For all their attention to cost reduction and restructuring, many companies are only now discovering a puzzling exception to the laws of economic gravity: capital programs keep going up, but show no sign of ever coming down. Despite top-level decrees and well-defined budgeting processes, the appetite for non-discretionary capital inexorably continues to grow. This should not, however, be surprising. Although senior managers can approve broad spending outlines and review major projects, they are powerless to drive out capital "from the top": real decision making gets done at the grassroots level. That is where the concrete opportunities lurk to make substantial, sustainable cuts in capital spending. And that is where they often remain hidden—unless and until managers come to view their company’s whole capital program not as an addiction to be fed, but as a rich vein of untapped value to be mined.

Capital planning and budgeting processes rarely focus on uncovering new ways to deploy assets as efficiently as possible

Let’s start with an uncomfortable fact: capital planning and budgeting processes rarely focus on uncovering new ways to deploy assets as efficiently as possible. Nor do they address the root causes of higher than necessary levels of capital spending: the entrenched tradeoffs and assumptions rooted in a corporation’s culture, incentive systems, and operational biases. As a result, ever more stringent project prioritization schemes, larger armies of financial analysts, and higher hurdle rates do little to stem the constant upward pressure for capital. Making a rigorous budgeting process even more rigorous is not the answer. It will never satisfy an institutionalized addiction to capital. Nor will it cure the mindset that such addiction breeds. What is needed, instead, is a different mindset entirely: an organization-wide commitment to search for—and free up—the value hidden by established policies and operational practices.

Such improvements in capital efficiency—that is, in the fundamental relationship between assets and revenue—are indeed possible.¹ During the past few years, for example, a number of electric utilities, telecommunications services providers, paper mills, natural gas pipelines, and other types of industrial companies, both regulated and non-regulated, have cut their annual capital requirements by an average of 25 percent.

These companies have succeeded by getting behind the misleading information and sub-optimal decision rules that usually obscure opportu-nities to reduce capital spending. Rather than setting out to fix the budgeting process—an effort that often results in walls covered with brown-paper process diagrams, but few bottom-line benefits—they have focused directly on the performance objective of improving cashflow. Rather than trying to tighten spending controls, they have fundamentally challenged the underlying tradeoffs, assumptions, and incentives that drive capital spending in the first place. In short, by uncovering and attacking the root causes of the capital hunger that leads to addiction, they have found a way to break their spending habit.

Capital hunger

Cultural attitudes and incentives exert a powerful influence on levels of capital spending

An organization’s cultural attitudes and incentives exert a powerful influence on levels of capital spending. A corporate culture that revolves, for example, around an ethic of "high quality at all costs" often leads to capital inefficiency. As a young, growing company strives to capture market share and consolidate its competitive position, it will often make capital decisions that trade off lower costs for higher service levels. Frequently, however, it will continue to make these tradeoffs as it matures—even when the basis of competition shifts. This mentality sets up an inexorable hunger for capital: front-line managers learn to focus on providing top-notch customer service, reliability, and product quality without ever examining the real economic implications of their decisions.

One large paper company faced constantly mounting capital demands, especially for purchases of new production equipment. Investigation revealed that plant managers, under heavy pressure to boost production levels and reduce down time, were upgrading to larger, more modern machines. They had not realized that scheduled repair time and annual maintenance programs could provide far less expensive ways to meet the same goals. By introducing a rotation and repair scheme and by incorporating capital charges into profitability measurements to discourage unnecessary spending on replacement equipment, the company was able to prune its annual capital budget by more than 50 percent.

Capital hunger grows where no incentives for improving capital efficiency exist, but penalties for poor operational performance are harsh

Capital hunger also grows where neither explicit nor implicit incentives for improving capital efficiency exist, but penalties for poor operational performance are harsh. When held accountable for revenue and profit targets, managers naturally tend to be concerned more with attracting and satisfying customers than with improving the return on the marginal capital dollar. To such managers, the risk-return equation is quite clear: better to be on the safe side, overengineer, and ensure high service levels than strive to be an unsung hero for cutting costs. The result is layers of excess safety stock buried in a company’s asset base and capital budget.

