Best Practice 3: Assessing Strategic Alignment
The most important scoring dimension when evaluating business cases should be the degree of strategic alignment. Every organization should have a clear vision for itself and pursue its core purpose passionately. This will mean saying “no” to many reasonable suggestions. But by doing less, and focusing on what’s most important, will help the organization achieve its goals sooner. Cascading enterprise strategies down to individual areas of responsibility and then formally assessing strategic alignment of initiatives within each area is a best-practice capital budgeting techniques.
Best Practice 4: Producing Reliable Project Schedules and Cash Flow Estimates
A key concern when budgeting and allocating capital resources is the degree of confidence in the scope, schedule, cost, and purported benefits of proposed initiatives. A common capital budgeting technique is to apply standardized financial analysis templates to collect and evaluate the data. Where an initiative requires the completion of a project, this should be decomposed into work breakdown components and activities, and inter-dependencies identified. All cost and effort estimates should be confidence-range based, and key assumptions identified. Any calculations should be standardized and leverage consistent parameters (such as discount, tax and exchange rates).
Best Practice 5: Evaluating Qualitative Benefits
Whilst capital budgeting is primarily focused on financial investments and expected financial returns, it is important that the capital budgeting method employed also accommodates the evaluation of qualitative benefits. Whilst it is anticipated that qualitative benefits may have eventual financial benefits, it may be too tenuous to assign explicit financial metrics to qualitative benefits such as employee satisfaction, customer service, or community engagement. However, by adopting scoring mechanisms, qualitative and quantitative metrics can be combined to determine an overall initiative prioritization score which can help expedite capital budgeting decisions.
Best Practice 6: Identifying the Risks of Inaction and Implementation
A key factor causing delays in the capital budgeting process is executive decision hesitancy related to the riskiness of an investment proposal. Modern capital budgeting techniques address the question of risk explicitly. The fact is that both commission and omission have risks. Failure to replace aging machinery can catastrophically disrupt business-as-usual activities. Failure to adopt new technologies can incur opportunity costs or severe competitive disadvantage.
Of course, replacing equipment unnecessarily or investing in failed technologies is also a waste. The fiduciary responsibility of executives is to assess both the urgency of action and the implementation risks, weigh these risks up against the anticipated benefits and choose initiatives accordingly. Determining and selecting project portfolios along the efficient frontier will ensure that organizational goals are delivered at the lowest possible cost and risk.
Best Practice 7: Adapting to Rapid Changes in the Operating Environment
The current operating environment is highly unstable in an era of war, climate change, and rapid technological advance. Such events result in supply chain delays, resource constraints, high inflation, rising interest rates, and fluctuating exchange rates. Effective capital budgeting techniques include parameter-based modeling and scenario-based impact simulations. Using these techniques allows the executive management team to plan and prepare for both best-case and worst-case scenarios.
Best Practice 8: Differentiating between Capex and Opex Cost Components
The key differences between capital budgeting and operational planning are the materiality and timescales involved. Operational expenses are easier to predict, monitor, and variances are immediately actionable. Capital expenditure, by contrast, remains on the balance sheet – the impact of poor investment decisions is typically more material and more delayed. A poorly evaluated investment in manufacturing capacity in a foreign country may only be fully appreciated many years after the fact. Useful capital budgeting techniques will carefully differentiate between the capex and opex components of an initiative, appreciating that the capex component carries the higher risk, due to its relative size and delayed benefit realization.
Best Practice 9: Keeping Track of Budget Availability and the Benefits of Zero-Based Budgeting
Organizations tend to either budget in buckets based on previous years’ experience or by individual item (zero-based budgeting). Zero-based budgeting is a more effective capital budgeting technique in that it seeks to ensure that capital is pre-allocated to the most important initiatives. The key risk of simply allocating capital budget buckets to individual areas for their consumption is that initiatives tend to get allocated on a first-come, first-served basis and the order of submissions may unduly influence the likelihood of approval.
When budget allocations are done applying zero-based budgeting techniques and based on a detailed list of appropriation requests, it is important to ensure that capital expenditure requests are then efficiently reconciled to these items. Substitutions inevitably occur because of newly identified risks and opportunities, and management should be able to trace the reallocation of funds to validate that these new items are indeed more important than the original budget earmarks.
