Written by: Richard Frykberg

Capital expenditure (CAPEX) is required to both sustain business as usual activities and to deliver long-term growth and both drivers need to be considered when prioritizing capital projects. A lack of timely and effective reinvestment in an organization’s operating assets can risk successful continued operations due to technical or commercial obsolescence. Conversely, brave and wise investment in new growth and technology can transform an organization and help achieve its strategic goals and objectives sooner. Therefore, how do you effectively balance your capital project demand between risk-mitigating asset replacement and risky new strategic investments and allocate your time and financial resources most effectively?

Factors to Consider when Prioritizing Capital Projects

Prioritizing capital projects effectively is a primary executive responsibility given both the materiality of funding involved and the potential consequences of getting the prioritization and allocation of capital wrong. Whilst experience and sound judgement are irreplaceable factors when prioritizing capital projects, applying a standardized rubric to support a fair, efficient, and justifiable basis for prioritizing projects can be highly beneficial to all stakeholders. A standardized business case template helps ensure that all the required project evaluation and scoring information is completely, consistently, and reliably captured to support project prioritization.

The key dimensions to be considered in evaluating and prioritizing capital projects include strategic alignment, relative benefit assessment, risk and sponsorship as outlined below.

Strategic Alignment and Business Objectives

The first and most crucial criterion for evaluation of investment proposals is the degree of alignment to organizational strategy. Great initiatives that do not directly support the strategic imperatives of the organization should be subordinated to those that do; otherwise said effectively prioritizing capital projects.

To enable initiatives to be strategically aligned, it is essential to define and provide visibility of the organizational strategy. Given the heightened expectations of both governments and consumers, enterprise strategies may be more nuanced than they once were. In addition to traditional growth and profitability goals and objectives, most organizations now include environmental, social and governance objectives into their strategic framework. For example, many organizations have adopted greenhouse gas emission reduction targets towards prioritizing capital projects.

Strategic organizational goals should be quantified and time-based. To be considered at a departmental level, it is beneficial to have a mechanism for cascading strategic goals down through each supporting area. Continuing with the above example, a particular factory site may set a greenhouse gas emission reduction target of 10% in 2024 through energy transition to renewables.

Individual project proposals can then be evaluated against a relevant set of strategic goals and objectives. Completing the example above, when evaluating replacement of a forklift fleet, the electric forklift option would strategically align better than the diesel alternative, and all else being equal, should be.

By ensuring that organizational strategy is disseminated through all areas, and that all investments are linked and evaluated with respect to their strategic alignment, will help ensure that resources are allocated to initiatives that deliver the most important outcomes.

Financial and Non-Financial Metrics in Prioritizing Capital Projects

Once strategic alignment of proposed investments is confirmed, it is still important to measure the relative benefits of competing candidate projects. Financial metrics are often applied to evaluate the relative merits of projects that are intended to produce financial returns through increased revenues or savings.

One of the most common, and simple to understand, financial metrics is the payback period. This is effectively the time taken to return the initial investment and may be calculated on either a cashflow or an accounting basis, on either nominal or discounted amounts. Payback period provides an indication of ‘riskiness’ of an investment, and projects with a faster payback period are generally prioritized highest.

A more sophisticated financial metric is net present value (NPV). This provides a relative assessment of the absolute value of the project, and theoretically, projects with the highest NPV should be prioritized first.

Return on investment (ROI) provides a good indication of capital efficiency. As capital availability is normally a key constraint, projects with a higher return on invested capital can help achieve financial objectives fastest. Focusing exclusively on project ROI may, however, tend to produce project portfolios consisting of many small tactical projects which may not be practically viable, given human resource capacity constraints.

Consequently, many organizations will use a combination of financial metrics such as NPV, IRR, and Payback Period. Effectively understanding these metrics, such as Net Present Value, will affect the reliability of your financial analysis.

However, not all strategic goals are financial. Therefore, in addition to financial metrics, many organizations are starting to incorporate non-financial metrics in their project prioritization process. For example, where a project has greenhouse gas emissions reduction benefits, the quantity of CO2 reduction may be captured as an objective means of comparing similar projects.

Where multiple financial and non-financial metrics are incorporated in the project evaluation, organizations will need a way of weighting and standardizing these metrics in the prioritization assessment.

Risk Assessment in Prioritizing Capital Projects

There are two key risks associated with prioritizing capital projects: the risk of not doing, and the risk of doing!

This magnitude of risk depends on capital project types. For sustenance projects; the risk of omission is the most prevalent. It may be practically impossible to assess the financial benefits of replacing core equipment or systems: failure to do so could be catastrophic. In respect of these projects, assessing the urgency of replacement is a critical factor in prioritizing capital projects.

