What is Capital Equipment? Challenge, Leasing Equipment in Procurement

What is Capital Equipment?

Capital goods are the goods required for producing finished goods from raw materials. These goods can also be called capital equipment in the context of procurement management. The value of capital equipment is determined by the present value of future cash streams or the profit it can generate for the organization.

For example, machinery required for production purposes including various components of a manufacturing plant is the capital equipment for an organization. Unlike raw materials, capital equipment is much costlier and generally a one-time purchase.

Characteristics of Capital Equipment Procurement as Compared to Procurement of Raw Materials

Let us discuss various characteristics of capital equipment procurement as compared to procurement of raw materials:

• The procurement of capital equipment is a one-time process, unlike raw materials which have to be procured on a regular basis.
  
  New purchases might happen when a new manufacturing plant is set up, when the old machinery needs to be replaced, or when the existing plant is expanded to increase its capacity.
  
  
• Capital equipment is an investment that is expected to produce profit streams in the future for many years. Hence, it is a fixed asset of the organization.
  
  The purchase of capital equipment is a capital expenditure as against the purchase of raw material, which is a revenue expenditure that finds a place in the profit and loss account.
  
  Capital expenditures (capex) are also a type of investment and like all other investments; an organization would like to generate the highest interest rate on this investment.
  
  The interest rate that is earned or generated by a capital investment is called as the rate of return or the return on investment (ROI). The ROI on Capex is calculated using the following steps:
  
  
  • Calculate the investment amount
    
    
  • Estimate the net cash flows (inflows and outflows) that would be produced by and incurred on the capital investment.
    
    
  • Calculate the estimated value of ROI using an appropriate capital budgeting technique such as Net Present Value (NPV). The calculation can be done by entering the values of cash flows into a spreadsheet program such as Excel.
    
    
• The process of investment decision belongs to a capital budgeting exercise and hence the primary responsibility of deciding on capital equipment lies with the finance department of the organization.
  
  Once the need for capital equipment is identified by the production and/or plant engineering, an equipment requisition is issued to the finance department.
  
  
• The capital budgeting exercise, which decides the worthiness of the capital equipment, involves several financial concepts and requires a financial management specialist, unlike the procurement of production items.
  
  In comparison, the decision of raw material purchase solely rests with the procurement department. There is no financial evaluation of the value of future cash streams in the case of procurement of production materials.
  
  
• Capital equipment might involve complex specifications that include operational, technical, and commercial requirements specific to the item purchased.
  
  
• A purchase order for capital equipment might involve just one item with all its specifications as against quantities purchased in volume in the case of production items.
  
  
• Capital equipment may not always be available with standard specifications, unlike production items. An organization may require equipment to be built by the selected supplier as per its own specifications dictated by its plant engineering decisions.
  
  
• The lead time involved in capital equipment purchase could be long as compared to the lead time involved in the procurement of production materials. Both the decision to purchase and actual procurement of capital equipment might involve long time frames.
  
  
• The cost of capital equipment tends to be very high compared to the cost of raw materials. Thus, more attention and involvement are required in the procurement of capital equipment.
  
  
• The capital equipment is associated with operation, downtime, maintenance, and repair issues. For example, some capital equipment items might involve less operational costs but may require higher initial costs, and an alternative one can involve higher operational costs and lower initial costs.
  
  Similarly, downtime (the time when the machinery is idle) involved in capital equipment can have significant costs associated with it.
  
  
• The capital equipment, once purchased, requires continuous and proper maintenance in order to ensure proper performance. The cost involved in maintenance, repair, and spare parts could be a significant percentage of the overall costs of capital equipment.
  
  Hence, the concept of Total Cost of Ownership (TCO) is more relevant in the case of capital equipment.
  
  
• The capital equipment can be disposed of at the end of its useful term. The sale of such used equipment may fetch some residual cash, which should be considered in the purchase evaluation.
  
