Question

Do capital projects always have to be able to pay for themselves over time? Or are there situations where a capital item may actually be a cost center rather than a revenue producing center? Would it make sense to spend money that is going to cost more money over time?

Answer 1

A capital project is usually taken by the company after considering all the factors like initial cash investment, projected cash flows, useful life and salvage value . Each project so selected must prove to be able to pay for itself with time and at the same time must contribute in increasing the production, cutting costs or adding corporate benefits to the entity.After all the evaluation and analysis if there stands a fair probability of earning profit from the capital project than the entity opts for that project. This implies that the capital projects are adopted when they always stand a chance to be able to pay for themselves over time.

A cost center is a division that incurs costs but does not generate enough revenue to cover the cost. whereas a revenue center is a division that generates enough revenues by selling the products or by providing services. Even after evaluating all the factors associated with the project selection there are situations which may turn up negative and hostile for the project. In such a situation the capital item may actually be a cost center rather than a revenue producing center. The expected investment of $100000 increases to $200000 due to breakdown of machinery ; this will reduce the expected profit calculated or the Net Present Value of the project and the company may not find the project feasible to be taken as the capital item will turn into a cost center rather than a revenue producing center.

It does not makes sense to spend money that is going to cost more money over time as it will not be in benefit of the company. Instead of earning profit it will be a loss making venture.