Capital is the foundation of every organization. Human, intellectual, and physical capital are required for organizations to survive and grow. Capital investment decisions will, therefore, determine the nature, pace, and successful execution of strategic objectives. Unfortunately, capital resources are invariably limited, and managers are required to make difficult choices.
Some capital projects will be approved, and others won’t, which emphasizes the importance of understanding capital project types. The most common examples of capital projects include property, plant construction, and critical infrastructure such as building roads and railways. Therefore, it’s important to understand the how to classify each of these capital projects into their respective types. For example, a sustenance project would expect to sustain existing financial and non-financial returns. With this, let’s discuss why project classification is so important.
In order to effectively evaluate, rank, and select the optimal capital project portfolio to progress, management will require capital projects to be appropriately classified, and measured accordingly. With a financial portfolio, first an investment strategy is determined with funding allocated by asset class (such as international equities) and then selection of individual shares is made from within that category. Organizations must approach their capital project portfolio the same way: first a high-level allocation of available budget between sustenance and growth categories is made, and then the best selection of projects is made within each category.
As expected, the nature of attributes considered, and depth of analysis performed, will vary considerably between capital projects in different categories: a simple like-for-like replacement of essential operating equipment, for example, will require far less analysis than the introduction of a new product line to a new market.
Capital Project Type Examples and Benefits
For effective classification of capital project types for capital budgeting purposes, you must consider the main types of capital projects, as well as their benefits. Therefore, let’s go through the four main capital project types and their benefits:
- Capital Replacement and Sustenance Projects are expected to sustain existing financial and non-financial returns.
- Growth and Savings Projects are expected to deliver additional financial returns via extension of product, market, or process.
- Strategic Projects expand the range of products and target markets addressed and deliver enhanced non-financial returns.
- Environmental, Social and Governance and Compliance Projects are expected to produce indirect (non-financial) returns.
The four main capital project types are presented diagrammatically below:
The nature of these projects and the relevant evaluation criteria of capital project types are examined throughout.
Capital Replacement and Sustenance Capital Project Types
Capital replacement and sustenance projects are undertaken to maintain existing business-as-usual operations. Most capital resources, excluding real-estate, depreciate over time and with usage and must be replaced eventually.
These projects are relatively straight-forward to assess: provided that the activity supported remains strategically aligned, the decision process will primarily be related to risk of asset failure, and therefore the urgency of the project. When assessing project delivery options, normally the most cost effective option is selected, considering utility value, and the Net Present Value (NVP) of maintenance charges and residual value within the planning horizon (typically limited to five years).
Growth and Savings Capital Project Types
Growth projects are undertaken to extend the range of products provided to existing markets, or to extend the target market to new geographies or related industries. Savings initiatives enhance the current product delivery mechanisms, predominantly through the application of new technologies.
Both growth and savings projects are evaluated on their expected financial returns. Sub-classifications within this category may be applied to identify the slightly different risk categories inherent in these types of projects:
- Savings Projects
- New Product Introduction Projects
- Customer Growth Projects
Depending on the degree of familiarity with any new technology, savings-related projects may be the lowest-risk as the expected return is measured with relevance to internal operational benefits only. New product and target market growth initiatives, by contrast, are subject to external dependencies. Will the new products achieve the assumed adoption rates by existing customers? Will we the same market share be achieved in the new target markets as we are enjoying in our existing markets?
The basis of evaluation of these projects is, however, very similar: financial metrics are calculated on the basis detailed financial analyses. Common evaluation metrics include payback period, internal rate of return and net present value. Many organizations present a key financial metric for all projects in the category and prioritize funding accordingly. For example, projects with the fastest payback periods are included first. Unfortunately, this will invariably result in a sub-optimal portfolio selection.
The four factors that must always be considered when evaluating growth and savings capital projects include:
- Risk of omission – the potential impact of not undertaking time-sensitive projects in terms of opportunity cost
- Risk of commission – the inherent risk of execution including an assessment of the probability distribution of outcomes
- Time value of money – ensuring that all financial measures account for the weighted average cost of capital
- Degree of Strategic alignment – just because a project delivers a financial return, doesn’t mean it should be pursued if not in accordance with the longer-term aspirations of the organization.
Strategic Capital Project Types
These projects are like growth and savings projects in that they are generally expected to produce significant financial or non-financial benefits to an organization in line with its strategic goals. This may involve introduction of a brand-new product category, addressing a totally new target market, or responding to community expectations or competitive pressures, for the long-term benefit of the organization. For example, an automotive company transitioning to electric vehicles, would undertake a series of strategic projects. Or a bricks-and-mortar retailer transitioning to an online store.
