9 Tips for Capex Budgeting
If you’ve been deducting depreciation of your vehicles, machinery and equipment to lower your income taxes but have not also been recognizing those deductions as an expense, you could be in for a rude awakening.
One of the biggest mistakes a small contractor can make is failing to budget for major capital expenditures, including replacement of current equipment.
Planning for organic growth
A company seeking steady, organic growth must “buy what it burns,” notes “Four Steps to Building a Capex Budget,” an article published by ConstructionEquipment.com about Capex budgeting. “It must invest at least enough to maintain fleet average age and realign its fleet to meet changes in the marketplace.”
In this scenario, a contractor must simply budget enough money every year to replace the machine hours burned in the previous year adjusted for their expected rate of growth.
Planning for ambitious growth
The capital planning process becomes more complicated, however, for contractors with ambitious growth plans. They must estimate the impact the costs and the revenues from new equipment purchases will have on their businesses. This has ramifications not just for cash flow, but for income taxes.
New equipment is considered a capital expenditure, or capex, if it is expected to generate benefits for more than one year. Examples include a work truck or van, a table saw or other piece of shop equipment, or a Bobcat excavator or other piece of heavy equipment.
Assets purchased and consumed within the same tax year, by contrast, are considered operational expenditures, or opex. These might include diesel fuel, saw blades, work gloves and possibly lithium-ion batteries.
While opex can be deducted from your income taxes in the year they are incurred, deductions for capex generally must be spread out over the expected useful life of the asset using depreciation schedules.
The caveat is that Congress occasionally passes legislation to allow expensing or accelerated depreciation of some capital investments to spur the economy, as it did in 2017 with the passage of the Tax Cuts and Jobs Act (TCJA), which we address in the list below.
Nine tips for planning for major equipment purchases:
- Take a medium-term view: Envision how you expect your business to change and grow over the next three to five years.
- Evaluate your organic growth needs: Do you see demand for some of your services increasing and others dropping? If so, how will that affect the replacement cycle for your existing equipment fleet? List all equipment you own that will cost more than $1,000 to replace and determine whether each piece aligns with your plans and market outlook and, if so, when you will need to replace them. This will give you a general idea of how much money you need to set aside in your capital budget to sustain your current, or organic, growth rate.
- Examine your growth plans: What vehicles and equipment will you need to purchase to implement your growth plans? If you have begun renting a certain piece of equipment more frequently, you may want to start budgeting for its purchase by adding it to your capital budget.
- Ownership costs: Remember to budget for sales and property taxes, insurance, fuel, training, routine maintenance, extended service agreements and any other costs that come along with buying and owning a major piece of capital equipment.
- Do a cash flow analysis: Run a cash flow report comparing the monthly cost of owning and operating the new equipment to the new revenue you expect it to generate. If you are an Excel nerd, you might benefit from watching this YouTube tutorial on using Excel for capital budgeting.
- Examine financing options: Review lease, finance and rent-to-own programs offered by the relevant dealers and determine what mix of cash and debt best meets your needs. Leasing is a good option for assets that are likely to quickly become obsolete, such as computers. Commercial vehicles and construction equipment are the first and fourth most commonly lease items, according to The Leasing Group.
- Don’t overpay: The whole point of investing in new equipment is to increase productivity per worker so you can be more competitive. If you overpay, you are sabotaging yourself.
- Protect your core assets: During the capex budgeting planning process, it will quickly become apparent that capex and opex are competing needs. Be leery of investing in new equipment that will require deferring maintenance on the core assets in your existing fleet.
- Review your plans with your accountant: Capital budgeting is a complex process, so be sure to get input from your accountant to determine how the various financing and depreciation options can affect your balance sheet, cash flow and income taxes. Make sure you inquire about accelerated expensing and depreciation allowed by the TCJA. The law allows businesses to write off most depreciable business assets — machinery, equipment, computers, appliances and furniture — entirely in the year they are put into service through 2022. The TCJA also doubled the maximum deduction businesses can claim under Section 179 of the U.S. tax code to $1 million a year. In addition to machinery and equipment, Section 179 assets include work vehicles, off-the-shelf computer software and improvements to the interior of existing non-residential buildings.