The common practice of setting budgets based on the previous year’s spending is another example of how incentives can blindly ratchet up expenditure. By encouraging managers to spend their entire budget, this approach consistently results in the "Christmas spending spree" syndrome—a huge December burst of spending, amounting to as much as 25 percent of the full year’s budget, just in advance of the annual capital budgeting cycle. Even in well-run companies, when no reward is offered for finding more efficient ways of using existing assets or cheaper solutions to new capital needs, budget negotiations become little more than a game in which managers strive to retain control over funds.

A third source of capital hunger is weak accountability for capital spending. Not carefully measuring the impact of capital programs reinforces the mentality that capital is "free." So do the usual conventions for allocating depreciation on shared assets among individual business units. Virtually all companies monitor sales and earnings performance against budget, but few track actual capital project results against projections over time. Consequently, engineers and project leaders feel little pressure to search for cheaper alternatives or to scrutinize an investment’s real payoff.

Regulated companies, in particular, tend to view capital spending quite differently from operating expense. Even as these companies face deregulation and mounting pressures on performance, such attitudes persist. As one telecommunications company executive put it, "We used to refer to operating expense as ’green dollars’ and capital expenditure as ’brown dollars.’ Capital just allowed us to increase our rate base." But even in non-regulated companies, managers who have never focused on tight value management often view capital programs as an entitlement rather than as a set of options that must be carefully weighed and traded off against other possible solutions.

Management processes

An organization’s culture is not, however, the only thing that contributes to upward pressure on capital spending. Formal management processes are also often at fault. Inadequate information and analysis are at the root of planning processes that fail to clarify the real economic implications, assumptions, and options associated with the capital program. Given the information normally available, it is not surprising that managers have trouble highlighting potential opportunities to reduce capital hunger. At one telecommunications company, misleading measures of capacity and utilization concealed large pockets of excess spare capacity. Although standard reports indicated utilization of around 80 percent, the true rate was only half as high—about 40 percent. Moreover, error-ridden databases obscured assets that could have been put to productive use. Since "you can’t manage what you can’t see," non-existent or, equally troubling, faulty information can be a major stumbling block to capital efficiency.

Capital budgeting methodologies often require a good deal of financial detail, but little analytic rigor

Another source of upward pressure on spending is the lack of sound analysis of capital programs and their impact. Many companies’ capital budgeting methodologies require a good deal of financial detail, but little analytic rigor. On close examination, the business cases for many large projects rest on murky assumptions or on patently unrealistic revenue or cost projections. At one telecommunications company, for example, the business case for a major switch expansion project omitted the cost of the additional capacity required to link the new switches to all the other locations in the network. Having initially approved the program (as a "strategic" imperative), senior managers were dismayed to watch the capital budget more than double. They finally halted construction and set about finding a more practical solution.

The approval of a "strategic" project often rests on nothing more substantial than high-level assumptions

In fact, major projects justified as "strategic" are frequently the worst culprits of weak analysis. Although most companies generate reams of paper to make the case for large capital outlays, the approval of a "strategic" project often rests on nothing more substantial than high-level assumptions. When an electric utility launched a major program to improve service reliability, engineers began to add transformer capacity, justifying the expenditure in terms of its strategic value. A closer look led, however, to an unexpected finding: adding transformers did not measurably improve reliability. What did was simple: trimming trees regularly to protect the lines. This allowed the company to reduce annual capital requirements by 15 percent and increase reliability at the same time.

Notwithstanding these difficulties, large capital projects do at least tend to command a fair share of management scrutiny. Most capital programs, however, are largely made up of hundreds of individual projects—most too small to receive any significant attention. The volumes of analysis that support them are usually full of unchallenged assumptions, unexplored sensitivities, and justifications based primarily on non-economic criteria.

Budgeting systems can drive up capital spending by focusing too narrowly on "the answer," rather than stimulating debate about alternatives

Even when budgeting systems are sufficiently rigorous, they can still drive up capital spending by focusing too narrowly on "the answer," rather than stimulating debate about alternatives. Few systems explicitly require the generation of multiple options or careful tradeoff analyses in justifying capital investments. The absence of such features inevitably limits the time spent searching for lower-cost solutions.

