In an earlier article we analysed how to prepare investment decisions quickly and efficiently. We clarified the most important principles and separated the investment calculations into a static and a dynamic group. With the static methods we can examine costs, profits, profitability and depreciation. The most known elements of the dynamic methods are value of capital, internal rate of return and annuity.
Under the static methods we first examined cost comparisons, establishing that this is simple, but if we are interested in the performance side of a project it is not enough. If we can plan the performance or output expected from the asset to be acquired, it can be worth examining the profit comparison method.
In what sense does a profit comparison do more?
In this case, not only the costs of the project or the investment are compared, but also its result and income-generating capacity. Thus, the performance of the individual projects becomes measurable too. This means an investment can be deemed more favourable even if it would otherwise have been neglected because of its higher overall cost.
If we manufacture products of nearly the same quality, then looking at the very costly investments it is worth selecting the one where production ensues at a lower unit price due to the higher capacity utilisation. Let us compare our planned costs for the whole year, but also consider the generated results. During a profit comparison calculation we can convert potential quality differences between the products to be manufactured into HUF, using the expected sales price difference.
A simple example of a profit comparison may look like this:
From the example it is clear that while the cost is higher (nearly HUF 7 million – approx. EUR 22,900 – for the new asset as opposed to HUF 1.8 million – approx. EUR 5,900), the expected revenues are also higher (HUF 18 million – approx. EUR 59,000 – for the new asset, and HUF 9.6 million – approx. EUR 31,500 – for the old asset, so the difference is HUF 8,400,000 – approx. EUR 27,500). If we base our decision on the profit comparison, then obviously we will choose to replace the old asset.
What are the advantages and disadvantages of a profit comparison?
It does have a decisive advantage in that, as opposed to the cost comparison mentioned above, it also considers the revenue aspect.
The potential disadvantages of the method are as follows:
- We receive no information on the extent of any capital investment.
- We do not see the profitability.
- If the useful lives of the assets to be acquired are different, we can draw the wrong conclusions in the case of an incorrect calculation.
- We did not examine the risks of the investment.
Where can we use it?
- If the assets to be acquired are relatively independent of each other, use of a profit comparison is limited.
- It is the most practical method for a capacity expansion, especially when a profitability ratio can clearly be allocated to the assets.
Finally, do not forget that a profit comparison, as a frequently used static investment evaluation method, does not consider the cost of external financing or depreciation.