Module 09 Making Smart Purchasing Decisions

Module Nine: Making Smart Purchasing Decisions

Sometimes, you may be asked to purchase something on behalf of the organization. When purchasing, determining if the expense is worth the investment is always a good practice. There are factors that you should determine before making a purchasing decision. Making 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. This module will discuss four tools for making smart purchasing decisions. Here are the topics for discussion:

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

Let us review the ten questions you must ask first.

10 Questions You Must Ask

Here are ten 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 we restore the old item you are replacing?
  • What is the return on the investment?
  • What are additional costs related to 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 build a case for buying the proposed item.

Determining the Payback Period

The time it takes to recover the purchase cost 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, the project annual cash inflows for this device are $5,000. Therefore, the payback period would be three years. 

The payback period is a simple calculation. However, it does not calculate profitability nor factor in money's time value. Other calculations like net present value or internal rate of return would calculate this for you.

The payback period is meant to help you quickly determine 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 to obtain the equipment with little or no money invested in it.

Leasing is just as beneficial as buying. In some cases, it is better. For example, with leasing, you do not have to expense depreciation. 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 capital for a business; instead, it is an expense, having the equipment leased may reduce the business's tax burden.

A drawback to leasing is the requirement of good credit. If a company is starting, it may find it 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 additional research time, but the payoff may be worth it.  

Lesson Summary

Making purchasing decisions is an important and potentially money-saving task for businesses. This module explores four tools to help you make smart decisions.
  • Ten questions you must ask
  • Determining the payback period
  • Deciding whether to lease or buy
  • Thinking outside the box
The ten questions you must consider include: whether the purchase is budgeted, lease or buy, make or buy, justification/business need, approval by upper management, if you can do without it, restoration of old item, return on investment, additional costs, and benefit of buying the item. The payback period is also important and calculated by dividing the purchase cost by annual cash inflows. Leasing has its advantages such as conserving cash, no depreciation expense, and tax benefits, but can be difficult with short credit history or buildings/property. Thinking outside the box can involve Internet markets, auctions, or closed companies, though this requires extra research.

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