Why do so many companies under spend against their capital expenditure plans? Where do the planned projects go? And why is under spending a problem anyway in these cash restrained times?
The main culprit is one of the usual suspects: the annual budgeting cycle. Much has been written about problems caused by the budget process. The shortfalls of a process designed to focus on a single financial year are nowhere more apparent than where multi-year investment expenditure is linked to the financial year, rather than the business cycle. This is a clear case of a budgeting process that drives unintended behaviour, resulting in:
- Under developed business cases to get projects into next year’s budget;
- Activity biased towards second half of year because of the need to develop improved business cases, or spend up to the budget limit in case it is removed in the following year; and
- Multi-year projects accelerated or decelerated across year-end to preserve
approved budget.
The negative impacts of this narrow focus on the business are numerous. They include cash flow volatility and inefficient resource utilisation, creating peaks and troughs.
In addition, new projects above the financial hurdle rate risk being delayed, even rejected outright as other budgeted projects get earlier approval. Inaccurate forecasts are another outcome, as they become driven by optimistic delivery timetables coupled with the perceived need to preserve the capital budget.
Breaking inefficient behaviour
There are four recommended steps to take. First, set multi-year capital budgets. These should be set in line with external benchmarks and internal strategy rather than lists of specific projects.
Second, take a tailored approach for different types of capital expenditure.
For example, in a manufacturing business, cap-ex might be focused on sustaining current production. Industry benchmarks, taking the economic cycle into account, and can be used to ascertain the level of expenditure required to sustain various types and ages of plant.
Other types of cap-ex may be focused on improvement and are set using strategic and internal benchmarks. Where the focus is development – usually the larger projects – a different approach is needed. To promote efficient behaviour in this case, it is important to have flexibility throughout the year to exploit specific opportunities that may arise.
In other words, the capital management process should be flexible to enable the business to initiate projects ‘in-year’ if they drive benefits, rather than waiting for an pre-defined approval cycle.
The third step is to use a full lifecycle approach, both for funding reviews and progress reviews. Business cases should be drawn up for the life of a project, rather than just the next year. For newly proposed or mandated projects, in addition to a strong business case it is important that the project fits with a company’s capital expenditure portfolio.
For the existing portfolio of capital expenditure, it is also important to review projects in terms of critical success factors, the benefits and measures used to track and realise them, costs at completion and deliverables/outcomes. A project must
also continue to support its business case, as well as the overall portfolio.
All company projects should be prioritised against the overall business
strategy.
Project parameters, key performance indicators (KPIs) and scope should be
reviewed against the established priorities and appropriate corrective actions
taken. It may be necessary to re-set parameters, change the scope or defer some
projects.
Corrective actions could include additional funding, agreement and regular monitoring of KPIs, tighter benefits tracking or even closing the project. After a project has been implemented, post project reviews should be used to refine project KPIs and deliverables for future capital expenditure.
Self-qualification
A fourth and final step towards efficient cap-ex management provides a simple and effective way to exclude under-developed projects from the budget list: insist all managers apply a quick ‘self-qualification’ test to each project.
The key parameters that need to be satisfied here are centred around value, relevance to business strategy or operational goals (cost reduction, customer satisfaction), deliverability and timeliness.
Providing the project meets acceptable minimum criteria against each of the main parameters outlined, the project is ready to proceed with the initial business case. By taking the time to carry out a quick self-assessment such as this, managers should be able to avoid unnecessary investment analysis and at the same time also avoid tying up the company’s limited capital budget.
So, in summary, by moving away from single-year capital budgeting and adopting these four steps, the problem associated with continually under-spending the capital budget should be eliminated.
The benefits should soon be seen company-wide in areas such as improved
resource utilisation, better investment decision-making and improved forecast
accuracy.
Capital projects should be a continuous activity linked to the business cycle,
not constrained by the straightjacket of financial year ends.
The project test
- Does it have value? What is the project’s financial value for return on investment or net present value?
- What are the project’s non-financial value drivers?
- Does the project support the company’s goals?
- How does this project support the company’s strategy?
- Does this project support revenue growth or cost reduction?
- Can we do it?
- What are the project risks?
- What are the business risks?
- What are the implementation risks?
- What are the risks of not doing this project?
- Why now? Is the timing of the project appropriate?
- If this project is not undertaken now what is the impact?
- How does this project fit with other projects within the company?
Mark Doyle is a former FD of numerous Diageo subsidiaries and is now an engagement director with Parson Consulting
