Business grow by making decisions around investing. Businesses of all sizes make investment decisions all the time. Some of these are fairly simple and straightforward, and don’t require much in the way of analysis. However, other investment decisions are more complex. These types of investment decisions tend to be for large amounts of money, invested over a period of years, with more than one option to consider. It’s these more complex investment decisions where business often make mistakes.
Here’s a simple example to illustrate:
Consider a business that currently purchases a business input, let’s call it a ‘widget’, and spends $100,000 per year on purchasing these widgets. Over 5 years, they will outlay $500,000 to purchase these widgets. Assume an inflation rate of 8% per annum.
The business has the opportunity to purchase a machine for $350,000 that will allow them to make their own widgets. The ongoing cost will be $20,000 per year. The total outlay over 5 years will be $450,000. So over 5 years, it’s $50,000 cheaper for the business to buy a machine and make its own widgets.
Or is it? This is where the time value of money and the rate of inflation has to be considered.
The time value of money simply means that a dollar today is worth more than a dollar tomorrow. That is, the value of a dollar decreases over time. The longer the time and the larger the inflation rate, the bigger the decrease.
In the example above, even though it appeared to be $50,000 cheaper to buy the machine, it would actually be about $5,000 more expensive over the 5 year period!
Why? Because the business was spending a large amount of money, $350,000, upfront in ‘today’s dollars’. The alternative of buying the widgets was a flat $100,000 per year. The value of $100,000 decreases as time goes on. So the value of $100,000 in the fifth year when inflation is 8% is a lot less than the value of $100,000 today. Add up the 5 year outlay at $100,000 per year, and the total cost is $399,000 adjusted for inflation. This compares to $404,000 for buying the machine and making their own widgets.
This simple example illustrates a couple of things. Firstly, it is very easy to make the wrong investment decision. Businesses make these mistakes all the time. Secondly, there are many variables that need to be taken into account when making a complex investment decision. These include such things as the rate of inflation, the cost of borrowing money, ongoing maintenance costs (if you buy a piece of equipment), and various other operational costs.
If you’ve enjoyed this example and want to know more, or if you have a business decision that you want some assistance with, feel free to contact the team at Clear Patch Commercial Consulting. We provide straight-forward advice that will add real value to your business.
James Hamilton & NEIL HALLs
The founders have years of experience across a diverse range of industries and business areas. Their aim is to ensure the team at Clear Path Commercial Consulting use this experience and their individual knowledge and skills to help our clients in their own business.