  The residual value of disposed capital equipment may differ depending on the time frame it has been in operation and the specified overall life term.
  
  
• The supplier market of capital equipment involves industrial manufacturers and is different from the supplier market of raw materials.
  
  
• While cross-functional procurement teams are preferred in the case of procurement decisions of raw materials, it is mandatory in the case of procurement of capital equipment.
  
  
• Capital equipment can be purchased from the used equipment market, unlike raw materials.
  
  
• There are several other factors that need to be considered in the case of procurement of capital equipment, such as performance guarantee and warranty required, phased payment of purchase cost with cautionary retention of a portion of purchase cost, several components of acquisition costs, installation, and commission costs, etc.
  
  
• The organization also needs to decide whether it should buy the required capital goods or take them on lease. Such a decision is termed a buy vs. lease decision.
  
  Both decisions have their own pros and cons. For example, an advantage of leasing is that it involves less amount of initial payment. Also, tax deductions can buy leased goods. However, the overall cost of the lease is quite high.
  
  On the contrary, buying capital goods makes the organization the owner of it and in various instances can be used to avail of tax breaks as well. However, the organization should be careful while buying such capital goods as the company may get stuck up with wrong and faulty products.

All the above characteristics make capital equipment procurement a specialized activity.

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Challenge of Procuring Capital Assets

The procurement of capital equipment entails several challenges, unlike the procurement of other purchase categories.

Various important challenges are explained as follows:

• In-frequent Nature of Capital Equipment Procurement
  
• Cost Components Involved
  
• Capital Equipment is an Investment and Not an Expenditure Category
  
• Size, value, and life-term of capital equipment
  
• Complex Requirements and Specifications
  
• Long Lead Time
  
• Downtime and MRO Costs
  
• Cross-functional Team Effort Required
  
• Financing Options
  
• Special Contract Provisions Required
  
• Associated Activities
  
• Costing Methodologies

In-frequent Nature of Capital Equipment Procurement

The first challenge in procuring capital assets is due to its infrequent and one-off nature. Because of this, traditional price analysis and cost analysis methods are not applicable for capital equipment procurement.

To analyze the investment worthiness of capital equipment, the finance professional would require a cost estimate of the equipment. However, the prices quoted by suppliers cannot be justified in terms of historical price basis or cannot be based on ‘should-cost’ modeling or value engineering.

Good procurement market research is required to arrive at the cost estimate to be used for investment valuation and to validate it.

Cost Components Involved

The purchase price of capital equipment would typically form a low percentage of the total cost of ownership of the equipment. There are several cost components involved in the acquisition and usage of capital equipment, unlike the cost involved with production items.

Usually, a life-cycle costing strategy is used to arrive at various cost components of procuring capital equipment. The components of the life cycle costing of capital equipment include:

• Cost of acquisition: It involves various costs, such as purchase cost, procurement overheads, cost of transportation and logistics, cost of quality checks, cost of inspection, etc.
  
  
• Cost of commissioning: It involves various costs, such as the cost of testing, the cost involved in pilot runs, labor costs, training costs, the cost of documentation, etc.
  
  
• Cost of operations: It involves various costs components, such as energy consumption, labor costs, cost of consumables, etc.
  
  
• Cost of maintenance: It involves various costs, such as the cost involved in MRO and the cost of maintaining spare parts inventory required during the life term of the equipment.
  
  
• Cost of the disposal: It involves various costs, such as environmental costs of disposal, etc.

All these life cycle costs should be taken into account while calculating the total cost of ownership of the equipment. The challenge is to both identify and accurately forecast these cost components as many of these components (e.g. MRO) pertain to future years making it uncertain.

Capital Equipment is an Investment and Not an Expenditure Category

The procurement of capital equipment is an investment that is expected to produce future profit streams. Hence, the evaluation of the worthiness of the equipment requires investment valuation.

This requires accurate projection of future revenues and costs arising from the equipment and calculating the net present value.