Asset use

A third root cause of capital inefficiency lies in the operational practices that govern the deployment of assets. The causes of excess spending often lie within the well-defined guidelines and processes that govern the activities of the planners and engineers responsible for deploying and maintaining assets and inventories.

Sometimes guidelines are simply ignored. One natural gas company found that workers were installing riser clamps on its pipelines 15 feet apart, when the spacing recommended by design was actually 25 feet. In other cases, guide-

lines are closely linked not to genuine economic drivers, but to extremely conservative assumptions made by risk-averse and highly quality-conscious engineers. In fact, the spacing recommended by outside contractors for the pipeline noted above was 50 feet, not 25. Following this recommendation cut annual capital spending on riser clamps by more than 60 percent.

Another problem is presented by the barriers between functional "smokestacks" that often block effective communication and coordination. Close interaction between marketing and operations, for example, is critical in assessing how to meet customers’ performance needs in the most cost-effective manner. Yet often the communication is one way at best. Pricing and promotion decisions can easily be a major driver of capital spending, since they affect peak capacity loads and fluctuations in demand. Such marketing decisions, however, are all too often presented to engineering as sacrosanct. Even worse, since marketing is usually rewarded for getting the customer—not on profitability criteria—capital appears "free."

This failure of communication can have a big impact on capital spending decisions. One telecommunications company set out to replace all its older switches on the strength of marketing’s belief that customers required service capabilities that could be delivered only by a newer switch. Closer examination, however, revealed that very few customers needed these capabilities—and that selectively upgrading a small number of older switches was a much more economic solution than wholesale replacement.

Finding the hidden opportunities

Improvements in capital efficiency reduce capital hunger by extending the life of existing assets and/or by reducing what is spent on new assets

Recognizing the causes of capital inefficiency is a necessary first step toward identifying specific opportunities for improvement. Because these are usually well hidden, it may take a structured investigation to uncover the largest potential savings and develop plans for capturing them. Such an investigation should concentrate on two questions: How can existing capacity utilization be increased? And how can new capacity be added more cheaply? These questions matter; overall improvements in capital efficiency reduce capital hunger—as well as the addiction to which it leads—by extending the life of existing assets (capital deferral) and/or by reducing the absolute amount spent on new assets (capital avoidance).

Increasing utilization

When managers uncover spare capacity "hidden" in an existing asset base, utilization may actually get worse before it gets better

The first step toward improving capital efficiency is to uncover the spare capacity "hidden" in the existing asset base. The initial impact of this exercise is somewhat counterintuitive: utilization may actually get worse before it gets better. Not only do companies discover excess capacity they did not know was there; they also create more of it by changing decision rules and guidelines to free up assets for sale, write-down, or re-use.

Simply cataloguing the location and value of owned or leased assets can be highly revealing

"Hidden" capacity. Because spare capacity is often masked by misleading measurements and incomplete or inaccurate databases, simply cataloguing the location and value of owned or leased assets can be highly revealing. A telecommunications company, for example, began its search for hidden capacity by examining its inventory of switch plug-ins—the computer boards that make up most of the value of a switch. Although headquarters’ reports indicated that the majority of the plug-ins were utilized, the true picture was quite different. Managers in the field were hoarding them, literally piling them up in closets and dark corners. Not visible in databases, these spares had no real cost to field managers, who viewed them as necessary insurance against the risk of a switch failure, given the unreliability of the central warehouse replenishment process. Fixing this process and recalling the spares allowed most new purchases to be deferred for more than three years, achieving a substantial saving.

Another telecommunications company found that much of its network capacity was either "reserved" or in the process of being disconnected owing to customer churn. This spare capacity showed up in databases as being "in use." But it was not—nor was it really needed. Engineers routinely overestimated capacity requirements for projects, since there was no charge for reserving capacity and no mechanism for clearing out superfluous capacity later on. Moreover, extended disconnect cycle times—caused by a historical bias that new customer service orders should take precedence over "re-work"—meant that capacity scheduled to be disconnected could not be factored into the company’s growth plan. As a result, "unavailable" capacity accounted for nearly 75 percent of planned capacity additions, which relentlessly forced up capital spending.

