MM/U3 Topic 5 Purchasing of Capital equipment’s
(a) Availability of funds
(b) The duration for which the equipment is required
(c) The necessity of the organization to obtain the equipment immediately (whereas purchase of new equipment may involve a lot of procedural and policy delay), and
(d) Capital equipment is available only on lease.
The major considerations of leasing as against purchasing capital equipment are:
- It may be very economical to lessee the equipment when it is needed for a relatively short period. On the other hand, since most leases are for definite terms and terminable on short notice, it may result in depriving the lessee of a needed facility.
- In context of fast changing technology and obsolescence of equipment, leasing could avoid the purchase of a less efficient piece of equipment.
- In general, in a lease the lessee bears the dismantling, loading and unloading charges and transportation expenses both ways, from lessors location to lessee’s and return, whereas in the purchase of new equipment, the equipment is generally sold at a delivered price.
- The rent of leased equipment is an item of expense for tax purposes while the purchase price is an investment to be depreciated a number of years. That is, as long as lease payments exceed the value of allowable depreciation, and additional tax benefit is accrued.
- One of the most important disadvantages of leasing is that the lesser retains control of the equipment and not the lessee. The loss of ownership places certain restrictions in the manner in which the equipment is to be operated and it is obligatory on the part of the lessee that he allows the lessor access to the equipment for inspection at any point of time.
Purchasing procedure of capital equipments involves the following steps.
STEP I: Need Generation of the Equipment
The first thing to do when procuring capital goods is to evaluate the need. This may arise for one of the following reasons.
(a) Starting of a new manufacturing activity.
(b) Expansion of existing manufacturing facilities.
(c) Replacement of old machinery and equipment; and
(d) Change over to a new process of manufacture.
STEP II: Obtaining the Preliminary Information
Rarely is the need for capital equipment absolute; it can usually be postponed until conditions for purchase become favourable. Although the initial inquiry may come to purchasing in the form of a requisition, more often than not the purpose at this point is only to obtain general information about the equipment in question, not to make an immediate purchase. The purchasing department consequently obtains general sales and operating literature, together with approximate price and delivery information.
STEP III: Study to Preliminary Information
The using department studies the preliminary information obtained by purchasing and determines the feasibility of pursuing the matter further.
STEP IV: Drawing of Detailed Specifications
If the decision is affirmative, detailed specifications then should be drawn up jointly by the using and engineering departments. Specifications should spell out unambiguously the required performance characteristics, desired operating features, and any unique design characteristics, necessitated by the current situation.
STEP V: Requesting Proposals from Selected Vendors
When the investigation is complete and specifications are firm, the Purchasing department formally requests proposals from the selected vendors. In the event that only one or two vendors can produce an acceptable machine, the buyer might very well choose to negotiate rather than bid the purchase.
STEP VI: Economic Analysis of Various Feasible Alternatives
An economic analysis- of the various feasible alternatives is made at this point. The finance department typically makes this analysis, based on operating and technical information provided by the purchasing, engineering and using departments.
STEP VII: Evaluation of Alternatives for Final Selection
The necessary facts are now ready for evaluation by the departments participating in the decision. In small companies, evaluation is frequently an informal affair while in large organisations, a formal committee meeting is the typical method of operation.
STEP VIII: Preparation of Written Report
The end result of the evaluation should be the preparation of a written report justifying the recommendation that a certain machine be purchased. The report should include a description of where and how the machine will be used, why it is required, estimated figures for its utilisation and its life, cost data for the existing operation and for the several alternatives considered.
Financial computations concerning the rate of return on investment (or other similar measures of profitability), together with any qualitative comments from the participants, should constitute the last section of the report.
STEP IX: Report Submission to Top Management
The written report is submitted to top management for a decision.