(This video chapter begins at 12:31 and ends at 14:05. Click on the blue dot at the 12:31 timestamp to play the video for this module.)

Making Smart Purchasing Decisions

Sometimes, you may be asked to purchase something on behalf of the organization. When purchasing, it is always a good practice to determine if the expense is worth the investment. There are factors that you should determine before making the purchasing decision. Being able to make purchasing proposals by showing the cost and benefit to the organization will help you save money for your company and make you more valuable to the management staff.

Our focus quote for this module:

“A budget tells us what we can’t afford, but it doesn’t keep us from buying it.”- William Feather

This module will discuss four tools in making smart purchasing decisions. Here are the topics for discussion:

• 10 questions you must ask
• Determining the payback period
• Deciding whether to lease or buy
• Thinking outside the box

Let us review the 10 questions you must ask first.

10 Questions You Must Ask

Here are 10 questions you should ask before you make a purchasing decision:

• Is this purchase budgeted?
• Lease or buy it?
• Make or buy it?
• What is the justification or business need for the purchase?
• Does this need to be approved by upper management?
• Can you do without the item?
• Can you restore the old item you are replacing?
• What is the return on the investment?
• What are additional costs related with the purchase?
  • Peripheral equipment
  • Labor
  • Transportation

• What is the benefit of buying this item?

These questions serve as a guide to making an informed decision. You should consult the budget team and subject matter experts to help you build a case for buying the proposed item.

Determining the Payback Period

The time it takes to recover the cost of a purchase is called the Payback Period. The payback period is determined by dividing the cost of the purchase by the annual cash inflows the purchase is projected to return.

Payback Period = Cost of Purchase/Annual Cash Inflows

For example, if you bought a new production device worth $15,000 and the project annual cash inflows for this device is $5,000. The payback period would be three years.

The payback period is a simple calculation. It does not calculate profitability nor does it factor the time value of money. There are other calculations, like net present value or internal rate of return, that would calculate this for you.

The payback period is meant to help you make a quick determination about the purchase you are considering.

Deciding Whether to Lease or Buy

Leasing equipment has several advantages. First, if owning the equipment is not an essential requirement, leasing allows you the ability to obtain the equipment with little or no money invested.

Leasing is just as beneficial as buying. In some cases, it is better. For example, with leasing you do not have expense depreciation. In fact, when the item breaks down or requires updating, the leasing company typically takes care of the equipment or replaces it.

Another advantage to leasing is the conserving of cash. The organization can use the cash for other business activities. Furthermore, some types of leases can bring a tax advantage. Since the lease is not actually capital for a business, but rather an expense, having the equipment leased may potentially reduce the tax burden on the business.

A drawback to leasing is the requirement of good credit. If a company is just starting, it may be difficult to lease equipment because of the short credit history of the organization.

Leasing may be at a disadvantage when it comes to buildings and property. Since lease terms renew every so often, the cost may rise over time. In this case, buying the building or property will provide a more stable cost even if the purchase is accomplished through a loan.

Buying property also brings tax advantages. Leasing, on the other hand, does not. When determining whether to lease or buy, here are some things to consider:

• Do you have the cash to buy the item?
• What tax break would you get if you leased the item?
• Is it necessary to own the item?
• Is having a fixed cost essential?

Thinking Outside the Box

There are many ways to buy things if you think outside the box. Here are some unorthodox resources for buying items for your company.

• Internet markets (ex. Craig’s List or eBay)
• Auctions
• Company closures

Thinking outside the box when making purchases may require some additional research time, the payoff may be worth it.

Practical Illustration

Lillian had to decide if her company should buy or lease an office building. There were several factors she needed to take into consideration. If she bought the office space, then would she lease or buy the equipment for the office? If she leased the office, would it be worth it in the long term? What were the tax implications? In order to answer these questions and determine the best course of action, Lillian consulted the budget team. Together, they systematically weighed the cost effectiveness of each option. Some choices began to emerge that were better suited to the company’s current budget and goals. In the end, Lillian made the choice and was glad that she weighed her options before making the choice.