For growth and savings projects there is also an urgency to be considered. The primary consideration of urgency here may be opportunity cost. If these projects are not undertaken, what is the likelihood and impact of not adopting modern technologies or capitalizing on time-sensitive competitive opportunities? Opportunity costs should be considered just as carefully as direct costs to ensure an appropriate balance between risk and return-based initiatives.

Prioritizing capital projects also involve some degree of implementation risk. For straight-forward replacement of depreciated assets of the same type, this risk may be low. On the other hand, introducing innovative technologies and products into new markets with new suppliers may be extremely risky. These additional risks may, however, be entirely justified by the transformational returns anticipated.

Organizations need a standardized method of assessing both project urgency and implementation risks and factoring these into their project prioritization assessments. Risk registers, risk matrices and questionnaires are frequently employed to support this requirement.

Stakeholder Engagement, Endorsement and Sponsorship

Most experienced executive managers will advise that when prioritizing capital project and making approval decisions the most valuable information contained in the business case submission is the audit trail of endorsements by technical specialists.

So, whilst it is imperative to have standardization of business case templates, strategic alignment, standardized benefit evaluation metrics, and comprehensive risk assessments, the input and experience of functional managers remains an essential data point for confident decision making.

Where such endorsement is informal, the value to the executive management team is lost or diminished. A more effective project prioritization system will ensure that all the right people are involved in project evaluations, their questions and responses collated, supporting documentation attached and their endorsement and approvals formally captured.

Project Portfolio Management and Capital Budgeting for Prioritizing Capital Projects

Once reliable business cases have been produced for all candidate projects, the process of effectively and efficiently selecting the optimal portfolio of projects to undertake commences.

Project Portfolio Management and Capital Budgeting typically involves the following steps:

• Applying a scoring methodology to project ranking towards prioritizing capital projects.
• Devolving responsibility to individual managers to submit their priority project portfolio for their responsible areas.
• Optimization of the project portfolio based on value assessments and resource (human and capital) constraints.
• Capital budget distribution between business units and investment reasons.
• Capital expenditure request approval in accordance with delegation of authority levels.

Evaluation and Scoring Methodologies

It is very hard for humans to perform multi-dimensional evaluations in their heads. To simplify the process of prioritizing capital projects typically requires candidate projects to be assigned a single assessment score. Traditionally, a single financial metric such as payback period might have served as the key ranking indicator. However, in today’s more demanding environment, multiple financial and non-financial metrics should be considered, and combined with strategic alignment and risk assessments, to produce a more balanced prioritization score.

As with financial portfolio planning, where it does not make sense to compare bonds and international equity investments, it does not really make sense to compare risk-based sustenance projects with transformational initiatives. For this reason, projects should be effectively categorized, and appropriate scoring methodologies applied by category. Sustenance projects will be prioritized more based on their urgency, and Growth projects more on their financial metrics.

One effective means of project scoring and ranking is to use a standardized scoring scale and apply weightings to calculate an overall score. With each important dimension evaluated on a consistent 10-point scale, and then weighted appropriately to organizational priorities by project category, a useful prioritization score can be determined.

At the end of the day, however, any such scoring mechanism serves only as a guide, and really helps management to focus on the margin: top scores may be automatically included as easy decisions, and bottom scores discounted early, to allow higher-value focus on the medium range opportunities.

Effective project scoring and ranking is crucial to ensuring you achieve your strategic goals.

Capital Project Portfolio Requests

Area managers should remain in control of prioritizing capital projects within their area of responsibility. Invariably, capital project demand exceeds the available human and financial capital available. Responsible area managers are typically best placed to appreciate the relative merits of individual initiatives. Standardization of business case templates, evaluation criteria, and scoring mechanisms should never seek to replace this local insight, but rather to supplement human decision making with a robust and efficient framework to make the best possible decisions when selecting projects that matter most.

Adopting zero-based budgeting concepts, the capital budgeting process should commence with a broad collection of needs, wants and ideas that help achieve the area’s strategic objectives. Early staging qualitative scoring measures can help prioritize these early-stage opportunities, and trigger preparation of investment proposals that are more likely to be approved. Area managers can then commence the budgeting process by submitting a capital project portfolio request to the centralized capex controller (or committee).

Based on top-down constraints, individual area submissions can either be approved or rejected, and refined budgeting constraint guidance provided. Where a portfolio request is rejected, it once again becomes the area manager’s responsibility to refine the budget portfolio or select an alternative lower-cost option in the delivery of an urgent requirement. This iterative process may continue with all areas, until an optimal, strategically aligned, and affordable capital project portfolio is approved.

