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Analyzing Investments in Equipment

By AICC Staff

September 12, 2017

width=250Converting has always been a pretty capital-intensive business, and the latest wave of innovations in equipment has ramped up the need for expensive upgrades rather dramatically. Thirty years ago, a 20-minute setup with 5,000 pieces per hour of throughput and pretty good print registration was state of the art. Now, state of the art is two-minute setups with 25,000 pieces per hour and very high-quality printing. Corrugators are faster, wider, and allow for the change of rolls at very high speeds. Specialty equipment to make retail-ready packaging and other point-of-sale and point-of-purchase packaging being demanded by retailers is now becoming more and more common. Digital printing technologies are still evolving rapidly, but are now running at such high speeds with absolutely beautiful printing that many are predicting they will soon be in line with corrugators and finishing equipment. Flexography may be on the way out as the preferred way that converters print and may be giving the lithographers a run for their money as well, at the very high end of printing.

Retooling an entire plant with state-of-the-art equipment could cost between and $10 million and $50 million, depending on the size of the plant and the diversity of the converting being done. All of this has of course been part of the reason for consolidation of converting operations. We just don’t need as many plants as we used to, since each plant can now produce many times what they could produce 25 years ago. But can this kind of investment be justified? Can a converter not begin to make these kinds of investments and stay competitive?

Capital investment decisions should be made based upon an internal rate of return (IRR) calculation. IRR is defined as the interest rate at which the net present value of the cash flows (both positive and negative) of an investment equal zero. So, if you were to purchase a piece of equipment for $1 million that you thought would have a useful life of seven years and it were to generate additional profit of $100,000 in the first year, increased by an additional $100,000 in each subsequent year, the calculated IRR would be 25 percent (per the IRR function in Microsoft Excel). Since most of you aren’t making close to 25 percent, this sounds like it would be an outstanding investment! Unfortunately, the “real world” isn’t such a neat and tidy place, where you know exactly how long an investment will go before it needs additional capital or becomes obsolete, and you know exactly how much cash flow the investment will generate in each subsequent year.

Calculating the investment within some reasonable margin for error is possible, although there are always unknowns. How much training will my staff need? Will all of my plates and dies fit the new machine? How much do I need to invest in spare parts? What is the resale value of my existing equipment? Similarly, calculating the incremental annual cash flow to be generated by the investment is also fraught with guesswork. How much additional sales will I generate by having this new piece of equipment? What will the additional operating costs and operating savings be? What additional infrastructure investments will we have to make to support this investment (designers, plant personnel, software, space, etc.)? So, what should a converter do in analyzing the effect that equipment investments will have on his operation? What type of equipment justification can and should be done?

The biggest effect fast-setup, high-throughput equipment will have on an operation is in the contribution dollars per hour of each order and on the total number of machine hours available to be sold. An order for 25,000 boxes that has $5,000 of contribution run on a machine that runs at 5,000 pieces per hour will yield contribution per machine hour of $1,000. Running the same order over a machine that can produce 25,000 units per hour will yield contribution per machine hour of $5,000. In addition, if the old machine is fairly busy and doesn’t have a lot of additional machine hours to sell, then the company has to consider adding additional shifts or producing orders with overtime pay. The newer, faster machine will give the company many more—potentially five times as many—machine hours to sell. So, at the end of the day, if the company is successful in selling the additional machine hours, they will be selling them at much higher contribution per machine hour levels; there is a lot more money to be made. The question is: Can they sell the additional hours? If they can’t, then they have spent millions of dollars for a machine that does things faster, but other than some plant labor and overtime, savings doesn’t add to their bottom line.

My advice to converters is to calculate the break-even point in additional sales in order for the company to generate enough additional sales to cover the incremental costs of the new equipment. This should be done at a conservative contribution level. So, if a company has been averaging 35 percent contribution levels on their existing business, they should project the incremental business at a lower rate. If the incremental cost to the company

of owning the new equipment is $500,000 per year, they need to generate $500,000 of additional contribution to break even. Since the machine is so much faster than their existing one, they can show a much higher contribution dollars per hour than they are showing now and have many more machine hours available to sell, which will allow them to be somewhat more aggressive in the marketplace than they are with their existing equipment.

At the end of the day, the newer equipment that is available today offers converters the opportunity to sell more machine hours at a much higher contribution rate per hour than they are currently able. The key question is: Can they sell the additional hours?


width=150Mitch Klingher is a partner at Klingher Nadler LLP. He can be reached at 201-731-3025 or mitch@klinghernadler.com.