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The board was concerned about an aspect of their decision making relating to the purchase of new equipment.
The arguments supporting the purchase became too predictable. Every year, machines with an offer of increasing order of functionality and greater level of technical sophistication would hit the market.
The board approved every such indent as a matter of faith, never ever questioning the merits of mechanically pensioning off the previously procured equipments.
Could the case for purchase be documented more rationally?
Data points
The capital budget process was revised to include the following considerations.
The need for purchase would be guided by the computation of residual Life of Critical Assets (LOCA).
The methodology for computation was illustrated with an example of the company deciding when to pension off the company car purchased in 2006 at a value of 1350K.
Computing LOCA value
The value of the residual LOCA was estimated and tracked financially over the entire life of the asset. It varied from (-155K) in the year of purchase in 2006 to + 175K .
The value of LOCA was arrived at as follows: Reduce the book value of assets by deducting the provisions kept for depreciation and the potential gain from the resale price realised and add the costs incurred towards maintenance, usage and refurbishment if any.
How the data connect
The proposed system of computation of LOCA brought in the requisite sensitivity for evaluating the purchase decisions with the additional considerations of the prices the assets were fetching in the resale market.
Additionally the costs of maintenance, usage and refurbishment that were habitually excluded from the capital budgeting decisions were reinforced.
Question for the Directors
The board commissioned a cross functional team from production, purchase and finance to make an inventory of all the critical assets of the company.
They were keen to know the residual LOCA of all the assets that were reflected in the balance sheet.
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