Balancing Human Resource and Capital Constraints amidst Prioritizing Capital Projects

Prioritizing capital projects and portfolio selection comes down to optimizing the value of projects selected within resource and financial constraints. Simplistic portfolio selection methods may simply order projects and then select from the top until the capital budget is consumed. This is unlikely to produce the optimal project portfolio because of the lumpiness of project capital demands. For example, if an ordered list fully consumes the budget after project C, it may be that doing smaller projects D & E would have provided a better outcome as they may have been more capital efficient.

Selecting the optimal project portfolio becomes harder when each project is not independent, but co-dependent or mutually exclusive with others. For example, project D may require project B to have been completed. Project C and Project D may both make use of the same resource (e.g., vacant property) and therefore only one of the two candidate projects can be accepted. Therefore, prioritizing capital projects can become quite convoluted.

A more advanced portfolio optimization strategy is to apply linear programming techniques to the portfolio selection process. Using computer simulations, an “efficient frontier” of optimal portfolio selections can be determined for a range of investment levels, illustrating the declining marginal utility as additional projects are included in an expanded portfolio.

Computer simulations can produce a much more effective portfolio selection, especially when the portfolio is constrained by two or more dimensions (such as human resources and funding) and incorporate project inter-dependencies, than manual or simplistic spreadsheet-based models which makes prioritizing capital projects more viable.

Capital Budget Allocation towards Prioritizing Capital Projects

The primary role of a centralized capex controller or committee is to ensure the appropriate allocation of capital budget amongst business units and by investment reason (i.e., sustenance vs growth). Whilst an organization may have an indicative top-down capital budget expectation, this is refined based on departmental submissions and iterative optimizations, until an annual budget is approved. This budget may end up incorporating justified redistribution of budget between areas and investment reasons in line with the current operating environment and strategic priorities.

A digitally enabled budgeting cycle eliminates numerous spreadsheet submissions and email exchanges and instead provides a single source of truth, automated approval workflows, and a standardized and transparent project evaluation and scoring system. The key benefit of this more efficient and seamless process is that it can be performed more regularly. Rather than relying on an annual, painful, and stressful budgeting cycle, capital budget reallocations can be done more frequently, efficiently, and effectively to ensure you are prioritizing capital projects.

By enabling a more agile budgeting process, you can more regularly begin prioritizing capital projects considering a rapidly changing operating environment. As the pandemic, war, climate change, and rapid advances in artificial intelligence have demonstrated, assumptions regarding growth, costs, and interest rates are highly variable. The set of assumptions forming the basis of prioritizing capital projects 18 months ago are likely quite different to the facts today, and in order ensure that scarce resources are wisely invested, a more agile budgeting process is more imperative than ever before.

Capital Expenditure Request Approval

Capital budgets are allocated to ensure that funding is not consumed on a first-come first-served basis but is strategically allocated to areas that must begin prioritizing capital projects on a fair and consistent basis. Some projects may already have reached a detailed project definition phase, but in other cases, the budget allocation is made based on higher-level investment proposals.

Therefore, most organizations introduce a final capital expenditure request (CER) approval process prior to project initiation and procurement activities commencing. It is expected that many CAPEX requests, also called Authorization for Expenditure (AFE) or Request for Appropriation (RFA), will have been budgeted. However, there will always be the need to support urgent unbudgeted capital expenditure requests, and to accommodate requests where the final approved amount varies from the originally budgeted amount.

This final capital expenditure request process should be tightly integrated with the capital budget to ensure real-time reconciliation between budgeted items and approved expenditure. Where there is an urgent need for prioritizing capital projects ahead of the budgeted project portfolio, it should be clear to executive approvals which substitutions have occurred and how the unbudgeted initiatives will be funded.

On final approval of capital expenditure requests, integration to execution (financial and project management systems) will help ensure there are no delays to the timely delivery of priority projects.

Prioritizing Capital Projects to Achieve Business Growth and Success

Prioritizing capital projects is essential to optimize the allocation of scarce human and financial resources. Effectively prioritizing capital projects requires both consistent and reliable business case preparation and agile portfolio planning and budgeting.

The digitalization of your processes to prioritizing capital projects will provide a single source of reliable data, seamless workflow routing for endorsement and approval, and automated integration with down-stream systems. The key business benefits will be a more agile response to prioritizing projects in a rapidly changing economic environment to help you gain competitive advantage and ensure you achieve your strategic goals sooner, at the lowest possible cost and risk.