Engineering guidelines. Managers can also boost utilization by taking a fresh look at spare capacity requirements and at the possibility of re-using equipment. One company reduced its stock of spare equipment by more than 60 percent by adopting an "inventory model" approach to classifying it (whether installed or in warehouses) as "work-in-process stock," "safety stock," and "maintenance spare." It then identified what created demand for each category. Key drivers of maintenance spare levels, for example, included equipment failure rates and replacement/repair cycle times. By replacing longstanding rules of thumb with economically sound targets, the company was able to identify over $80 million of existing equipment that could be used in place of new purchases.

Altering the "triggers" of capacity growth is another way to delay capital spending. Relying on historical decision rules or past experience, engineers regularly propose adding new plant well in advance of demand. This is not always necessary. By calculating the value of building a new substation now as compared with four years from now, an electric utility found that waiting would reduce investment cost by more than 10 percent—with only a low risk of bumping up against the capacity limits of existing facilities. In fact, delaying the investment significantly reduced the risk of stranding plant should expected demand not materialize.

Identifying hidden spare capacity and revising decision rules to free up additional assets have an immediate impact on capital spending. As spare assets are sold, written off, or re-used, both utilization and cashflow increase. In addition, tighter capacity guidelines generate ongoing savings by reducing overall demand. Creating such guidelines has other beneficial effects—among them, improved analysis and decision making, tighter capacity management processes, and better information systems.

Adding capacity

The second step toward improving capital efficiency—finding ways to meet business needs at a lower capital cost—requires just as much investigation and analytical rigor as "mining" spare capacity out of the existing asset base.

Requiring engineers to develop a range of design alternatives can illuminate possible tradeoffs

Lower-cost designs. There are numerous ways to reduce the cost of new capital investments that are never—or only rarely—considered. In many companies, risk-averse engineers trade off lower cost for quality long before senior management reviews design recommendations. Simply requiring engineers to develop and present a range of design alternatives can illuminate possible tradeoffs between new and used equipment, between standard and substitute materials, and between labor and capital.

These new options can often produce dramatic cost reductions with little impact on quality. A paper mill, for example, slashed its investment in pulp grinders by purchasing used equipment—at one-tenth of the cost of new machines—and by transferring spare grinders from another mill—at just one-fiftieth the cost. Similarly, engineers at a natural gas pipeline determined that putting up an outdoor enclosure shed with acoustic insulation for their compressor equipment, rather than a traditional building, would halve costs.

Developing a reliable fact base can help break down the controversy associated with challenging conventional wisdom

Developing a reliable fact base can help break down the controversy associated with challenging conventional wisdom. Because the managers at an electric utility were convinced that service interruptions due to gas plant outages must be avoided at all costs, the company invested millions each year in petroleum back-up. Yet no one had ever explored alternative ways of supplying power if the gas plants failed. In fact, many existed, including buying electricity from other plants and shifting production within the system. Selecting carefully from these options allowed management to reduce costs while continuing to provide ample back-up capacity.

Execution costs. Improving the "blocking and tackling" of day-to-day execution is another important lever for adding new capacity more cheaply. Consider, for example, the effects of strong project management skills. The familiar lack of up-front coordination between planning and engineering can easily lead to management’s approving projects too early in the design stage. The likely result: designs that do not meet real needs, serious delays, and an even more serious run-up in costs. The same problems occur when rigorous contingency planning does not get done. As one telecommunications company recently learned, not anticipating long delays in operating systems development almost tripled the investment required to deploy a new switch.

By itself, however, tight project management is not enough. Faulty general management processes also allow costs to creep up. When the telecommunications company described above uncovered a hoard of spare switch plug-in equipment, it found that inadequate asset management processes were at the root of the problem. Materials managers focused on meeting accounting and regulatory requirements, not on core activities such as ordering, repair, distribution, and tracking. "Administered" rather than "managed," the plug-in inventory management process was out of control. By refocusing efforts, developing clear metrics, and instituting accountability for stock levels, the company quickly cut both cycle times and administrative costs.

Curing capital addiction—and making the cure stick—requires a fundamental rethinking of the way capital decisions are made and executed. Hunting for "hidden" capacity—and the value hidden within it—must become standard practice. So, too, must management processes that realign incentives and generate lower-cost options for all new claims on capital. Business-as-usual approaches will not work. Old habits die hard. But they can be changed—if managers are prepared to make the effort.