Tuesday, April 22, 2008

Justifying Capital Investments in Energy Improvements

Businesses invest in themselves for two basic reasons: to grow their revenue potential, or to reduce their operating expense burdens. Energy improvements are generally perceived as expense reduction efforts, although some companies are able and willing to tabulate the productivity gains (and incremental revenue) that result from the recapture of energy waste.

These two basic investment agendas are frequently—and erroneously—commingled in one capital budgeting process. Companies will, in other words, have cost reduction proposals competing against new investment initiatives in the same capital budget selection exercise. And of course, most people rank these proposals using simple payback criteria.

Most of you know that I advise against using simple payback to measure energy improvements. This is explained at length in an earlier post. I also realize most people are going to rely on simple payback measures anyway.

It’s not unusual for energy-saving and other cost reduction proposals to be passed over in favor of new initiatives, such as plant expansions, new product line machine tooling, and the like. Keep in mind that new initiatives are ones that represent a commitment to an activity that did not exist before. The owner’s alternative to such investments is to simply keep the money. Contrast this with an energy saving initiative. In this case, the investment allows a reduction in future expenses to which the facility is already committed. When this is the case, the owner does NOT have the option of keeping the money—the choice is to (1) make an investment that reduces future expenses, or (2) not make the investment and keep shelling out for those higher future expenses. “Keeping the money” is not an option.

So here’s the capital budgeting implication for people who insist on using simple payback: If you are going to refuse an energy-reduction investment in favor of a new initiative, the cost portion of your payback calculation really should reflect the capital cost of the new initiative PLUS the capitalized cost of the incremental operating expense you will carry because you refused to implement the cost-saving investment. This way, new investment should “work that much harder” because it needs to compensate for the money you left on the table by deciding to live with the energy waste. If the payback covers this total inflated cost, then great—you’ve made the best investment.

Read between the lines: by refusing energy cost-reduction initiatives and adding the capitalized cost of avoidable waste to your new initiative, you make it less likely for that initiative to meet its payback hurdle.

Read again between the lines: by accepting energy cost-reduction initiatives, you create new cash flow that effectively supplements whatever cash flow you think your new initiative may generate—thus raising the likelihood of your new initiative’s success.



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