Common Challenges in the Capital Budgeting Process
The capital budgeting process is all about making strategic, high-value and long-term business investment decisions. In addition to routine replacement of depreciated assets, you need to make important decisions on how to achieve your growth aspirations through investment in new technologies, capacities and markets. The key questions executives are challenged by when allocating capital and assigning their key resources are outlined below.
Sustenance vs Growth Investments
Given that most companies have constrained funding capacity and limited people, how is allocation between capital budgeting project types optimized? Without ongoing sustenance of the capital base required to support your business-as-usual activities, there is a risk of failure or obsolescence of current assets impacting successful ongoing operations.
By simply standing still, however, there is a significant risk that you are moving backwards as competitors adopt newer technologies, scale activities and engage new emerging markets. In a similar way to financial portfolios which are based on asset class allocation prior to selecting individual investments, the capital budgeting process should allocate capital appropriately between sustenance and transformational growth initiatives.
Risk vs Return
Most project initiatives presented to management for approval reflect a positive anticipated return. However, the inherent risk associated with competing projects is harder to assess. Naturally, the preferred choice between two projects is that which offers a similar return with less risk. But how much risk is acceptable to achieve a higher return?
Organizations cannot, and should not, seek to eliminate all risk. They should, however, ensure that they get commensurate returns for the level of risk taken on. A key challenge of the capital budgeting process is evaluating the riskiness of any initiative, and of the capital project portfolio as a whole.
Net Present Value or Internal Rate of Return
Both the absolute amount and timing of expected investment returns are key considerations in the capital budgeting process. While, from an economic perspective, higher net present value (NPV) initiatives are preferred, from a management perspective, faster returns may be prioritized due to capital efficiency and perceptions of risk. Providing management with performance incentives that prioritize short-term outcomes ahead of long-term strategic goals can also lead to an undue focus on payback period rather than NPV.
Non-Financial Objectives and Metrics
Not so long ago, the sole purpose of most corporations was to make money. Accordingly, potential investments could be evaluated simply on the basis of financial return. Corporations are now also expected to meet Environment, Social and Governance (ESG) targets.
For example, if your organization has a declared ambition to be net-zero by 2030, how does that impact your evaluation process and metrics? An improved capital budgeting process needs to support the inclusion of qualitative and other non-financial metrics for effective project comparison and ranking.
Collaboration, Endorsement and Approval
While the capital budgeting process utilizes data and metrics, it’s ultimately about people: Project managers want to deliver successful projects. Area managers want to meet their growth and productivity targets through effective investment of time and money. Executives want to meet their fiduciary responsibilities to the organization and its stakeholders.
Whilst technical decisions may rely on the data presented, at more senior organizational levels, it’s the opinions of trusted lieutenants that carry most weight. Therefore, an effective capital budgeting solution enables the seamless collaboration of people and their comments, endorsements and approvals to get the best, and confident capital investment decisions by executives.
Individual vs Capital Committee Approvals
Some lower-value capital budgeting decisions are routine and can be made directly by responsible managers within their delegation of authority; higher-value or broad-impact decisions will require the support of a multi-disciplinary committee.
For example, a major reallocation of budget from strategic initiative to another in response to geo-political change should be evaluated and confirmed by all impacted area managers. The capital budgeting process and workflows should enable a quick, easy and informed decision by individual managers and more thorough committee-based approvals where appropriate — while not being constrained to one mechanism or the other.
The Costs and Risks Inherent in Manual Capital Budgeting Processes
Many organizations allocate senior finance specialists to administer the capital budgeting process. These individuals have a deep understanding of financial planning and capital budgeting analysis, and are experts in data management and presentation.
For many, their tool of trade is the spreadsheet, and they employ spreadsheets extensively to gather budget wish-list requests, evaluate business cases, prioritize and distribute funding, forecast and monitor project performance. There are, however, important costs and risks associated with this approach as outlined below.
Inefficient Manual Administration
Distribution of templates, emailing of documents, collation, rekeying, data extraction and report preparation all consume significant non-value effort. Some of this effort is dispersed across multiple responsibility areas, while others are centralized within a central Capital Expenditure (CapEx) control function. All of it is a waste of effort.
Not only is this a direct cost to the organization, but the key risk is that so much time is spent administering the process, that insufficient time is invested in ideation or in deeper evaluation of initiatives. The consequence of all this wasted administrative effort is that better initiatives are not identified, and returns are diminished.
Weak Financial Controls and Process Management
Any control is only as strong as its weakest link. The access security and integrity of manually prepared and exchanged spreadsheets is inherently compromized. The lack of update audit trails dilutes accountability. Confidential initiatives may be inadvertently exposed causing internal disruption or competitive disadvantage.
