A core concept of zero-base budgeting is to ensure organizational expenditure is optimized towards the attainment of strategic goals and objectives amidst all capital investments. This is in contrast to the classic budgeting process whereby a bucket of funds is made available for capital works, disbursed on a first-come first-served basis. The risk of the classic approach is that the capital budget amount is typically set with reference to prior period expenditure, and closely aligned to the sustenance of the existing asset base.
Unfortunately, a dynamic operating environment and competitive pressures mean that most organizations need to evolve, and simply replacing assets and doing what was done before is certain to result in ultimate failure. The strategic plan identifies future-focused goals and objectives. Subject to averting any catastrophic risk to current operations, every dollar of expenditure should be directed towards achieving those goals as quickly, cost-effectively, and at as lower risk as possible. The key steps to strategic project portfolio management are provided below.
Defining the Strategic Goals of Capital Investments
Naturally, strategically aligning a project portfolio must start with a shared understanding of the ultimate organizational goals and objectives.
Organizational Structure Alignment to Strategy
A typical organization embodies several operating structures to facilitate operations. Go-to-market activities are typically structured around territories, sales offices and sales distribution channels. Supply chain activities will be structured around procurement types, plants and manufacturing processes. Human resources may be structured according to jurisdiction, payroll area and employment type. Finance is structured by legal entity and consolidation group. But strategic investments need their own structure. Unencumbered by the process participants of today, the investment management hierarchy should be about optimizing the structure and key management responsibility areas to deliver on the organizational vision and mission.
The top of the investment management hierarchy reflects the organization as a whole. This node represents the highest level of authority in the organization, such as the board of directors. Each subordinate hierarchy node represents a responsibility area for delivery of the overall strategy. This second level may represent the executive management team and the chief-executive officer. Sub-ordinate to the CEO, the investment management hierarchy should be structured entirely in support of strategy, and not simply replicate existing reporting lines, geographies, legal or operating structures, unless they effectively support the strategic direction. For industries undergoing immense upheaval (such as utilities, automotive, retail) a clean-slate approach should be adopted to outlining the target operating state. Legacy units (such as coal-fired power stations, combustion engine manufacturing plants, and physical stores) may even be bundled into a ‘legacy business’ node, whilst new areas of investment (such as wind-turbine research, Electric vehicle technology, and online store marketing) as assigned dedicated nodes and supporting teams.
All nodes of the investment management hierarchy must describe simply and intuitively their value contribution and be assigned a manager. It is this manager who will ultimately be responsible for selecting the investment initiatives of that area of responsibility.
SMART Area goals
Each node of the investment management hierarchy should have strategic goals described. The goals should be:
- Specific (detailed and clear)
- Measurable (quantifiable and trackable)
- Achievable (ambitious by attainable in the timeframe)
- Relevant (in view of the strategic goals)
The goals will include value-based outcomes in support of the higher-level node’s targets. For example, if the CEO and management team set an organizational goal of growing revenues by $100m in 2023, the consumer goods business unit may take up a proportionate goal of say $25m revenue growth.
Strategic goals are not just financial. For example, in order to retain access to major customers, a manufacturer may determine a strategic need to reduce its greenhouse gas emissions by 20% in 2023 (in support of a net-zero emission target by 2030). This target may be achieved by more local sourcing of component inputs, and so the procurement department may seek to support this corporate initiative by increasing local content by 15%.
Allocation of Funding and Resources
Once the investment management hierarchy is determined, and organizational goals cascaded down to all investment management responsibility areas, strategic human resource and capital budget allocation can follow. In zero-base budgeting theory, each capital budgeting cycle starts with a blank sheet. In practice, the process is iterative: ongoing projects inherit a level of carry-forward budget commitments, and a high-level top-down allocation of budget reflective of strategic intent may commence the budgeting cycle. Each area manager will identify the investment opportunities within their domain of operations and propose a strategic project portfolio.
Aligning Capital Investments with Strategic Goals
Zero-base budgeting of capital projects operates at the granular level. Each investment proposal or business case requires careful consideration of its strategic alignment to ensure that the investment of scarce capital and human resources is optimized towards achieving strategic goals.
Strategic vs Business-as-Usual Projects
Most organizations have a category of projects deemed ‘strategic’. The primary assessment of projects in this category is the degree of strategic alignment. But strategic alignment is relevant to all investment decisions and should accordingly always be assessed. For example, even asset replacement projects should consider the strategic dimension. If the current asset is not important to future strategy, reinvestment can be deprioritized. Conversely, a strategic initiative may not have a measurable financial payback – but this project may be crucial to realization of a transformation strategy and should likely be prioritized ahead of a business-as-usual growth initiative with more predictable financial returns. For example, investing in a new ecommerce platform may be more important than opening yet another retail store.
