Purchasing Capital Equipment: The Cost of Ownership
Purchasers must consider both the obvious costs as well as the less-obvious costs when it comes to machinery.
Director, Medical Business Development
Alkar-Rapidpak (Lodi, WI)
Packaging equipment commonly used by manufacturers of disposable medical devices typically has a lifetime of 10 years or more. When considering the purchase of capital equipment, manufacturers should think beyond the obvious cost factors and look for other, less apparent, cost implications that can have a considerable impact over the equipment’s lifetime. Further, while the more-obvious costs and benefits upon which capital purchases may be comparable from one vendor to another, such as direct labor, material cost, and purchase price, the less-obvious costs and benefits can vary widely. These costs should be considered in the appropriation of capital. They can be the deciding factor in vendor selection.
THE OBVIOUS COSTS
Labor. When considering investing in new packaging equipment, the impact of the investment on direct labor is an obvious consideration. In addition to supporting the launch of new products, reduction of labor cost is one of the most common justifications for investment in new packaging equipment.
Materials. Along with supporting new product launches or reducing labor costs, material cost reduction is the other most common reason for acquiring new packaging machinery. Similar to direct labor, the impact of proposed machinery on material costs is easy to identify. In almost all cases, material and labor costs are reflected as specific line items in the cost of goods sold.
Purchase Price. Purchase price is always a primary consideration in the acquisition of new packaging lines. It is easy to identify, and its impact is easy to calculate. As a capital expense, the purchase price is allocated over a number of years. Typically, the cost of the machinery is depreciated over a period of seven to eight years, even though packaging equipment often has a much longer lifetime. The purchase price, as a cost, generally does not show up as a direct line item in cost of goods sold, but it is more often covered in overhead allocation.
Table I. Cost of ownership.
(click image to enlarge)
There a number of costs associated with operating packaging lines that may be less obvious than direct labor and material cost. The costs associated with operating packaging equipment, good or bad, will often be bourn on an ongoing basis for 10 years or more.
Electricity. Virtually all packaging machinery is driven by electric motors. The cost of electricity can be measured easily through the kilowatt consumption of the machinery and multiplying this against the local utility price. This cost can vary from one machine or one vendor to another, although not to the degree that the cost of pneumatics can vary.
Compressed Air. Using compressed air is one of the best examples of hidden costs that can be substantial, even though it is seldom considered in the justification of capital equipment.
Pneumatics is often used as an auxiliary source of energy for moving machine tools and other elements of the packaging system. Compressed air is generated by electrically powered air compressors and then distributed via a system of piping. The cost of compressed air consumption is a function of the cost to generate the compressed air and the efficiency of the distribution system. It has been estimated to be in the range of $0.023 per cfm per hour.1 By way of illustration, consider a packaging machine running three shifts per day with a compressed air demand of 80 cfm. Using a cost factor of $0.023 per cfm per hour, the cost of compressed air for this machine over a year’s time would be calculated as follows:
50 weeks per year × 5 days per week × 7.3 hours uptime per shift × 3 shifts × 80 cfm × $0.023 per cfm = $10,074 per annum
For most horizontal form-fill-seal (HFFS) machinery commonly used in the marketplace today (with the exception of RapidPak’s patented servo lifting systems), an air consumption of 80 cfm or more would be typical. There are a number of references available for measuring and calculating the cost of compressed air.2
Downtime is another cost. Essentially, there are two types of downtime. One is scheduled downtime, which would include scheduled maintenance and changeovers. The other is unanticipated stoppage because of breakdowns. While it is difficult to project how much time will be lost in the case of unscheduled downtime and how much labor will be required to bring the asset back on stream, scheduled downtime is more predictable. It is possible to estimate the revenue lost because of time spent on changeovers.