Analytical Delays and Data Expiry Risks
Any report that relies on uncontrolled, manually prepared data is typically provided too late or contains out of date data. Due to the effort required to manually collect and present forecasts, for example, there is typically a delay in their preparation and presentation. The longer it takes to get information, the less time we have to take mitigating actions, and the greater the risk of over-spend on failing projects.
The source of the data may itself be out of date. If the available budget is stored off-system, for example, it’s only as current as the last edit. Any delays in updating this budget reference for actual expenditures, forecasts or budget reallocations will impact its reliability for decision making.
Zero-Based Budgets Become Budget Buckets
For many organizations applying a manual capital budgeting process, the annual budget is based on an approved list of investment initiatives. In theory, actual expenditure requests should reference the approved budget list. In practice, however, the reconciliation and administration of the budget details becomes too onerous, is neglected, and the area budget becomes a budget bucket from which funding is dispersed to individual initiatives during the year.
This is like preparing a shopping list and making tough decisions between essentials and treats, constrained by your cash inflow and resources, and then leaving it behind as you head off to the shops. You may remember most of the important items — but what is the likelihood that you forget something important or make wasteful substitutions by being tempted in the checkout line? While your partner may forgive you when you get home, your organizational stakeholders may not be as forgiving when you’re dealing with a multi-million-dollar CapEx budget!
Capital Budgeting Process Strategies to Eliminate Waste and Maximize Return
Given the challenges and risks inherent in the capital budgeting process, some strategies on how to eliminate waste from your capital budget are provided below:
Define and Cascade your Strategy to All Areas
The effectiveness of the capital budgeting process is literally mission critical and is a key executive management responsibility. Picking the right investments enables an organization to maximize returns and achieve its strategic goals sooner — at the lowest cost and least risk. Conversely, the misallocation of capital and resources to bad initiatives is not only a waste of time and money, but may permanently impact an organization’s future cash flow.
Facilitate Broad Ideation and Prioritize Quickly
Not all transformational ideas emanate from the executive management team, and not every operational risk and investment opportunity is visible to the C-suite. Therefore, it’s imperative to open the funnel to new ideas to everyone.
Make it easy for all staff members to understand the current strategic priorities within their area and register investment proposals easily and efficiently. After due consideration, impractical ideas can be discarded. But initiatives for urgent risk mitigation, or high-value innovation, should be rapidly escalated, more fully evaluated and incorporated in the capital budget efficiently when appropriate.
Standardize Evaluation, Scoring and Prioritization
Apples and oranges are difficult to compare. Yet, that is what comparing competing investment initiatives is like. Without a clear objective in mind, both are healthy fruit. The first questions are: what is the constraint? Is it budget or weight? What is the goal? Is it calories, vitamin C, longevity or flavor? If it’s multiple criteria, how are these to be balanced? Once we have established a rubric for evaluation, the choice can be quite straightforward. If we’re looking for a high vitamin C food for a sailing trip, oranges may be the best option!
To effectively compare the business cases for alternative investment proposals, you should standardize the project evaluation, scoring and ranking methodology. Ensure that any metrics (such as Payback Period) are calculated consistently, and provide a clear and transparent basis for project scoring. Such measures help to expedite and ensure the effectiveness of project prioritization.
Optimize Project Portfolio Selection
Once a complete list of candidate projects has been collected and consistently evaluated to produce a prioritization index, the capital budgeting process requires the optimal selection of project initiatives within capital and resourcing constraints.
A typical manual spreadsheet-based approach to project portfolio selection is to sort the project demand wish-list by a single measure and allocate budget top-down until all the budget is consumed. This is a simple and efficient method, but is unlikely to produce the optimal capital project portfolio.
A more sophisticated portfolio optimization technique is to allow capital budgeting software to automatically propose optimal project portfolios, considering all the interdependencies between projects, for a range of investment and resourcing levels (an efficient frontier of portfolios). Managers are then able to apply judgment in the assessment of investment, risk and return trade-offs, confident that wherever they land in this evaluation, the project portfolio selection will be theoretically optimized.
Link CapEx Requests to Your Budget
The purpose of budgeting is to assess the full suite of candidate projects and allocate funding to the most important and high value items. The fact that a project has been budgeted does not, however, mean that it will necessarily be executed. And not all projects that get executed will have been budgeted, as some critical investments will be required during the year that were not considered during the budgeting cycle.