The degree of change, the uncertainty of the outcome, and the imperative of action together define a strategic project. The common characteristic of strategic projects is that the organization has limited experience in their execution, and they are inherently high-risk. While detailed financial analyses of these projects will typically be required, the financial metrics presented will be subject to a healthy degree of scepticism.
Nevertheless, projects of this type will be approved by executive management when their implementation is considered imperative to an organization achieving its strategic vision. Projects of this type are hardly ever funded from a budget ‘bucket’ and are nearly always approved by Chief Executive Officers, and often by the board of directors when the investment exceeds a certain threshold.
Strategic project evaluations are therefore the most comprehensive. The justifications in the business cases produced are more important than just ‘the numbers’. Scoring models will need to accommodate both the quantitative as well as qualitative assessments of the project and its preferred option.
Environmental, Social and Governance and Compliance Capital Project Types
Environmental, Social and Governance and Compliance Projects are not directly motivated by financial considerations.
Environmental projects are expected to fulfil an organization’s obligations to the natural environment through pollution abatement. Many organizations have explicitly committed to carbon emission abatement as the world strives to achieve net-zero emissions and thereby limit the effect of climate change. Other environmental objectives include reductions in landfill, water usage, and noise.
Social projects are expected to address community concerns around inequality, diversity other development goals. Governance projects seek to improve internal governance procedures for corporate transparency and eliminate negative behaviours such bribery, corruption , money-laundering and other illegal pursuits.
Compliance projects respond to legal mandates and seek to mitigate an organization’s liability for infringement. These projects include compliance with new governmental regulations as well as common law imperatives to provide safe working conditions for staff, and safe products for customers.
These project types are all grouped together as they share a similar nature: their immediate financial benefits may not be possible to reliably measure, but the required investments may nevertheless be imperative for long-term organizational success. As a result, financial analyses, where they are produced, play a less important role in the evaluation of these projects, but may provide a differentiator, where two projects otherwise produce a similar outcome.
More important in the evaluation of these projects is a direct assessment of actual benefit where possible (for example, tonnes of carbon dioxide eliminated) or at least a qualitative assessment related to the purported objective. Practically, the formal evaluation of non-financial outcomes can be the most challenging, as most accounting systems have not matured to the point where reliable facts and figures can be produced to substantiate non-financial costs and benefits, such as the quantity or value of greenhouse gases produced.
For many regulatory compliance projects, the investment will be mandatory, and no further evaluation required other than picking the best technical option to deliver the required outcome.
Combination Capital Project Types
The goal of classification is to refine the evaluation criteria applied to ultimately aid the prioritization of projects seeking funding. Naturally, many projects achieve multiple objectives, and discrete classification is not always possible. For example, installation of solar panels may have both environmental and financial return benefits.
To accommodate this overlap of benefit expectation, projects should be classified in accordance with their primary motivation, and secondary evaluation criteria applied to address these secondary benefits. For example, when considering carbon-abatement initiatives, those that also have a better financial return should be prioritized, all else being equal.
The Importance of Project Classification for the Effective Evaluation and Prioritization of Capital Project Types
Many capital projects are required merely to replace depreciated assets that are essential to business-as-usual operations. The evaluation of these projects normally rests on the urgency of replacement, and the best option to perform essentially the same task as the current asset. Growth and savings projects are expected to produce a measurable financial return, and evaluation of these project will typically include a financial analysis based on organizational experience.
Strategic projects are the most onerous to assess as they will involve the introduction of new product categories, brand new target markets or substantially different technologies. Evaluation of strategic projects will focus carefully on risk and return dimensions, as by definition the organization will be venturing into the relative unknown.
Environmental, social, governance and compliance projects are possibly the most challenging to evaluate, as the experience and standardization of measures is still in its infancy. But most organizations are now compelled to consider more than their traditional shareholders: staff, society, and the environment are now important stakeholders and organizations must respond through conviction, community pressure, or increasingly due to government mandate. If your current system does not effectively support the classification and evaluation process of project types, you should consider Stratex Online.
Stratex Online provides an effective means to collect project initiative ideas, score and rank projects based on their project type, and select your optimal project portfolio in accordance with your budget constraints. Initiate this new knowledge by exploring how Stratex Online can help you to utilize online business case templates to build a better business case.