It’s the curse of every CFO. It’s the blight that mysteriously lures managers into exaggerating the return on invested capital. It’s the deep, dark chasm that separates earth-shaking ROI from the reality of misguided monies. It’s the Capex Hex. And it dilutes financial performance with little regard for industry, department or manager.
Year after year approved capital expenditures fail to deliver at the anticipated levels; often barely covering the cost of the capital. McKinsey, in a related survey, addressed under-performing resources stating that despite CEO involvement and focusing on the proper areas or factors, resource allocation remains suboptimal. The cause of these improper allocations is typically traced back to “non-integrated” decision making and disparate planning processes.
Corporate executives report that 17% of the capital invested by their companies went towards under-performing investments that should be terminated. Another 16% of their investments were a mistake to have been financed in the first place. Even worse, another 21% of capital should have been approved, but was not. (1)
To combat, or at least minimize, these under-performing investments, senior executives deploy a legion of analysts; each charged with “breaking the spell.” The analysts, armed with hundreds of spreadsheets, reach into the unknowns of IT attempting to bring light to the investments by quantifying select performance metrics. Terms like yield, throughput, inventory days, ability to deliver, and so on, become “defenders of the plan;” giving credence to the investment decision.
Of course the Capex Hex is nothing more than an imprudent approach to evaluating the true economic impact of investment choices and decisions. Specifically, the Capex Hex contains three critical tribulations, or root causes, for under-performing capital: isolation, relationships, and history.
Capex Hex: Isolation
The first and perhaps the most costly root cause of under-performing capital is isolation. Capital investments are routinely initiated at the departmental level without regard of impact on ancillary departments.
For example, operations invests in a new packaging and labeling machine that doubles throughput, only to realize that logistics cannot “code and load” shipments at the same rate.
Capex Hex: Relationships
Once investment decision making has moved from isolation, executives must consider the relationships each investment has on correlating investments or activities. In other words, investments impact investments. Therefore optimal decision making requires the ability to mix, match and sequence investments.
When evaluating capital spending and opportunity investing, the top brass must see the big picture. For example, approving the new packing and labeling machine as mentioned above, and converting two receiving bays to shipping bays, may deliver the anticipated financial return.
Capex Hex: History
Another critical disconnect is the use of heuristics and history for projecting the financial impact of an investment. Average costs and margins derived from the “plan of record,” are consistently off target. This occurs because historical costs can not consider the marginal impact the investment may have on key variables such as processing costs, input prices and tax liabilities.
Borrowing from the example above, while the new and improved packaging and labeling machine did double throughput, it also increased the company’s amount of “waste ink.” This, according to regulations as defined by the Environmental Protection Agency (EPA), changed the company’s waste status to “large generator,” requiring the company to add new containment equipment and to provide compliance training for select personnel.
Integrated Business Planning Breaks the Capex Hex
Integrated Business Planning (IBP) breaks this profit-diluting hex by connecting planning across the enterprise. IBP, which uses a holistic enterprise model, determines the true economical impact of each investment within a portfolio of investments. IBP captures all available financial improvement opportunities without the use of reality-distorting assumptions.
According to Tim Payne, research director at Gartner:
IBP is the strategic planning and consistency framework that unifies the plans across business functions and integrates those plans to the corporate key performance indicators. One of its key outputs is to convert the strategic plans into meaningful financial plans that show the impact of the high-level strategies on the key financial reports of the organization. (2)
IBP was not practiced in the past because of technological constraints. Creating a holistic model of an enterprise; then creating “what-if” scenarios, simulation and sensitivity analysis, optimization (to any variable of objective function), and determining infeasibility and “next best alternatives” was simply not possible. Additionally, no application could view all possibilities while simultaneously considering all process and market dynamics, and their corresponding financial outcomes.
New software has emerged with unsurpassed processing and modeling capabilities, putting IBP on the CFO’s short list. However, Integrated Business Planning also requires key decision makers to re-engineer their project evaluation processes. Moving forward, corporate managers and department heads must work in concert as a cross-functional team. This will enable them to determine the true financial impact of their respective actions at the enterprise level.
By adopting Integrated Business Planning, companies will increase profitability by using greater insights to make faster, more informed decisions. In addition, strategic initiatives can be directly aligned with execution, while increasing the returns from invested capital. In other words, Integrated Business Planning will enable companies to break the Capex Hex.
(1) Garbuio, M., Lovallo, D. and Viguerie, P., (McKinsey & Company survey), How companies spend their money. The McKinsey Quarterly. June 2007. p7.
(2) Payne, T. (Gartner, 2008) Integrated Business Planning Fills the Gap between Strategic Planning and S&OP. G00157655, p 4.
Tags: Capex, capital expenditure, capital investments, integrated planning, optimal decision making
