One of the questions that I get asked most often by business owners is how to decide between one or more options – when faced with path A or B, how do you know which fork to choose and what the potential outcome may be?
These sorts of question arise for businesses of all sizes and they’re just as important for the small business owner as for the large business owner. In the past three months, I’ve helped a painter/decorator decide if he should change his van and I’ve helped a large food manufacturer decide whether to outsource production, or keep it in house. For both of them, their decision was important and could have an impact on their business.
The value of good advice
I wasn’t long qualified as an accountant when an old school friend, now a dentist, asked me if he should refurbish his dental surgery. He’d already asked his accountant, who replied “that’s up to you”. That answer wasn’t very helpful. We know it was up to him to decide but his accountant wasn’t providing him with any advice as to how to make that decision.
To put it bluntly, he wasn’t adding much additional value as an accountant.
But (thankfully) times have changed, and most good accountants now realise that a large part of their role it to help with this kind of decision making – whether it’s supplying the right numbers, forecasting the potential outcomes or looking at the strategic implications.
So how do I go about making financial decisions?
I focus on the cash flows in your business and compare the different cash flow relating to all the options.
The simplest way to explain my approach is to imagine that the business has a large barrel of cash and ask what will happen to the cash in each of the scenarios. What money will come in and what money will go out? Once I identify the cash flows, I enter them into a table with three columns.
- The first column is for the cash flows in the current situation.
- The third column is for the cash flows in the alternative situation.
- The middle column is for the difference in cash flow between the two options (I’ll show you an example of a completed table shortly).
Before you do that, you need to decide what sort of a time period you’re going to consider. Its common to look at a decision over the life of the relevant item – so if it’s a van and you plan on changing again in three years, then you might evaluate it over three years. If you’re looking at outsourcing production, you might just look first at one year and then consider whether you need to review a longer period.
So, let’s look at the van example.
How much will a new van cost?
Let’s say John is currently running an 8-year-old van. His garage has a good 3-year-old van for €12,000 and will give him €1,500 for the old one. John wants to know if he should change.
The first thing I will ask is what the current van is costing him. He tells me his current van works up the following costs:
- €3,600 a year in diesel to fuel the van.
- €300 a year to tax and €500 a year to insure it.
- Repair costs as the van had been giving him trouble which needed repair
- €100 per day to hire a replacement van while his own was off the road – he expects this to continue and suggests that I allow 5 days a year for being off the road with maintenance work.
- 2 days a year in lost earnings while he is dealing with the van – where he normally earns €400 per day on average.
- Overall the van is costing John about €2,000 a year in maintenance, €1,000 of which is normal wear and tear, the other €1,000 is due to breakdowns.
Next, let’s look at the costs of buying a new van:
- The new van John has his eye on will cost €12,000
- We can then subtract the €1,500 trade-in on the old van.
- John reckons he’ll sell the van on in 3 years for €4,000.
- He estimates that it will cost him about €3,100 a year in diesel.
- It will cost him €250 a year to tax it but €600 a year to insure it.
- He’s not expecting to have any breakdown days or van hire.
So, overall the new van should cost about €1,000 a year in maintenance, which is all for normal wear and tear.
Note – these are not real numbers. They’re my best guesses to develop a reasonable example for you.
I put my table together, taking three years into account.
| ||Current Van ||Difference ||New Van ||Comment |
|Investment ||0 ||-10,500 ||-10,500 ||As I’m only looking at what will happen from now, I don’t consider the cost of the current van. |
|Fuel ||-10,800 ||1,500 ||-9,300 ||This is fuel cost over 3 years, based on the info supplied. |
|Maintenance ||-6,000 ||3,000 ||-3,000 ||Maintenance cost over 3 years. based on the info supplied. |
|Van Hire ||-1,500 ||1,500 ||0 ||5 days pa for 3 years at 100 per day |
|Lost Earnings ||-2,400 ||2,400 ||0 ||2 days a year for 3 years at 400 per day |
|Tax ||-900 ||150 ||-750 ||Info as supplied |
|Insurance ||-1,500 ||-300 ||-1,800 ||Info as supplied |
|Resale Value ||0 ||4,000 ||4,000 ||Info as supplied |
|Net Cash In/(Out) ||-23,100 ||1,850 ||-21,350 || |
Positives in the cash flows are ‘cash in’ and negatives are ‘cash out’. In the difference column, positives show where the new option is better than the current option; i.e. cash in, or less cash out.
So, what the above table tells us is that a new van looks like it will save about €1,850 over the three years. We need to be careful and remember that we’re making assumptions, albeit reasonable ones, about the performance and reliability of the new van. We need to be confident that we are aware of, and considering all of, the costs.
We’re not taking into account intangible elements like the effect on his business profile of driving in a newer van. Also, we’re not taking into account the effect on customers of cancelling work because the van let him down. And we’re also not taking into account the effect of having a reliable van and less stress and worry on John himself. We can allow for those in our decision but it’s hard to quantify them and put them in the table.
The bottom line is that the new van looks like it will save him €1,850 over the three years but there are some intangibles that might also be worth a lot to John and only he can put a value on those. I think most of us would change the van based on the info above.
The time value of money
Another factor to take into account is what accountants call the ‘time value of money’.
If I ask you which would you prefer – €1,000 now or €1,000 in 1 year – you’ll all intuitively know that if I get €1,000 now I could invest it somewhere and maybe make another €10 to €30, say €20, in that year. That means that €1,000 now is really worth €1,020 in 1 year. This is what we call the time value of money.
For some decisions, it can be worth taking this time value of money into account. If you have high interest rates and two options with very different cash flow patterns then it may be worth looking at. But for most day-to-day investments, it’s not worth the additional work – and in any event it will involve other assumptions.
A systematic approach to decision-making
So, that’s how I recommend that you approach decision-making – by systematically breaking down those cash flows and seeing which scenario works out best for your business.
- Identify the options available to you.
- Note down the cash flows for each option.
- Put them into a table and see which one looks best.
Put a little bit of time into challenging your assumptions and into thinking through the options to make sure you have considered everything that is relevant. And armed with your outputs you can be confident you’re making the best decision for the future.
Next time we’ll look at some more practical examples of how this can be put into practise.
If you’d like any assistance with your business decision-making, please do get in touch to see how we can help