In today’s inflationary business landscape, using funds for Capital Expenditures requires a cautious posture. Optimizing how well capital is planned and allocated is a crucial driver of shareholder value and competitive advantage. It is part art and part science, a complex process to master in the office of finance. The science may be straightforward; however, the art is in navigating politics and competing initiatives.
Less Than Optimal Processes, Questionable Outcomes
Achieving the desired returns on investment and impact from capital expenditures requires a well-orchestrated and governed process. While the capital expenditure planning process is a subset of overall financial planning, organizations often need more explicit guidelines, governance, and visibility to the capital process.
In many cases, capital spending decisions are made based on political influence or advocacy and who has the loudest voice requesting it. Political power leads to arguments about which divisions or branches should receive funding.
Many organizations will have the following problem characteristics in their current state:
- Setting arbitrary targets by adding an increment to last year’s capital number to determine how much to budget this year
- The company knows it is spending a lot on capital but does not have an appreciation of whether it is getting its desired return on investments
- Project owners are accountable for time and cost, but not the post-implementation benefit targets
- Metrics used to measure the merits of capital expenditure are not consistent, loosely defined, or are the result of subjective assumptions
- Ongoing measurement & benchmarking of capital projects in flight and production is difficult as there is no system to support the end-to-end process and to stage all data and documentation in one place (manual methods)
- Annual Capital Allocation is reallocated at the business unit level without visibility of the quality of the reallocation
Optimal Process, Assured Outcomes
Optimizing the capital planning process starts with setting a “Strategic Direction” for the organization’s priorities for capital spending. The strategy includes ranking the categories for capital spending based on these priorities. These can include, for example, classifying the spend for safety-standards-compliance ahead of branch leasehold improvements. Additional segmentation, for instance, between capital spend that generates a return and those that do not, is also essential.
With categorization comes the prioritization of investments based on the return and measuring the impact on operations and customers. A governance model for reallocating approved capital expenditures is vital to the visibility of field decisions to move capital dollars around once the budget is set. The following are key characteristics of an optimal best capital planning process:
- Metrics should be standardized such that the Finance organization can rank & benchmark capital allocation requests (Assets & Projects)
- Use key, clear metrics in the evaluation of capital allocation requests. All capital allocation should be evaluated using the same criteria, with a focus on metrics that align to return on investment and create shareholder value
- Classify capital requests to assist with ranking them. Examples include Safety Compliance, Replacement, Expanded Capacity, Customer Experience, etc.
- Create a governance model for the documentation & review process
- Explore risks and opportunities
- Material capital requests require documentation presenting alternatives
Decision Metrics and Measuring Outcomes
Defining key metrics that will be used to evaluate the merits of a capital expenditure request and those used to measure its attainment of target returns is foundational to favorable outcomes and returns on investment.
- Key Metrics for Standardization as to how capital request decisions are evaluated include:
- Time Horizon, Labor, Materials & Equipment Pro-Form by month (Inputs)
- Revenue (if applicable) realization time horizon, by month (Inputs)
- Total Forecasted cash expenditures by month position (Inputs)
- In production service date target (Input)
- Payback period (Calculated)
- Return on Invested Capital (Calculated)
- Internal Rate of Return (Calculated)
- Opportunity Cost of Capital (Calculated)
- Depreciation Pro-Forma for the life of the project (calculated)
- Tax Provision Benefits & Impact (calculated)
- Variances from Target Metrics
Process governance and visibility are essential for an optimized capital expenditure planning process. Finance organizations should adopt the following governance principles to ensure target outcomes are realized:
- Rank proposed capital based on agreed-upon metrics and publish to stakeholders for discussion & review
- Make final capital decisions based on the criticality of classification, using ranking based on agreed-upon metrics
- Establish unique asset or project numbers for approved capital expenditures. Require an approved or un-approved designation for expenditure and PO (Purchase Orders) issuance
- Measure capital projects monthly, updating budget with actuals, forecast to the end of the project
- Continuously measure & rank projects in flight for variances to budget
- Rank material projects for variance risk & cancellation, publish to key stakeholders
- Monitor material projects for in-service date attainment. Perform monthly analysis of material projects once in service against budgeted performance metrics
- Publish project performance once in service, as compared to budget, and publish to key stakeholders monthly
If capital expenditures are a material part of your financial planning cycle, revisit the process well ahead of the next budget cycle, improving the process by introducing a strategic direction, governing principles, consistent evaluation metrics, and enhanced communication with stakeholders. Leading Corporate Performance Management (CPM) software solutions offer a platform to re-invent and optimize the capital expenditure planning process. Consider CPM solution adoption as part of the overall process improvement initiative. Perficient can assist with strategy development, software evaluation, and implementation. Investments assured.