The mechanism for transitioning from a budgeted item to an approved project for execution is the Capital Expenditure Request (CER) or Authorization for Expenditure (AFE) Request. It’s these CapEx Requests that are typically subjected to delegation of authority approval prior to project setup and procurement activities officially commencing.
Where an unbudgeted CapEx request is submitted for approval, any substitute projects should be clearly identified, the reallocation justified, and the remaining budget reconciled to provide executives with confidence that this unbudgeted project is indeed funded and of greater priority than the originally budgeted items.
Forecast and Monitor Actively
If capital budgeting is about the allocation of funding to planned initiatives, forecasting is the extrapolation of actual spend on approved initiatives. The reconciliation of capital budgets and capital project forecasts is an important finance process to ensure the availability of required funding.
However, in addition to the capital cost component of projects and the related expenditure cash flow requirements, sophisticated capital budgeting solutions will also forecast the expected financial impact of the capital project portfolio in progress.
When capital projects are delayed, lower-than expected capital expenditure in the current year may negatively impact the projected financial return for future years. This relationship between balance sheet funding of assets, and the longer-term profit and loss impacts from growth and savings initiatives, is key in mapping an organization’s progress towards its strategic objectives.
Project Portfolio Management and Capital Budgeting
Project portfolio management is the practice of choosing the right projects at the right time, and managing their successful delivery within a consistent governance framework. Capital budgeting is about allocating funding to projects and investments that matter most towards achieving an organization’s strategic objectives.
While not all projects are capital in nature, and not all capital investments are project-based, project portfolio management and capital budgeting are deeply entwined. Some of the key similarities and differences between project portfolio management and capital budgeting process are considered below.
Direct Capital Purchases vs Capital Projects
All organizations make a high volume of direct capital purchases, including vehicles and equipment. Most execute only a limited number of high-value, complex, multi-year projects. The most common capital projects include construction, refurbishment and IT-related projects.
It’s typically only these resource intensive capital projects that are included in the project portfolio management system, whilst all capital purchases require budgeting and approval. Direct capital purchases may generate a project code in the accounting system for cost tracking but will typically not be included in the project portfolio management system.
How the Project Portfolio Management and Capital Budgeting Process Interact
Simple project portfolio management can be conducted within your capital budgeting process.
Where organizations have a dedicated project portfolio management function this tends to be focused on resourcing and governance processes and is often located in the Information Technology department, whereas the CapEx controlling function tends to be focused on cashflow and is located within Finance.
Project portfolio managers tend to make use of software linked to their project management software (such as Microsoft Project or Oracle Primavera), whereas Finance CapEx controllers leverage analytic tools connected to their financial systems, and rely extensively on spreadsheets as a data exchange, modeling and presentation platform.
An effective capital budgeting software solution needs to seamlessly connect both people and capital to the delivery of strategically important initiatives and should thus provide integration with both finance and project management software solutions.
Capital Project Cashflows and Scheduling
Project portfolio management seeks to actively monitor the scheduling of projects and resource interdependencies; capital budgeting seeks to control the cashflow expenditure on projects and timing of expected benefits.
While project portfolio management systems can provide a roll-up of a more granular level of task and resource management, they seldom support analysis of actual costs and commitments, or a standardized projection of future depreciation, revenues and cost savings. Typically, project managers support this intersection of project performance and financial impact analysis. Spreadsheets are heavily relied upon for the transformation of project status to financial forecasting.
A more effective capital budgeting software solution combines project planning and delivery management with financial analysis and forecasting.
Project Initiation and Carry-forward Projects
Early-stage ideation and strategic initiatives will typically originate in the capital budgeting process. Approved and carry-forward projects will be reflected in the project portfolio management, financial and capital budgeting systems.
Your capital budgeting software should combine both new and in-progress initiatives for holistic analysis.
Automation and Optimization
Project portfolio management systems are not the preferred platform for capital budgeting, as they don’t include direct capital purchases and don’t consistently capture anticipated financial projections.
Modern capital budgeting software solutions will combine both projects and direct purchase requests in order to automate the optimal allocation of capital and resources to the most valuable initiatives.
Judgement and Workflow Enablement
Despite the need for the capital budgeting system to offer sophisticated portfolio recommendations, responsibility should remain with area managers to optimize their capital budget allocation. Only area managers have the experience and judgment to fine-tune portfolio selections.
The benefit of automation is that the obvious items can be automatically included or excluded, and management attention can be focused on the marginal items. Area managers should then have the ability to request a project portfolio in broad alignment with initial top-down budget distributions but exceed original allocations if justifiable.