Best Practice 10: Ensuring Capital Approvals in Accordance with Delegation of Authority Policies
Just because an initiative is budgeted does not mean the initiative will necessarily progress. Most capital budgeting techniques only require higher level investment proposals to be prepared at the budgeting stage. Once budgeted, more detailed business case justifications are prepared to support capital expenditure requests (CER’s).
CER’s are normally routed to senior executives for final approval in accordance with financial delegation of authority policy. When a Capital Expenditure Request is unbudgeted, and no substitute project funding has been identified, a more extensive and higher-level approval process is typically triggered. For effective compliance, auditability and efficiency, these approvals should be automated and verifiable digital signatures collected in preference to paper-based sign-offs.
Best Practice 11: Overcoming Limitations of Spreadsheets for Capital Budgeting Purposes
The capital budgeting process is typically administered by the finance department, and frequently results in heavy reliance on spreadsheets for data collection, calculation, and analysis. Spreadsheet knowledge and expertise is readily available throughout an organization and most departmental and project managers can collaborate effectively through the exchange of spreadsheets. It can thus be extremely difficult to change this practice. However, spreadsheets are fraught with risk. The key virtue of spreadsheets – their flexibility – is also their major weakness.
The first major problem of spreadsheets is data scope. The rows and columns paradigm encourages a two-dimensional simplification of a complex data model. The most obvious deficiency is that lists of initiatives are assigned to single rows with static columnar attributes. This prohibits a deeper consideration of solution alternatives and provides limited scope to extend the data analysis of projects of a very different nature.
For example, in a waste management company, collection vehicles would be a primary asset type. The required information to effectively assess the replacement of a truck should include various models of various manufacturers. This analysis would be very different to a proposal to upgrade the financial software. But by including all budgeted items in a single spreadsheet, this subtlety is often forfeited as spreadsheets do not effectively support flexible data sets by project type.
The second major problem of spreadsheets is data quality. The flexibility of spreadsheets makes it hard to enforce data validations, data completeness, and calculation integrity. Misallocations of funds have frequently resulted from inaccurate financial metrics resulting from inaccurate data entry and corrupted formulae in spreadsheet-based templates.
A third major weakness of spreadsheets is data governance. Access to row-level confidential project data and traceability of updates is very hard to manage. Consequently, individual spreadsheets are often retained for each area, and a central administrator given the task of collation and consolidation for management reporting. This necessitates onerous reconciliation and non-value-added administrative activity. More effective capital budgeting techniques maintain a single source of truth for budgeted initiatives, all the way from idea to productive asset.
Evaluation of Poor Capital Budgeting Techniques
The most common capital budgeting techniques have severe deficiencies, which are as follows.
Over-Simplified Project Ranking Methods
High value capital investments require sophisticated business case evaluation. Too often, simple asset replacement evaluations are assessed alongside high-risk transformational projects. The primary consideration when considering asset replacements is the risk of failure – the key choice being to defer the replacement for another year. For growth and savings initiatives, the primary focus is on return on investment. For transformational initiatives, the major driver is strategic imperativeness, and risk management is a key consideration. Therefore, to effectively evaluate and prioritize project initiatives, they should be appropriately classified and assessed accordingly.
Sub-Optimal Project Portfolio Selection by Sorting
Once a prioritization assessment has been conducted, project portfolio selection is often reduced to sorting and selecting until the budget allocation is consumed. This approach is, however, unlikely to produce the optimal portfolio. More sophisticated portfolio selection algorithms can ensure that alternative portfolios are identified along an ‘efficient frontier’ of risk and return assessments. Applying multi-dimensional constraints including budget and resource capacity will enable executives to select an optimal project portfolio that is achievable and provides the best possible return for the level of risk assumed.
Failure to Forecast and Re-evaluate Carry-Forward Projects
Many organizations focus their capital budgeting techniques on planning data, and making capital project prioritization and selection decisions accordingly. More effective capital budgeting project processes also consider the in-progress and completed projects. As not all projects fit neatly into discrete financial years, there will always be a number of carry-forward projects to consider as part of any budgeting cycle. Actual expenditure to date should be considered a sunk cost, and in each budgeting cycle carry-forward projects should be compared to new initiatives only on the basis of planned or re-forecasted cost and benefit assessments.