The Cost of Changeover. The value of production lost to changeovers is reflected by the hours of production lost and the value of the goods not produced during this time period. As such, the value of the production lost over a year’s time can be calculated as:
Hours of production lost per year × Number of packages that would have been produced × The value of the product × The rate of earnings before taxes for the product that would have been produced
Consider a fully utilized line packaging a variety of products with four two-hour changeovers per month, running 20 packages per cycle, 20 cycles per minute (or 400 packages a minute), where the product has a dollar value of 10 cents per unit and the company expects earnings before taxes of 15%. The cost of changeover would be calculated as follows:
2 × 60 × 4 × 12 × $0.10 × 0.15 = $34,560
Considering this cost over the lifetime of the equipment, downtime warrants consideration in the justification of capital.
Unscheduled Downtime. Projecting unscheduled downtime can be difficult. However, when selecting vendors, purchasers might consider the local availability of spare parts, availability of service technicians, and ease of access to critical components on the machine by maintenance personnel. The ratio of the machine builder’s units installed per technician is the best predictor of service response. When considering these factors, input from maintenance personnel should be sought out.
Table II. Net present value comparison for Vendor A vs. Vendor B. Cost of ownership.
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IMPLICATIONS AND DISCUSSIONS
The importance of these considerations becomes even more apparent when they are looked at over the useful life of the equipment. Table I summarizes the impact of the above examples over a 10-year period. The grand total indicates that over a 10-year period, these two items would have a cumulative cost of $446,340.
This number is quite a revelation. It highlights the fact that the less-obvious costs can still be significant and that they should be considered when justifying capital expenditure. It is worth reconciling the impact of these factors against the purchase price of the machinery. In fact, the impact of some of these less-obvious costs can more than outweigh a difference in purchase price of the machinery.
Net Present Value. “The time value of money takes into account that a dollar (or any monetary unit) received today is worth more than a dollar received tomorrow. The reason is that a dollar received today can be invested to start earning interest, so it is worth more than a dollar received tomorrow. The time value of money is the opportunity cost (interest forgone) from not having the money today.”4
Reconciling the future revenue stream against the initial capital outlay by discounting the future revenue stream gives the net present value of the total proposition.
For the above revenue stream, a basic financial model can be built that reconciles the downstream impact of cost and revenue factors against the purchase price in today’s dollars. To do this, one simply incorporates a discount rate to adjust for the value of future revenues. By discounting future revenues, the total value of this revenue stream is reflected in today’s dollars, and the summary value is the net present value of the total proposition.
Table I also takes the revenue stream reflected in the example above and applies a discount to future costs. At a discount rate of 10%, the net present value of the proposition is $287,316. That is to say that the total value of the projected cost in today’s dollars is $287,316.
Vendor Selection. A higher-priced vendor may provide machinery with a lower cost of operation. The savings from this lower cost of operation may offset the higher price. Upon approval of the capital spending, purchasers should look beyond the fundamental issues such as labor and materials when selecting vendors.
Taking the net-present-value model, adding one more line item called difference in capital, and using the individual line items to reflect a difference in performance between the two vendors, a good comparison of the relative cost of ownership between them can be made.
By way of example as shown in Table II, assume two vendors are being considered. Vendor A has a purchase price $80,000 higher than Vendor B, but the higher-priced vendor offers a shorter changeover time and less compressed-air consumption.
In this case, in spite of the higher initial purchase price, Vendor A still has a positive net present value and therefore the higher-priced option would be a better financial proposition. In other words, even with an $80,000-higher purchase price, the advantages in lower air consumption and shorter changeover time over a 10-year period, even after discounting, would more than offset the higher purchase price.
1. Higgins, Robert C. Analysis for Financial Management, 1992. Richard D. Irwin Inc., Boston. Pages 219 – 253.
2. “Compressed Tip Sheet #1” (DOE/GO- 102004-1926), Industrial Technologies Program, Energy Efficiency and Renewable Energy, U.S. Department of Energy. Washington, DC. August 4, 2004.
3. “Cost per CFM” The Compressor Guy, (www.thecompressorguy.com/images/Cost%20per%20CFM.pdf)
4. Horngren, Charles T., Foster, George, Datar, Srikant; Cost Accounting, A Managerial Emphasis, 1994 Prentice Hall, Englewood Cliffs, NJ, 684–687.