The central CapEx controller should then be able to accept or reject these submissions and iterate an investment proposal and reallocate budget between areas until an enterprise capital budget is determined. This interaction between area managers and the CapEx controller should be fully digital, and based on a single source of truth at all times.
An Unstable Economic Environment Requires Agile Capital Budgeting
The reason many organizations haven’t deployed advanced capital budgeting process solutions is that the volume and complexity of their capital expenditure historically didn’t require a specialized solution. However, we are no longer in a stable and predictable operating environment.
First COVID, and then the war in Europe, together with the impacts and concerns of climate change and the unrelenting march of technology, especially artificial intelligence, have meant that our planning assumptions from 12 months ago are no longer valid. Rapid cost increases, supply chain delays, resource unavailability, ratcheting interest rates and myriad other environmental impacts require that we are more agile in the prioritization and allocation of funding to projects.
Legacy capital budgeting processes involving manual manipulation of spreadsheets are no longer up to the task of ensuring the optimal allocation of funds in such a dynamic operating environment. By contrast, a capital budgeting software solution, such as Stratex Online, can dramatically accelerate the capital budgeting process and allow you to re-prioritize budget allocations on a more regular basis — with greater efficiency and optimal outcome effectiveness.
Standardizing Financial Analysis for Objective Decision-Making
At the heart of the capital budgeting process is the business case. The business case, and its associated financial analysis, forms the basis for the prioritization and allocation of scarce capital and labor resources. The right content and effective evaluation of business cases will help eliminate budget waste and help maximize the return on investment from capital projects.
Structured Component Asset Breakdowns and Tax Shields
To calculate the tax-shield from capital investments, capital projects will need to be decomposed into constituent components, differentiating between resulting assets such as land, buildings and equipment. While there is typically no depreciation and tax benefit from land investments, buildings and equipment are depreciated over future periods and provide a tax-offset benefit.
Large Multi-Phase Project Scheduling Dependencies
Most large capital projects are delivered over multiple periods. An effective financial analysis should not simply assume that all costs are incurred at the beginning, but should rather model the work breakdown and interdependency between activities. This will allow for more accurate cashflow forecasts by period, and provide additional flexibility when projects are rescheduled.
Automated Financial KPIs and Metrics
An effective financial analysis template should automatically calculate key financial metrics such as Net Present Value (NPV), Return on Investment (ROI) and Payback Period. A single method of Payback Period calculation should be employed, with a discounted accounting Payback Period being the most common.
Differentiating CAPEX and OPEX on capital projects
Other than direct purchases, most capital projects will incorporate an amount of both Capital Expenditure (CapEx) and Operational Expenditure (OpEx). This split between CapEx and OpEx should be retained throughout the project budgeting and execution lifecycle. The key difference is that OpEx costs flow immediately to the organization’s bottom-line net result as expenditure, whereas CapEx remains on the balance sheet and impacts the profit and loss statement through depreciation charges over future periods.
Annual Budgeting and Monitoring
All corporations are required to produce annual financial statements. The timing of actual expenditure cashflows and anticipated benefits needs to be assigned to a fiscal year. While actual costs and forecasts are typically updated on a monthly basis, it’s important for financial analysis purposes to be able to monitor current and future years’ fiscal impacts of every budgeted capital item.
Typically, project level reports are structured to provide overall financial analyses as well as annual view to identify projects that may be under budget this year, but are projecting an overspend next year. Identifying projects with projected large expenditure variances early is a key control in mitigating project waste.
Accounting View Projection
Just as important as managing the costs on budgeted capital projects, is monitoring the anticipated benefits. If any of the underlying business assumptions change, the financial analysis in the business case should be updated accordingly. For example, if project input costs are forecast to be higher than anticipated by inflation, the same inflation expectation could be applied to expected operational benefits. Consequently, an increased budget allocation to complete the project may be more than compensated for by higher future cash flows.
Alternatively, if a project is facing delays and market research indicates that a competitor has gained a head-start within a certain market as a result, timely financial analysis updates may lead to curtailing project investment. This eliminates budget waste and increases the overall ROI for the portfolio.
Gain Further Valuable Insights: Watch the Webinar
In many ways, successful capital expenditure projects start with the end in mind. To help you refine your capital budgeting efforts, watch our Webinar, titled ‘How to Eliminate Waste from your Capital Budget.’ In this webinar, we cover:
- How to avoid wasting capital on failed projects.
- The process of identifying gaps within your current process.
- Key dimensions by which all capital budgets should be assessed by.
And, you’ll learn how to implement an effective project evaluation and ranking methodology to optimize the time and money allocated to strategic imperatives. Click here to watch the webinar now.