buy Equipment?
Content-Length: 13666
X-UIDL: 839351131.004

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Opportunity Knocking To Buy Equipment?
Transmitted from Poukeepsie, New York

Crouser Report August 1996
Dear Friends. . . .

Is Opportunity Knocking On Your Door? One reader recently said it was
knocking for him to buy equipment and he was concerned about justifying
equipment purchases. So, for all of you who hear your own opportunities
knocking, here is our reply. Please note that the following is based on new
equipment offering a new service. A slightly different evaluation is required
on replacement equipment. 

The reader wrote: 

Tom. . . .I just heard about a used Xerox 5775 color
copier that Xerox is selling at a used copier sale this week. We have been
discussing the purchase of a color copier for a few months. This sounds like
it may be a decent buy, they are asking $11,995, I can get it for $10,000, It
comes with a one year warranty. We have been getting several calls a week
lately as to if we have a color copier, plus some of our existing accounts
are asking. They now go to a competitor a couple of blocks away. At our year
end 5/31/96 our current ratio was 2.8. We have the cash to buy outright if we
want to, would think it may be better to finance than to outlay the cash
though, would appreciate your thoughts on this. . . .Would appreciate it if
you could reply quickly as the copier sale starts Wednesday 7/24/96.



And thus starts the typical question about the deal which won t go away.
First, I would note, the reader selected an apt title, 

Opportunity
Knocking.

 Why? Most of us don t evaluate the status of all of our equipment
needs at one time. Rather, we wait for a salesperson to knock on the door and
then evaluate that proposal by itself.

So, let s start with the basics. Step One: Does This Printer Have Money To
Invest? In short, yes this one does as he had a strong 2.8 current ratio.
Additionally, I have worked with him and also know he is dealing with real
numbers. Frequently, the discussion doesn t get beyond this point for the
printer is trying a form of lotto investment (buy the piece of equipment and
hope that it spins off enough money to pay for it - closely kin to lotto
educational funds for the kids and lotto retirement).

Next, we should look for a way to translate demand into sales dollars. Most
of the time printers will say, 

You can t tell what the demand will be. .
.you d be guessing!

 Well, if you can t measure demand, then you don t have
any demand so don t do the deal. 

Lots,

 

bunches

 and 

all kinds

 are
measurements of hopes, dreams and desires, not reality. So, in order to
determine demand, write down which customers would buy and how much they
would buy based on what? How do you do this? Asking them toe-to-toe would be
one way. If Joe the Realtor has said he would buy color prints from you, then
talk to Joe and ask how many he needs and how often would he project he would
need them. 

Well,

 a printer would say, 

I can t talk to everyone who would
possibly need color copies.

 No, but you could talk to enough to determine if
you would generally have enough volume to support the purchase. Added
together, these customers represent your sales revenue. Specifically. Not
generally.

Now, some printers actually do this step. They do talk to customers and have
a general idea. Then, they think they have analyzed the deal and make a
decision. They say, if I need $2,000 a month in sales and find customers
demand to be $20,000 a month, that s good and do it. If they need $2,000 a
month and find only $1,000 worth of business, that s bad but they still do
it. . . . .okay, just kidding. They don t do it.
	Well, not so fast on the decision. We re not there yet. We have completed
the very important Step Two: Write Down Which Customers Would Buy And How
Much They Would Buy Based On What. This information will be extremely
important in a future analysis step. Let s say you have identified $2,000 of
sales. Now, let s move on to the next step.

Step Three: Calculate Your Direct Operating Costs. How much will the direct
operating costs of this be such as meter clicks, continuing maintenance,
toners, etc.? Disregard the base cost of the equipment (the $10,000) for now.
Let s say, for every dollar of sales, direct costs will be 15%. Take our
sales volume from Step One ($2,000) and multiply it by the operating costs
(15%) to estimate the direct operating costs of ($2,000 x 15%) $300.

Step Four: Estimate Your Marginal Income: Marginal income is defined as:

Sales (Marginal) Revenue - (Marginal) Cost = (Marginal) Income
or
$2000 sales - $300  (direct costs) = $1700

Step Five: Divide The Total Cost Of The Investment By The Marginal Income To
Estimate Payback. Divide the marginal income on a monthly or yearly basis
into the selling price. We estimate sales of $2,000 - costs of $300 and
marginal income of  $1,700. The $10,000 investment divided by $1700 marginal
income yields a payback of less than six months ($10,000 / $1700 = 5.88).

