Updated: Mar 23, 2022
When it comes to investing in capital equipment for your business, you have three basic choices: buy used, buy new, or lease. And, as you can imagine, these options come with a variety of investment costs and benefits. However, there is one cost that is often forgotten and that is the opportunity cost of the money spent on these capital purchases. In other words, what else could you have done with that money if you hadn’t spent it on capital equipment?
Capital equipment is a significant investment in your business. If you’re wondering how much it will cost you, how long you’ll have to use it, and if it’s worth the expense, then you’ve come to the right place. In this article, we’ll take a closer look at the opportunity cost of capital equipment, explain why it’s important to understand, and offer some ideas on how to put a value on your investment.
What is the Opportunity Cost of Capital Equipment?
Opportunity cost is the cost of an alternative. In other words, it’s the value of what you give up to do something else. So, when you invest in capital equipment, you are giving up any other investment opportunities that could have been made with the money you spent.
For example, let’s say that you want to purchase a new machine for your business. With a $5,000 budget, you could either buy a used machine or new machine and get some good use out of it before it wears out. If you buy a used machine for $2,000 and then spend $3,000 on repairs over the next few years, your total cost would be $5,000. On the other hand, if you buy a brand-new one for $4,500 and then spend about 10 percent of its value per year on repairs for five years ($375), your total cost would be just under $6,500.
The difference between these two options is made up in opportunity costs: You have to consider how much money was spent not invested elsewhere because it was put into capital equipment instead (i.e., opportunity cost). As we mentioned earlier in this article though, often forgotten is that opportunity costs also includes time as well as money lost from not investing in alternative opportunities - like taking on another project for example. And remember that having an alternate project can also help grow your business by establishing relationships or building expertise in different areas that
Why is the Opportunity Cost of Capital Equipment Important?
The opportunity cost of capital equipment is a value for the potential earnings you could have generated if you had invested in something else. It’s an important consideration to understand because it can help you make the best decision for your company.
Let’s say, for example, you invest $5,000 in a new computer. That money could have been used elsewhere, such as hiring an intern or purchasing supplies to grow your business. You might be wondering how much that investment would be worth over time or what it would return on your investment (ROI). With the opportunity cost of capital equipment, you can account for these considerations and come up with a better understanding of the ROI for this purchase.
How to Calculate Opportunity Cost of Capital Equipment
When you invest in capital equipment, you’re essentially spending your money on the purchase of the equipment and then the money necessary to maintain or service it. However, there is one cost that is often forgotten and that is the opportunity cost of the money spent on these capital purchases. In other words, what else could you have done with that money if you hadn’t spent it on capital equipment?
Opportunity cost in this sense refers to the best alternative use of your funds. For example, if you had spent $1,000 on a new printer for your business and had an opportunity to invest that same $1,000 elsewhere, then the opportunity cost would be whatever return rate you could have gotten from investing in something else.
To calculate opportunity cost using a simple interest calculator:
-Enter your initial investment amount ($1000).
-Enter your annual interest rate (5%).
-Enter number of years (10).
-Under "Type" select "Simple Interest".
-Press "Calculate Now"
The Bottom Line
The bottom line is that it’s important to understand the opportunity cost of capital equipment before making a final decision. It may seem like you’re spending money, but that money could be better spent on other things. Investing in capital equipment requires a lot of time and money so make sure you know what you’re getting into before taking the plunge.
Now it seems like I wrote all of that to scare people away from capital equipment. That couldn't be further from the truth! The point of this article is to help business owners to identify what their true agenda and purpose is for purchasing said equipment rather than making an emotional purchase. Here are the reasons a business owner would consider purchasing capital equipment.
Cash Infusion: This is typically done where the return on investment can be realized over a short period of time. This is typically where the cost of goods are low but the profit margins are high due to a multitude of reasons.
Branding: This is typically the choice when a business is moving to brand their business in a very defined way and chooses equipment that supports that branding.
Cash & Branding: ALWAYS THE BEST CHOICE! Whenever possible this is the best choice, but certainly all three choices have their place. What's important is that the business owner understands exactly the 'why' behind the purchase of their capital equipment.
Cherie's Success Through Active Listening class is designed to enhance the business owner's ability to communicate 'value' to the customer. Creating value - both for your equipment, and most importantly for you as a business owner will build trust which in turn shortens the ROI cycle.