As specialized finance expertise is required at the time of investment valuation; procurement professionals have to work closely with the finance department in procurement decisions.

Size, value, and life-term of capital equipment

The size, value, and life term of capital equipment make it a challenging decision. Since the decision is irrevocable and the organization has to live with any wrong decision made; great care and attention is needed in both investment decision and supplier selection.

Complex Requirements and Specifications

Unlike production items, capital equipment involves complex specifications. There are several requirements that need to be spelled out as part of the RFQ/Purchase order (refer to the section of the procurement process).

Specifying all requirements and obtaining vendor compliance could be a significant challenge; especially, since requirements could be unclear during the preparatory phase of equipment procurement.

Long Lead Time

In general, procurement of capital equipment involves a long lead time and any delay in timelines may cause huge losses.

The procurement of capital assets needs to be constantly monitored whether the activities are performed in adherence with the agreement and achievement of milestones, which further requires the involvement of a project management expert.

Downtime and MRO Costs

Capital equipment involves downtime and MRO-related costs, which though constitute a significant portion of overall costs, and may not be known accurately during the purchase. Contract provisions should be able to handle these uncertainties, especially for MRO items required during the life of capital equipment.

This is because the equipment is subject to technological obsolescence. Similarly, downtime associated with the equipment can entail significant opportunity costs, which need to be analyzed in terms of reliability metrics.

Cross-functional Team Effort Required

Procurement decisions and purchases of capital equipment require the involvement of several stakeholders within the organization, such as the user department that initially generates requisitions for equipment, the operations department, plant engineers, the finance department, and the procurement department.

Efficient collaboration on the part of procurement professionals becomes very important and challenging as the interests of each of these stakeholders could be diverse and conflicting.

Financing Options

Owing to its high cost, capital equipment may be needed to be purchased through other options, such as leasing and used equipment market. In the case of leasing, a proper lease vs. buy evaluation needs to be done.

In the case of the used equipment market, additional care needs to be taken with regard to the suitability and performance capability of the used equipment.

Special Contract Provisions Required

As mentioned in the previous section, there are several factors, apart from the price that needs to be considered in the case of procurement of capital equipment, for example:

• Performance guarantee and warranty required
  
  
• Clauses regarding maintenance support and spare parts support
  
  
• Need for aftersales service and associated costs
  
  
• Decision on the requirement of phased payment of purchase cost based on milestones
  
  
• Need for cautionary retention of a portion of the purchase cost
  
  
• Clauses pertaining to various components of TCO costs, such as erection and commission costs, inspection and pilot operation costs, etc.

Associated Activities

Procurement of capital equipment does not stop with purchase alone. It requires several other steps before it is available for production, which include installation, inspection, assembly, test run, pilot operation, and commissioning.

All these might involve several other external entities, such as inspection agencies, commissioning contractors, etc. The involvement of procurement personnel both from the cost and supplier relationship dimensions can be critical.

Costing Methodologies

It is also difficult to carry out Activity Based Costing (ABC) and/or Zero Based Costing (ZBC) for capital goods.

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Leasing Equipment in Procurement

One of the important concerns in the procurement of capital goods is the huge costs involved, unlike the purchase of raw materials. While the purchased raw materials can be converted into cash by the end of the operating cycle, the investment in capital equipment has a long gestation period before it can be earned back through profits generated by the machinery.

The financing of huge costs involved in the purchase of machinery is an equally important decision in the procurement of capital equipment. In order to avoid making huge capital expenditures upfront, organizations may decide to lease the equipment.

In the case of leasing, the purchase cost of the equipment is not paid upfront, but in the form of rentals over the life of the equipment. If an organization had planned to raise debt capital for the purchase of the machinery, the usage of leasing obviates the need for debt; thereby reducing the debt in the balance sheet.

However, obligations to pay lease rentals over the life term of the equipment will remain as a hidden debt on the balance sheet. Apart from showing a better debt leverage picture in the balance sheet, leasing can also provide several tax advantages depending on the laws concerning leasing in the concerned country.

