Justifying capital expenditures in the laboratory

Oct. 1, 2002

Capital justification is a major process for you as a laboratory administrator. You must be able to decide the capital needs of your laboratory, and then be able to convince the financial department and others in the institution that your need is not only justifiable, but also more important than other requests for capital made by other department administrators. 

In reality, you are asking the institution to make an investment in your project, whether that be a new instrument, lab remodeling, or any other project requiring the expenditure of capital monies. You have to show that the investment is worthwhile, and most of the time, that it will add dollars to the bottom line. Very few requests are strategic; i.e., they are needed to exist, but are not necessarily financially justifiable. An example would be a laboratory computer system. These systems are almost never financially justifiable read profitable but they are needed for most hospitals today to be competitive and stay in business. 

Three things are important to this process:

  • Sound needs assessment;
  • Good financial justification;
  • Excellent presentation of the request package (proforma).

Sound needs-assessment

It is easy to desire something, but it is another issue when you have to justify that desire to someone controlling the financial assets. In the healthcare arena, that justification should include a list of the reasons that the capital should be spent. It must be compelling enough that the financial agent of the institution thinks your need is more important than other needs in the institution. This is because there are always more requests for capital dollars than are available. Remember, every need will set an expectation for your reviewers (Table 1).

Example Justification Needs

Need Expectations
New competitive technology
  • Physicians/patients will come to institution because you
    can do something others can’t do.
More automated equipment
  • You will save staff by automation.
  • You can get your work out even though there are staff
  • You can make up for staff you can’t find because of
    medical technologist shortage.
Replacement equipment
  • Your old equipment is broken and too expensive to
  • Your equipment is so old, they don’t stock parts for its
Equipment for new testing
  • You can create new outreach revenue.
  • Physicians are requesting a test be brought in-house.

Good financial justification

Now that you have established your needs, you will have to justify the expenditure from a financial point of view, remembering to put emphasis on the expectations you have created. For example, you can estimate the increase in revenue because of the new competitive technology. The justification will be most likely in the form of a five-year spreadsheet showing discounted cash flows for each of the five years (see Fig. 1). The key indicators of financial viability for the project will be return on investment (ROI) and net present value (NPV), along with internal rate of return (IRR). Definitions for these indicators are listed in Table 2. This five-year spreadsheet, along with supporting documentation, is usually referred to as a proforma.

Financial indicator Definition
Return on investment
  • Monies or percent gain earned on the investment.
  • The NPV is the calculated expected net monetary gain or
    loss from a project by discounting all expected cash flows
    to the present value, using a desired rate of return. If
    this is a positive number, then the cash flows from the
    equipment covers its costs.
Net presentr value
Internal rate of return (IRR)
  • Return that makes the net present value
    (NPV) of a
    project equal to zero. The IRR is useful to determine
    wheter or not an investment is expected to increase in
    value. In addition, the IRR is useful in determining if
    the project achieves the desired internal returns required
    by a company, the hurdle rate.

Return on investment, which is equal to the investment divided by the sum of the returns, expressed as a percentage, gives an estimate of the value of the project.

Discounted cash flows are values of future expected cash receipts and expenditures at a common date. Since it will cost more to buy a new instrument in five years than it does today, the flows are discounted to make up for the reduced buying power of future money. The discount rate is also called the cost of capital and is obtained from the finance department. Various components make up this cost of capital. One important component is the lost opportunity cost. This term defines what would be the return on the money if it were used for another investment instead of yours. The other component is the current rate for borrowing money. A part of each of these is used in the calculation that the finance department uses to come up with the cost of capital number.

That number is usually 7 percent to 8 percent. After obtaining that number from your finance department, plug it into a tables book or spreadsheet formula to obtain the discounted cash flows. The sum of these discounted cash flows minus the investment is called the net present value.

The discount rate when the NPV is zero is the IRR. The institution usually has an established IRR value, which any project must meet to be considered viable. This viable rate is called the hurdle rate. Like the cost of capital, it should be obtained from your finance department.

Excellent presentation of the request package (proforma)

You have done a lot of work gathering your information and assembling the
proforma. Now you must present it in a format that will look professional. You are asking someone to invest in you and your ideas. Make it easy for them to understand your proposal. The adage A picture is worth a thousand words is also true in helping secure money from the finance department. Use graphics to explain your outcomes and sell your ideas. You are essentially selling your ideas, which they will buy with their money. 

Since you are dealing with financial people, in order to have the best credibility possible, your presentation must look like it came from a financial person. Make sure it looks and feels successful. Use at least 24-pound and at least 94-brightness paper. Put it in a binder, if that is acceptable at your institution. 

If you are doing an oral presentation, make sure your slides or overheads look professional and not just like something you threw together. Most importantly, make sure you can explain how you arrived at your numbers. Nothing kills a proposal more than having the person asking someone to invest in their project not being able to justify their financial data. Even if your institution uses a specific form for capital requests, it is important that you understand how the numbers are generated.

Work, knowledge, and sound ideas will bring success in the justification of capital expenses.

Click here to view the slide slow “Proforma Development for Capital Budgeting.” To advance to the next slide, click somewhere on the page.

Lawrence J. Crolla, Ph.D., is a laboratory consultant for hospitals across the country and is Managing Director of World-Wide Healthcare Consulting, Ltd. Dr. Crolla is the co-author of The CLIA 88 Implementation Guidelines, a manual of explanation and forms to aid laboratories in obtaining CLIA compliance. He also has co-developed SUMNET, a cost accounting software program for micro-costing healthcare procedures.

© 2002 Nelson Publishing, Inc. All rights reserved.