Practical, step-by-step guides for the busy FM
June 2000
The Effects of the Business Cycle on Budgeting Decisions
Facilities owned and leased by companies to support their operations undergo changes that closely parallel those of the products and services they produce. Multiple stages of product development may occur in the same company, so the facilities manager will have to track the various stages for each product and be prepared to allocate space accordingly. The conventional stages of development include embryonic, growth, maturity, and decline. The placement of any project within a life cycle stage has a definite effect on whether a project’s costs are classified as capital or expense.
Embryonic Stage. In the embryonic stage of product development, sales growth tends to be slow because of buyer unfamiliarity and inertia. This stage requires heavy start-up investments in research, manufacturing, and marketing. It tends to be unprofitable and often involves high risks and a negative cash flow.
Capital budgeted costs will probably be minimal in the embryonic stage. Management normally waits until a market test of a new product or new service generates a favorable response and a marketing plan has been developed before it expends large amounts of money on fixed assets. Most costs will be expensed, but some costs will be capitalized because of the varying ability to write off research and development expenses in the early and later stages of a project.
Growth Stage. In the growth stage, sales of the product begin to take off. Demand for the product or service is strong and growing at increasing rates. As sales grow more rapidly, the product begins to generate profits. However, cash flow in the growth stage may remain negative because large investments are made in marketing, plant capacity, and equipment.
Industry expansion generally implies expanding capital investments. A facilities manager is faced with expansions in physical plant and equipment assets. One generally expects an organization operating with a rapidly expanding product to generate more churn than one with a stable product.Decisions as to whether costs are expensed or capitalized in the growth stage depend primarily on the policy of the company to show a loss early in the process, or a loss which can be carried over to offset later profits. Depreciation of equipment and buildings begins immediately. As a result, profits in the growth stage are offset by depreciation allowances.
Maturity Stage. In the maturity stage, sales may stabilize or continue to grow. Market penetration remains stable. Marginal producers have been cleared from the industry and few, if any, entrants are attracted because of reduced growth rates. Both profits and cash flow peak in this phase. Corporate strategy shifts to a more conservative posture as the company protects itself from competitors attempting to erode market share and profits. Capital investments are offset by depreciation in the maturity stage. Losses from early years may be used to offset profits. Capitalizing expenses to generate more depreciation may be regarded as a favorable strategy.
Decline Stage. In the decline stage, the product generates fewer sales. Companies operating in declining cycles tend to milk the business of all possible profits and cash flow, using this money to invest in other product in earlier stages of the life cycle. As many items as possible will be expensed as the product life cycle comes to an end.
Placement of the product in the business life cycle is one of the critical elements in the decision to expense or capitalize various costs. Additionally, the placement of a product in the life cycle will have a significant impact on the willingness of senior management to invest in facilities to support the product. For example, it is rare for a new building to be approved for a product in a declining product cycle.
In some instances, it is difficult for managers to acknowledge that a product is in the decline stage. They may use the opportunity to lobby for new resources and expanded facilities. In such instances, a facilities manager must have a clear understanding of the company’s business and actual product life cycles. A working knowledge of where each product is in the life cycle will give the facilities manager a clearer picture for determining needs.
This installment of FM Check List is adapted from BOMI Institute’s Real Estate Investment and Finance course, (www.bomi-edu.org/19062.html), a required course in BOMI Institute’s Facilities Management Administrator (FMA) program.