The word lease is defined as “an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments, the right to use an asset for an agreed period of time.” In practice, leasing is similar to renting the equipment instead of purchasing it.

Types of Leasing

• Operating Lease
  
• Finance lease or capital lease

Operating Lease

In the case of an operating lease, equipment is acquired for a specific period of usage. At the end of the period, the equipment will be returned back to the lessor. The objective is to obtain the use of the equipment for temporary requirements and avoid permanent acquisition of the equipment involving huge expenditure.

Finance lease or capital lease

In the finance lease, all risks and rewards incidents are transferred substantially to the ownership of the equipment.

In the finance lease, there are three parties involved in the transaction:

• the buying organization (lessee)
• the equipment manufacturer
• the leasing finance company (lessor)

Compared to an operating lease, the finance lease is actually a non-cancellable finance transaction and is an alternative to the permanent acquisition of equipment through normal purchase mode. The lease period in the case of a finance lease is normally for the entire life term of the equipment and, practically, there will be no returning back of the equipment to the lessor.

In other words, equipment under the operating lease may again be leased to another manufacturer, at the end of the lease period; while a finance lease is equivalent to purchase by the manufacturer.

The differences between these two types of leasing lie in the mode of payment of the cost of the equipment and interest costs. However, in both cases, ownership of the equipment rests with the lessor during the lease period. In the case of a finance lease, the ownership of equipment will be transferred to the lessee, at the end of the lease term.

Leasing may be cost advantageous over buying the equipment, if the company has debt-related tax advantages and if the income tax laws allow expensing the lease rentals instead of capitalizing them. But, if the laws allow only the interest portion to be expensed, then it depends on the interest cost involved in the lease transaction as compared to the pure debt financing option. There could also be several other factors depending on the laws concerning the leasing transaction.

A lease vs. buy analysis may be done as a part of the capital budgeting exercise to determine the mode of financing of the equipment, once the decision to acquire the equipment is made in the preparatory phase. Leasing the equipment has both advantages and disadvantages for the lessee, the buying organization.

Advantages of Leasing in Procurement

Some of the benefits of leasing are listed below:

• Leasing eliminates the need for paying upfront the entire cost of the equipment. Thus, it frees up cash that can be used for other business or investment opportunities.
  
  
• Leasing transactions can be structured as per the requirements of the lessee. Lease rentals to be paid every year can be matched with cash flows generated by the equipment. The matching of cash flows provides for better financial ratios.
  
  
• Leasing is an off-balance sheet transaction. It avoids the need for debt financing, which could increase the debt-equity ratio of the company and projects a better financial position in the balance sheet (though lease obligations information may need to be provided in the annual report).
  
  
• Leasing is normally obtained through a non-banking leasing finance company and, therefore, it does not affect the existing line of credit limits with banks.
  
  
• Leasing may provide several tax-related advantages, especially,\ if the income tax laws allow expensing lease rentals (this is normally the case for operating leases). This can bring down the tax liabilities of a business significantly.
  
  
• Operating leases are cancellable and provide protection against technology obsolescence of equipment.

Disadvantages of Leasing in Procurement

Some disadvantages of leasing are listed below:

• Leasing is a more expensive option compared to buying the equipment. This is because lease rentals include interest cost as it is a form of debt financing. In comparison, there is no interest cost burden if the equipment is purchased outright.
  
  
• Finance lease contracts are not cancellable. Though the lessee does not have ownership of the equipment; risks and rewards associated with the leased equipment are transferred to the lessee, and there is no difference in this respect from purchasing the equipment.
  
  
• If contracts are made when interest costs were very high, the company has to live with the interest burden. Even if the interest rates fall later, the company cannot replace the debt burden.
  
  
• Leasing might require legal guarantees and related fees. These costs are not applicable when the equipment is purchased.
  
  
• The operating lease restricts the control over the usage of the equipment since the ownership rests with the lessor.