Result: We can say, based on the sales and cost assumptions herein, that we
can take $10,000 of our money, put it into this investment and have our money
back in about six months. This result, of course, does us no good unless we
are comparing it to something else. This is why one can never justify one
single piece of equipment by itself. Justifying one piece of equipment at a
time will always come out with a positive answer.

Compare: In order to decide, we must compare this knocking investment
opportunity with others. Do you need a color copier worse than a new press or
would leaving the money in a bank be a more rewarding venture? 

Well, we did compare and here are the results:

Color Copier, $10,000 investment, 6 month payback
Press, $50,000 investment, 2 year payback
New Location, $100,000 investment, 5 year payback

Given these three opportunities only, the color copier would be the best use
of our excess working capital. Why? It has the lowest investment (lower risk)
and the fastest payback period. In short, should we invest our money here, we
would get it back in six months and be able to do this same process again. I
recommend using this payback as the first cut at helping you decide among
alternatives. Some situations will require a more sophisticated approach
dealing with the present and future values of money, especially if the cash
flows (in and out) are erratic. But you are still not finished with your
analysis.

JURY OF EXECUTIVE OPINION

When boys do all these calculations by themselves, they tend to be overly
optimistic and somewhat slanted to what they want rather than what they
should get. So, we use a Jury of Executive Opinion to balance the owner s
enthusiasm for the color copier. As noted before, capital budgeting (making
investment decisions) should be done all at one time and all investments
compared to alternatives. And it shouldn t just be done by the guy who is
panting after the equipment. So, we would advise you use a jury of executive
opinion.

Specifically, solicit the opinion of other experts within your realm who
could place a degree of probability upon your deal. This 

jury

 can be made
up of other people knowledgeable about your situation, but must include the
stakeholders in the business (read: your spouse) Do not include the person
who is selling the equipment, nor would you include a press operator who is
lusting after the proposed press. However, there is nothing wrong with
including a press operator as long as you would allow them to give you honest
answers. I would choose two to five other people who are knowledgeable about
your situation. Your accountant, another printer, another business person
and/or a consultant could be part of this jury. You will then tell which
customers will buy, how much they will buy and what this opinion is based
upon. (Told you it would be important later.) Only you will know if you give
them all of the facts and present them with an honest portrayal of the
situation. Give them honest information and you will get the best results.

After your 

jury

 has heard you out, they will return to you a percentage of
probability. 

I think you have a 90% chance of doing what you say you are
going to do.

 Or, maybe it is 50%, or 25%. If I were one of your jurors and
you told me what an Idaho printer once did, 

I know this new color copier
will have to be sold, but there is plenty of market here to do it.

 I asked
him, 

How many sales calls have you made on your current color copier in the
last year. And, since you haven t made any, why should I expect you to make
them in the future?

 I gave him a 10% chance of hitting his sales goal. (He
bought the equipment anyway, just as he bought other equipment until the
financial 

Peter Principle

 caught up with him. He spent all of his credit
until his cash flow was real tight. Then a downturn occurred, he didn t have
enough cash flow, so he went out of business.)

Now, take the consensus probability, say 60%, back to Step Two and
recalculate. Reform the payback period and then see what you have. You may
find that some obscure investment opportunities look at lot more secure than
the first time through. Then get the jury to rate the options again. . .and
when you can get your jury up in the high probability numbers (90% or so),
then choose between the investment alternatives.



Boy, that s a lot of work, isn t it?

 Yep. 

Bet you a lot of companies don t
fool with all this.

 Yep. (Worked with a newspaper who put $2 million in a
new press without any justification whatsoever. . . .they were having cash
flow problems.) Payback is an easy way to do a first cut on assessing
equipment investments. It s not the only way, but it is a good way. As Henry
Clay said, 

Statistics are no substitute for judgment.

 These methods are not
meant to replace judgment. They are meant to give you a structure within
which you can then use your judgment. More sophisticated tools should be used
(present and future values, etc.) with more complex problems or for deciding
between opportunities that are very similar. 
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salesperson in addition to anything anyone else wants to bring up. Call Clark
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							Happy Trails,
							Tom Crouser

P.S. 	Good judgment. How do you get it? Experience. How do you get
experience? Bad judgment. Anonymous (and not the author of 

Primary Colors

)
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