Capital Project Types: What are They and How to Classify Them

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.

Leaders must approach their capital project portfolio the same way to avoid capital project failure: 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. That variation is codified. AACE International’s Cost Estimate Classification System is not one document but a family. Generic principles sit in Recommended Practice 17R-97, and separate classification tables follow for road and rail, buildings and general construction, mining, hydropower, pipelines and process plant, because the deliverables that define scope differ according to what is being built. The reason a classification system needs an entry per asset type is the same reason a capital portfolio needs one per project type: the questions that establish whether an estimate can be trusted are not the same questions in each case. A like-for-like replacement can be assessed early because the scope is already known. A new product line in a new market cannot. Matching the depth of analysis to the type of project is the practical purpose of the classification set out below.

Classification is not an administrative step before evaluation; it is what makes evaluation possible. A capital project cannot be scored against the right criteria until its type is known, because each type is justified on a different basis: replacement on urgency and risk, growth and savings on financial return, strategic on strategic fit under uncertainty, and compliance on obligation. Applying one evaluation model across all four is the most common reason a capital portfolio looks rigorous and still selects the wrong projects, and it is one of the reasons capital projects fail before any work begins.

Capital Project Type Examples and Benefits

Capital projects fall into four types; replacement and sustenance, growth and savings, strategic, and ESG and compliance, and each is justified on a different basis, which is why each needs a different depth of evaluation.

1. Capital Replacement and Sustenance Projects are expected to sustain existing financial and non-financial returns.
2. Growth and Savings Projects are expected to deliver additional financial returns via extension of product, market, or process.
3. Strategic Projects expand the range of products and target markets addressed and deliver enhanced non-financial returns.
4. Environmental, Social and Governance and Compliance Projects are expected to produce indirect (non-financial) returns.

Stratex Online holds the project type as a field on the request itself, so the evaluation model, the scoring criteria and the approval path follow from the classification rather than being chosen case by case.

The four main capital project types are presented diagrammatically below:

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 (NPV) of maintenance charges and residual value within the planning horizon – typically limited to five years.

Replacement and Sustenance Projects in Practice

The identifying test for this type is that the output does not change. The organization is buying back capability it already had, not adding capability it did not. Public sector: replacing pumps at a water treatment plant, resurfacing an arterial road, or renewing rolling stock on an existing rail line. Private sector: replacing a production line reaching end of service life, refreshing a data center cooling plant, or renewing a delivery fleet.

Growth and Savings Capital Project Types

Growth and savings projects are undertaken to deliver a measurable financial return: growth by extending the products offered or the markets served, savings by lowering the cost of delivering what the organization already does. Both growth and savings capital 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:

1. Risk of omission – the potential impact of not undertaking time-sensitive projects in terms of opportunity cost
2. Risk of commission – the inherent risk of execution including an assessment of the probability distribution of outcomes
3. Time value of money – ensuring that all financial measures account for the weighted average cost of capital
4. 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.

Growth and Savings Projects in Practice

The identifying test is that the benefit is measurable in money and can be attributed to the project. Public sector: a new terminal building to increase airport throughput, or a plant upgrade that reduces the cost of treating each megaliter. Private sector: opening a distribution center in a new region, adding a second production line for an existing product, or automating a manual packing process.

Strategic Capital Project Types

A strategic project commits the organization to something it has not done before in pursuit of its long-term strategy, and is defined by the degree of change, the uncertainty of the outcome and the imperative to act. That may mean introducing 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. An automotive company transitioning to electric vehicles, would undertake a series of strategic projects, as would a bricks-and-mortar retailer transitioning to an online store.

Because an organization has limited experience in their execution, strategic projects are inherently high-risk. While detailed financial analyses will typically be required, the financial metrics presented will be subject to a healthy degree of skepticism.

Nevertheless, projects of this type will be approved by executive management when their implementation is considered imperative to an organization achieving its strategic vision. They 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.

Strategic Projects in Practice

The identifying test is unfamiliarity: if the organization has done this before the estimates can be grounded in its own experience, and if it has not, the financial case is a projection rather than a forecast. Public sector: a health system building an entirely new model of community care delivery, or a utility entering large-scale energy storage for the first time. Private sector: a mining company moving into downstream processing it has never operated, or a bank replacing a core banking platform it has run for thirty years.

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 behaviors 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, tones 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.

Environmental, Social, Governance and Compliance Projects in Practice

The identifying test is that the trigger sits outside the financial case: a regulator, a permit condition, a court, a community expectation or a board commitment makes the project necessary. Public sector: upgrading a wastewater outfall to meet a new discharge permit, or retrofitting a public building for accessibility. Private sector: installing emissions abatement on a stack, replacing refrigerants to meet a phase-out schedule, or rebuilding a records system to satisfy a new reporting obligation.

Combination Capital Project Types

A combination project delivers benefits in more than one category at once, and is classified by the benefit that would justify it on its own. 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.

In Stratex Online a combination project carries its primary type plus secondary evaluation criteria, so a carbon-abatement project with a financial return is ranked against other abatement projects and still credited for the return.

Combination Projects in Practice

The test is which single benefit would have carried the business case without the others. Replacing a diesel fleet with electric vehicles renews an asset that was due for replacement anyway, cuts running cost, and meets an emissions commitment, all at once. A plant upgrade mandated by a new safety regulation may also lift throughput. A building retrofit undertaken for accessibility may also cut energy use.

The Importance of Project Classification for the Effective Evaluation and Prioritization of Capital Project Types

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 and apply project screening. It then enables organizations to score and rank projects based on their project type and select an optimal project portfolio in line with budget constraints. In doing so, it brings structure, transparency, and strategic focus to capital planning.