Incentives and Credits as Financial Strategies in Location Decisions
11 Mar, 2014By: Christopher Steele
Money isn’t everything. Just as it is true in other areas of life, money is also not everything when making site locations decisions. Access to workforce, to core partner firms and organizations, a good business environment and other key factors all work toward the overall attractiveness of a community and a site.
Nonetheless, even these factors may be assigned a financial value. Lack of access to a particular kind of employee may result in increased costs resulting from the need to recruit to the location. Not having the right suppliers, vendors or other partners in place might result in increased costs from longer production timelines or increased inventory costs. Certainly taxes and regulation have some fairly direct impacts on the company’s books.
As a result, site selectors and their corporate clients must always have the bottom line in mind. Each decision and tradeoff has a fiscal impact. If done with forethought, each of these decisions can also be viewed and balanced in a true financial strategy with risks and benefits offsetting each other.
Basic Financial Considerations
It’s helpful to first outline exactly how financial considerations affect location decisions. Very early on, the consultant or company should develop a cost model to identify and examine all pertinent costs – those that vary across location or scenario. In some situations, it may also be necessary (or desirable) to examine a full financial analysis of the company at that location, especially if there will be revenue accruing to the location. In this case, income may vary depending on the location, as will the company’s tax exposure.
The financial analysis needs to include both one-time and ongoing, run-rate costs. One-time costs are those that are incurred to set up the new facility and could include facility or land purchase, construction, fit-out, furniture, utility connection and other hard costs as well as relocation, recruiting, training and other personnel costs. Run-rate costs are the everyday things purchased or leased every day to run the business, including facility rent or mortgage costs, depreciation, wages and benefits, ongoing recruitment and training, utilities, shipping and transportation, raw materials and taxes.
From this, the consultant or company can make a reasonable assessment of the overall cost of doing business in one location or situation over another. This is usually done against either a base case or a no-change scenario. All costs are evaluated both on a cash basis and on a net present value basis over the likely lifespan of the project (or at least five to 10 years). In this way, the analyst can see the impact of one-time costs against ongoing benefits.
Test, Test and Test Again
A cost or discounted cash flow model tool in itself is not a best practice. Instead, it is critically important that this tool be queried so that risks, sensitivities and other issues are identified and controlled early. After all, any fool can build a cost model (and many of them do). It takes someone with talent to use a cost model to build a meaningful strategy. Each variable should be seen as exactly that – something to be varied. None of the assumptions on variables will test out to be exactly right in practice, and indeed they will change over the lifespan of the project.
In each case, the consultant or analyst must attempt to discover how each location or scenario positions the new facility (and the company as a whole) to labor cost inflation, tax and regulatory costs, overall return on investment (or net present value) and the period needed to achieve the financial goals for the project. It is also important to note that some projects will also bring additional factors to the analysis. For example, projects involving multiple countries will also involve exposure to changes in the exchange rate. Projects involving goods movement will include factors to examine how the cost of fuel will impact the decision on how to ship products.
In short, if there is a factor in the cost analysis, it is worth identifying the points at which the variance of that cost factor materially impacts the decision on where to locate. Once this is known, it is up to the consultant and the company to come up with appropriate means for controlling that risk.
Cash Dollars, Book Dollars and Tax Dollars
Most of what has been discussed so far involves looking at the cash basis for the company’s financial situation – the actual flow of dollars in real-time. However, as a consultant or as the company’s staff examining a potential location decision, it is also important to view the decision through two other lenses: the company’s accounting perspective and its tax liability.
The accounting treatment of a corporate action is based on a series of federal (and in some cases international) rules on how the overall financial obligation needs to be shown on the company’s book of accounts. Increasingly, accounting rules from the FASB (Financial Accounting Standards Board) and the IASB (International Accounting Standards Board) have changed their standards to make sure the contractual commitments companies make are shown as long-term liabilities on the company books. Leases are getting considerably more and more attention and the standards for operating lease treatment (which ordinarily looks like a one-time expense) are getting tougher and tougher. Consultants and analysts should ensure an accountant reviews whether leases will be shown as operating or capital leases (looking like ownership) and provides an opinion on the overall impact on the company’s financial position.
