FINANCING AN AWARD WINNING PLANT

By Deborah Rechnitz CMA CMC

Rarely does anyone set about to build an award winning plant for the heck of it. These plants and stores are designing and built for the long-term purpose of making more money. The intention is to either increase sales in a great looking, well located store and / or to reduce costs with an efficient, well thought out work flow. In both of these situations, there is a great deal of risk offset by a great potential return. Paying for the risk occurs on the front end with the hope that the potential return will emerge.

The Costs. There are lots of obvious costs associated with a remodel, an expansion, and / or a new location. Those can be detailed and budgeted. Then there are all sorts of unanticipated costs.

Some of the unanticipated costs come, not surprisingly, from the government in additional fees, studies and required design changes to meet unknown or reinterpreted building codes. Other, unexpected costs come from suppliers where there were no fixed fees negotiated. Many of these additional costs come from owners making decisions as opportunities arise during the process. In one classic case, spot cooling was installed in a new plant for all press station operators at a major, but budgeted expense. It was so effective that all other employees in the plant demanded a similar cooling system for their workstations as well including the assembly and the spotting departments. Unbudgeted, but critical, this became an additional, unplanned expenditure related to a new plant.

Great care is often taken in budgeting these types of projects. Frequently these budgets get very specific, down to the last penny, so to speak, because there are no many dollars at stake. The budget can include the environmental testing and purchase of land, design and building a structure, installing new electrical, piping and utilities, moving existing equipment and buying new equipment. In every situation there will be cost over runs. Rarely does it go the other way. This isn't necessarily bad, but it does need to be a part of the budget. As a rule of thumb, cost over runs seem to average about 20% of a project.

Paying for the project. The size of the project frequently guides this decision, but that should not necessarily be the case.

A small project, such as opening a small new dry store, can cost between $50,000 and $150,000. Where should the money come from? Frequently owners have saved this amount of money in anticipation of opening a single store and budget to spend all of the savings for deposits on the utilities, the telephone and prepaid rent, and outfitting the new store with counters, carpet, wall paper, rails, signs and computers. Significant cost over runs are unusual in these projects. No debt is incurred and everything looks good, on paper.

A new location has some additional and significant costs that occur once the door opens. Advertising costs occur. At least one brand new employee is hired. There are no sales to offset any of these costs. Frequently savings cover these kinds of costs until the sales catch up with the costs. But, in our example above, the savings have been spent for the new store and its improvements. The result is a cash squeeze. Costs have risen faster than sales, profit has fallen and there is no cash in savings to make up the difference. Payables start being held. Vendors start being the source of cash.

Larger projects have similar issues, but the size and scope of the project makes the up front cash requirement much larger. Large projects generally have unexpected situations that may exceed the budget by 20%. In addition, start up issues in new plants usually result in increased costs instead of decreased costs in the short term. This occurs for a variety of reasons. First, employee turnover frequently occurs whenever there is a significant change. Whether the change was an improvement or not, it is change and some people have trouble adapting. Turnover always costs more money in overtime, recruitment, training, and getting someone up to speed. A second area has to do with new system requirements. A major change in plant size frequently requires a change in systems from a day - lot system, for instance, to a piece - lot system. While these systems are in transition losses, late orders, and add to the unexpected expenses in a new plant. The source of cash to pay for these items will determine the short term and long term health of the company.

Staying Healthy during and after the Project. In many cases, these types of projects represent the single biggest expense that most operators have every carried out. There are lots of unknowns and uncertainties. The first step is to establish the budget for the capital expenses and then to add a contingency of 20% or so, for all of the unknown items. The next step is to look beyond the completion of the project and realistically consider the cash requirements of the start up operating costs. These unfavorable operating costs can continue between six months and two years depending on how radical the operating changes were. These costs also need to be added to the capital budget. Now you have a complete list of your real cash requirements.

The next step in the process is to decide how to finance the project. A natural inclination is to use existing cash reserves or to fund projects directly out of operating profits. Cash reserves frequently are used to cover your vendor payments in the slowest months of the year and then you rebuild those reserves during the strong sales months. Rarely are these reserves large enough to handle large capital projects unless you have consciously planned and saved for this project. Expecting to use existing operating profits is also risky. These profits generally pay for normal repair and replacement along with payouts to owners. Profits are usually inadequate, in the short term, to cover the entire cost of large projects and unexpectedly large operating expenses. This strategy is usually very uncomfortable for owners as they see profits fall and cash reserves disappear.

An alternative is third party financing. Bank financing, for instance, is frequently frowned upon by small business. It is seen as difficult to get, it requires personal guarantees, and once have it, there becomes a new worry about the ability to repay. These are justifiable worries, but third party financing usually reflects a better business decision with more manageable financial payments, that trying to fund projects out of the existing business and threatening the health of the business.

These types of projects don't expect immediate profits returned to the business. Even a new store can take a year to break even and two years before it is really contributing its fair share of profits. Larger projects, like a new plant, are expected to last somewhere between 10 and 30 years. Paying for these projects must be on the same time line as the return these projects are expected to have. For instance, a new plant may expect to last 10 years before another set of major changes is expected. For the first few years there will be cost over runs and higher than projected operating costs. Thereafter, costs will fall and the plant will contribute more and more to the profits of the business. Payments for this project should follow a similar path. Payments need to stretch out over the same 10-year period. In this way a business can remain healthy as it continues to grow.

Published in the American Drycleaner, January 2001

Back To: Articles Menu | Go To: Next Article