Not Doing Post-Implementation Reviews
Capital budgeting techniques that fail to consider actual outcomes never improve. In order to learn from prior experience, formal post-implementation project reviews should be conducted to assess actual cost, schedule and scope performance, as well as the achievement of purported benefits. Where the actual experience deviates from expectations, the root cause should be identified, and corrective actions implemented. Just knowing that post-implementation reviews will be conducted helps ensure that unrealistic promises are not made in business case submissions.
Undue Reliance on Single Financial Metrics
The biggest deficiency of many capital budgeting processes is over reliance on a single financial metric. Despite its well-known limitations, payback period is the most common capital budgeting technique. Theoretically, NPV is the more important measure. So, what are the differences and benefits of payback period vs net present value and why you need both?
Payback Period vs NPV
Payback Period is a straight-forward metric that indicates the time required for an investment to recover its initial cost. Payback Period can be calculated on a nominal accounting or discounted cash flow basis. Payback Period is expressed in years, with the shortest time to break-even being the most attractive.
NPV is the sum of all project cash inflows and outflows discounted to their present value. The larger the NPV of a project, the more valuable it is.
Payback has proven to be a popular and resilient measure as it is very easy for management to understand and provides a good indication of risk: the longer the payback period, the less likely it is to eventuate. As management teams are often incentivized on short-term results, many organizations will simply apply a cut-off threshold: projects that don’t deliver a payback within 3 years, for example, may be automatically shelved.
There are two obvious limitations to the Payback period: unless expected returns are similar, it does not effectively help prioritize projects as the quantum of benefit is not considered. And it may also unduly eliminate transformational opportunities that exceed the threshold period but deliver tremendous long term investment results.
Obviously, a $1m project that returns $5m in profits over 5 years is preferable to a $100k project that delivers $101k profit after 2 years. NPV provides the best guidance for project prioritization. By adopting a discount rate that incorporates a risk premium, long term investment benefits can be fairly evaluated, and the Net Present Value therefore gives a reliable indication of a project’s total value.
The disadvantage of NPV is that it doesn’t address capital efficiency. If two projects have an equivalent NPV, how should they be prioritized? A key capital budgeting technique is to consider Internal Rate of Return (IRR) as a capital efficiency measure. IRR is the effective rate of return at which a project’s cash flows break-even. If a projects’ IRR exceeds an organizations’ cost of capital, it will produce a positive NPV and should be undertaken. Generally, given constrained access to capital, organizations should prioritize projects with the highest IRRs.
However, capital may not be the only constraint. Most organizations are also constrained by resources and the risk tolerance of stakeholders. A project portfolio composed of too many low-value, high IRR, projects may not be manageable. And the projects with the highest IRR’s are also likely to be the most risky.
It is clear that a single financial metric, whether it be Payback Period, NPV, or IRR is not a reliable measure for project prioritization. A better capital budgeting technique is to consider a broad set of financial and non-financial metrics to obtain a more balanced assessment of project priority for capital budget allocation.
Effective Project Ranking and Portfolio Selection Techniques
Modern capital budgeting techniques incorporate holistic support for initiative identification, evaluation, selection, budget allocation, forecasting, monitoring, and review.
Scoring and Ranking Projects to Ensure Optimal Portfolio Selection
All initiatives should be consistently classified by investment reason. These reasons typically include replacement, growth, saving, compliance, and transformation. Within each class of project, a consistent evaluation and scoring rubric should be applied. Based on the assessment of a number of key dimensions including strategic alignment, urgency, benefit and implementation risks an overall score should be assigned. This score should then be considered in the preparation of an optimized and balanced project portfolio within capital, resourcing, and risk tolerance constraints.
Identifying Necessary and Strategic Projects
Certain capital expenditure is essential, and any scoring mechanism should ensure that these initiatives are always prioritized. These include urgent replacement of critical infrastructure and strategically imperative projects required to ensure an organizations’ continuity. These essential projects can be accommodated in the scoring methodology by assigning the highest priority to high-urgency risk assessments and strategically important initiatives.
Accommodating for Project Interdependencies
Any interdependencies should be identified and automatically considered when making project portfolio decisions. For example, initiatives may be codependent (include both or neither) or mutually incompatible (only one or the other).