Cost Benefit Analysis
Of course, strategy cannot be achieved at any cost. There is always more than one way to achieve a strategic outcome. New technology, for example, can be developed, acquired, or leased. To be successful, an organization must continuously identify and select those projects that most rapidly advance the organization at least cost and risk. Therefore, as with any project, due diligence must be applied in determining the cost profile of each delivery option of each investment proposal. Common financial metrics such as Net Present Value, Internal Rate of Return and Payback period must also be considered for strategic initiatives where calculable. Where the benefit cannot be reliably quantified, a qualitative assessment must be furnished. Ultimately, a relative score should be produced for both the benefit and strategic alignment dimensions of a business case for effective inclusion in a strategic project portfolio.
Degree of Strategic Alignment
But how exactly is degree of strategic alignment measured? If an investment management area has multiple strategic objectives, how is the alignment assessed? What happens when, as is commonly the case, some of the strategic objectives are somewhat conflicting?
For example, a manufacturing plant may have strategic objectives to increase throughput by 25% and simultaneously to reduce emissions by 30%. One initiative, for example, new production line automation may increase throughput substantially, but have no impact on emissions. Solar conversion, however, may reduce emissions but have not improvement to throughput. Introducing electric forklifts may help achieve both goals but be more expensive. Given constrained funding capacity, which initiative should be prioritized?
The practical approach is to weight each objective. Which strategic objective is the more important overall? Then the relative support of each initiative to the goal can be scored from negative impact to highly positive impact. By applying the weights to the individual alignment scores, a net alignment score can be assessed.
Or course any mechanical scoring mechanism is intended only to assist decisions makers. Ultimately decisions are a human responsibility. But by applying a consistent framework and approach, the attention of management can be focussed on the boundary – obviously aligned or misaligned initiative can be quickly assessed, and further evaluation focussed on the grey-area in-between.
Urgency and Risk
Whilst relative strategic alignment and benefit are the most important dimensions to strategic project portfolio management, the other key dimensions to project evaluation should not be ignored.
Urgency addresses the inherent risk of inaction or omission. This can apply to both business-as-usual replacements (impact of equipment failure) and strategic initiatives (opportunity cost of delay).
Confidence addresses the inherent risk of action or commission. How likely is the initiative to succeed? This implementation risk assessment will deal with aspects such as technological familiarity, commercial mitigations, and organizational readiness.
Considering the urgency and confidence dimensions will further help prioritize a project portfolio with otherwise similar benefit, cost and strategic alignment assessments.
Strategic project portfolio selection will inevitably result in a de-prioritization of certain replacement initiatives proposed by business-as-usual engineering and maintenance teams. This will expose an organization to a level of operating risk by, for example, delaying the replacement of ageing, but functional, assets. Whilst overall the strategic benefit may be greater, and the overall risk to organizational success reduced, this can be a difficult change for those individuals who have worked hard for the effective and continuous operation of current facilities.
Any pivot to more strategic project portfolio management should thus take care to consider those individuals impacted by the change in project selection approach. A clear explanation of the reasons for the budget allocation through a transparent and fair initiative scoring and ranking process, with clear evaluation of strategic importance, will greatly reduce the resistance of those charged with delivery of business-as-usual operations.
Strategic change is normally broadly dispersed within multiple areas of the organization. It is thus important to understand the co-dependency of initiatives to each other. Some projects will rely on others also being done. Others will be mutually exclusive. Identifying these inter-dependencies is especially important when they relate to projects in different areas of responsibility to ensure that cohesive strategic change can be achieved.
Project Portfolio Selection
Following rigorous evaluation of project business case proposals, only the selection remains. This is where more sophisticated technology solutions can greatly improve on the traditional spreadsheet method of review and selection. Modern capex management solutions are able to apply portfolio simulation, and artificial intelligence machine learning algorithms, to assist decision makers make optimal portfolio selections.
Modern capex management systems can define the efficient frontier – the optimal portfolio selection and outcome at each investment increment to assist management teams make informed zero-base budgeting decisions.
In addition, with more automated and facilitated portfolio planning, the frequency of rebalance the future project portfolio can be increase from an annual cycle to quarterly or even monthly review to accommodate our turbulent times.
Make Better Capital Investment Decisions
How an organization invests scarce human and capital resources will determine its future. The larger and more mature an organization, the greater the burden of sustenance of the existing capital base. However, tempting as it is to allocate capital budget primarily to the replacement of existing assets to sustain current business-as-usual operations, it is essential for all organizations to invest strategically. Simply replacing depreciating assets will ensure organizational decline due to the unrelenting pace of technological change and competitive forces. Therefore, however constrained resource and funding capacities are, organizations will need to make a concerted effort to redirect capital to more strategic use. Sometimes this will increase business-as-usual operating risk and persist inefficiencies. But replacing capital is even more wasteful if the strategic direction will likely render that capacity commercially obsolete anyway. To wisely balance the capital project portfolio between sustenance and strategic growth initiatives involves a multi-dimensional analysis. Whilst strategic alignment is key, the optimal portfolio will still need to also consider relative benefits, urgency, and risk.
Stratex Online provides a ready-to-use platform to assist organizations make strategically aligned capital allocation decisions to ensure that goals are achieved sooner and at the lowest possible cost and risk.