While reviewing the financial analysis with the accountants, it is also appropriate to examine the company’s tax position and how it could be affected by the new location decision. This includes several key questions: First, will the new location create a new taxable nexus in the new location that could create new and troubling exposure for the company? Second, and inversely, does the new location represent an opportunity to consolidate activities in a location with more favorable tax treatment? Last, it is also appropriate to see whether there are tax credits or other offsets available to make the new location even more attractive. The last comment will be discussed again later.
How to Address Possible Financial Risks
Typically, there are two kinds of financial risk that can argue against a project or a location investment going forward: The risk of high ongoing costs, or a high initial cost to establish the location. High ongoing costs may be due to potential changes in labor costs, uncertainty in transportation costs or other ongoing risks. One-time initial costs to establish the location are generally easier to identify and estimate, but a high initial hurdle cost sometimes can be high enough that the prospective advantages – financial, operational or strategic – simply may not justify the initial investment.
Financial risks can be addressed through several tools ranging from choosing other alternative locations, developing some form of insurance, partnering with suppliers/vendors, offloading some financial risks to the public sector or through an honest assessment that the risk is unlikely to occur or – if it does – it will not materially impact the cost of the decision.
Plusses and Minuses of Going to the Public Sector
Of course, going to the public sector for help usually means taking advantage of incentive or credit programs. Incentives and credits have had something of a mottled reputation for some time. For some, they are an effective way of building new clusters, bringing new investment or more commitment to an area that needs it. They can be characterized as tools to build upon a region’s existing strengths. Or, conversely, they can be described as corporate welfare – readily and commonly misused by corporations and the consultants who advise them. On the latter point, the New York Times ran a three-part, front-page series in November 2012 on the evils and errors of incentive programs throughout the United States.
Each of the Times articles and most public debate assume that incentives are a zero-sum game, and that they simply transfer wealth from existing residents to a new corporate entity. This perspective implies that incentives are always to the detriment of the community offering them.
However, well-designed and negotiated incentives are not a zero-sum game and should be included in some way in framing the relationship between the public and private sector. It is also important to understand that incentives need not be purely financial, but may – as has been implied elsewhere in this article – affect other risks that carry a financial implication.
When both a company’s and community’s goals are clear, the desired outcomes are realistic, and the responsibility of all parties expressly laid forth, benefits can be achieved for both the public and private sector. These incentives must be evaluated in the context of the community’s other business fundamentals, the company’s obligations under the program(s) and the potential risk of clawbacks so that the program complements the other reasons for considering the community.
Also remember that incentives carry reporting and filing obligations. Some incentive programs have administrative burdens so high that compliance is almost more costly than the value of the credit, especially for smaller companies. Failure to comply with these requirements also can result in partial or full clawback or forfeit of future benefits. It is critically important that any knowledge gained in this negotiation be passed along to the team who will be responsible for the project execution and future operation for the new location.
Execution is Critical
Interestingly, two of the last and most important pieces in a successful financial analysis for site selection are communications and execution. It does no one any good if a strategy has demonstrated its brilliance on a spreadsheet, but is not carried forth in the actual transaction or business operation.
By way of example, the author can cite a client who selected a lower cost location for a backoffice operation approximately 20 years ago. When asked roughly two years after the facility was put in place how the operation was faring, the client noted that some of the projected cost savings had not been realized. It was only after an examination of operating budgets that the client noted that they were paying the same average wage rate in the new location as they had in the major metropolitan area they had relocated from. They had failed to compute a new wage scale in the new location. (In the process, they also created a minor wage war among their peers in the new location.)
Whether the factor is wages, real estate strategy, incentives or some other factor, it is critical that the client’s team understand the decisions made, the strategy selected and the reasons why. Only with this knowledge will the company be able to effectively execute the location strategy. Moreover, no battle plan ever fully survives the first encounter with the enemy, and the client’s team will most certainly need to have intimate enough knowledge of the strategy to adapt it to the exact situation they encounter in the new situation.
An open mind, thorough analysis and a healthy respect of the unknown serve the location consultant and her or his client well when examining the financial implications of a location decision. The steps outlined above represent a good start to a thorough process, but true wisdom comes through experience and asking a lot of questions!