Budget Version Management
Budgets are a management tool to help executives make optimal capital allocation decisions and to align all aspects of an organization. However, they shouldn’t impair an organization’s agility to respond to market forces. Rather than locking into a fixed annual capital budget, a better capital budgeting technique is to employ budget versions that can be updated periodically in light of new information. Even where the total capital budget capacity is fixed, budget versions allow for an effective re-prioritization of projects as changing circumstances require.
Accounting View Benefit Projections
When evaluating a capital project budget, executives should be provided with summary information as to both the expected cash flow requirements to deliver the project portfolio, and the anticipated future year impacts. For example, capital investments made today will impact future operating results though additional depreciation expenses, with off-setting revenue increases and cost savings. Presenting this future accounting view is one of many beneficial capital budgeting techniques to gain management approval for the annual capital budget.
Human Judgement and Integration Workflow
An often-overlooked capital budgeting technique is the involvement of key individuals in project feasibility analysis. What may not be reflected in the numbers is the experience and judgment of specialized staff. Collaborating effectively and obtaining technical endorsement from functional departments such as finance and engineering helps executive managers make better informed and more confident decisions.
How to Digitally Enhance your Capital Budgeting Techniques
Modern technology can play a pivotal role in refining and expediting the capital budgeting process.
Streamline the Annual Budget Creation Process with a Single Source of Truth
The biggest issue with many legacy capital budgeting processes is the dispersal of budget, forecast, procurement and actual data amongst multiple spreadsheet repositories and systems. The key opportunity with digital transformation of the capital budgeting process is to consolidate all the data into a single, secure online repository. This provides authenticated, real-time access to all participants, at all times, to take effected and informed action when required.
Promote Strategic Alignment as a Key Driver of Project Prioritization
For most organizations, the demand for capital and resources consistently exceeds the supply. The most important driver of project prioritization and capital budget allocation should be the degree of strategic alignment. Good ideas that cannot be directly related to current strategic priorities should be deferred. To help align capital budgeting and expenditure requests to these strategic goals, the strategy needs to be exposed to initiators, and this is effectively achieved through an online platform.
Simplify the User Experience for All Participants
Modern web applications provide a much more user-friendly and accessible interface for end-users than old-fashioned paper forms or their Excel/Word/Pdf replacements. Importantly, online web-applications can respond dynamically to user-input. The required inputs for a routine fixed asset replacement can be much simpler than those required for a multi-million-dollar international expansion!
Standardize Financial Analysis Calculations with Centralized Assumptions
To provide executives with confidence in the reliability of presented financial metrics, a systemized business case model and standardized calculations are required. With an online solution, these calculations can be based on consistent planning parameters and assumptions including discount, tax and exchange rates.
Authenticate all Participants and Enhance Data Security with Fine-Grained Authorizations
With modern systems, all participants can be consistently authenticated, and authorized to access data only within their area of responsibility. This will help ensure that confidential investment proposals are not inadvertently exposed.
Automate Workflow Routing
In manually operated systems, significant effort is expended determining required approvers and chasing them up for decisions. In a digital environment, delegation of authority approval routing is fully automated, and approvers decisions are instantly applied, and detailed audit trails maintained. This helps ensure that a capital budgeting decision is always made in compliance with your procurement policies and are fully auditable.
Enable Self-Service Financial Analysis
With digital online systems, access to real-time data is greatly facilitated. Rather than relying on a central finance team to compile and distribute monthly reports, managers can access real-time data to help monitor the progress of key initiatives. This data can be accessed through end-user tools such as Excel to provide flexible analysis, with confidence that the data source is reliable and secure.
Implement Monthly Forecasting
The capital expenditure forecast is even more important than the budget. The forecast indicates the likely timing of cash flow expenditures, and when expected benefits are likely to flow. In the current environment, many projects are suffering supply chain or resource related delays. Understanding the impact of these delays in project delivery is essential to identifying the opportunity to potentially bring other projects forward. A digital online solution makes reviewing projects and updating forecasts much easier than the traditional spreadsheet-exchange methods.
The Impact of External Factors on Capital Budgeting Techniques
External factors, such as the pandemic, wars, climate change, artificial intelligence and machine learning are having a direct impact on key assumptions such as consumer demand, costs, and interest rates. More than ever, organizations require the application of capital budgeting techniques that enhance their ability to be more agile to new market threats and opportunities.
Stratex Online is a ready to run software as a service solution that provides a single source of truth and seamless approval workflows for your most critical capital budgeting and allocation decisions.