Want to know if your company is using its capital productively? Then ask yourself (or better still, your business unit leaders) a few questions. Do your business units rely heavily on capital spending to improve performance? Are rates of return below what was promised during project evaluation? Do divisions have to spend all of this year’s capital budget to ensure funding for next year? Is there any explicit accountability for capital spending? Do big capital projects receive less scrutiny than ongoing operating expenses? And is capital spending linked with strategy?

The management of capital investment has an enormous effect on profitability and competitiveness, yet few companies do it effectively. We believe that the use of evaluation tools, disciplined processes, and best practices can help companies trim capital spending by up to a quarter without reducing capacity or functionality—and improve their operating costs and revenues through better investment decisions.

So for those who answered yes, yes, yes, yes, no, yes, hmm ... maybe not, here follows a guide out of the capital "doom loop" in which senior management loses faith in the capital alloca-tion process, sets project hurdle rates above the cost of capital,

limits investment, and ultimately undermines the company’s competitive position (Exhibit 1).

The stages of capital spending

The road to capital productivity begins with a tight link between capital spending and business strategy. It is paramount that companies understand at the outset a capital project’s impact on cost structure, profitability, and competitive position. Early definition of scope and rigorous project evaluation are essential to maximizing financial returns and managing risks, yet few companies put in the time and effort required to perform these tasks (Exhibit 2).

If a project goes ahead, execution must be world class to maximize the value created. This typically calls for ruthless control to stop the project escalating, along with superior project management. Any deviation from the approved scope should be treated with the same rigor and return requirements as the original project. In addition, mechanisms should be put in place so that individuals constantly challenge the myriad decisions that can affect the total installed cost of a project. Areas often overlooked include order expediting, built-in equipment redundancy, and equipment purchasing practices. Finally, proper performance measures are needed to optimize spending and to encourage and reward the right behavior in employees.

Pre-investment planning

Pre-investment planning is about justifying the need for investments and deciding on their timing. This may seem obvious enough, yet few companies are able to articulate the strategic value of their capital investments or recognize the latent capacity in their existing plant and equipment. Devising a facility plan that specifies a plant’s technical capabilities, intended markets, and future strategy creates a clear link between corporate strategy and capital investment, and is especially useful when a company has many plants. The facility plan provides the basis for making fact-based tradeoffs concerning capacity and product mix investments between plants. Such a plan also provides a framework for organizing and ranking large capital expenditures.

Before they invest, companies should ask themselves three key questions:

Is there a real need for this project?

Establish that there is a genuine business need for the investment, that it supports corporate strategy, and that it will enhance the company’s competitive position. Consider alternative solutions and "debottlenecking" options. One pulp and paper manufacturer planned to spend $500,000 to replace a winder machine identified as the cause of many stoppages. This capital investment would pay back in less than two years when offset against the expected reduction in machine downtime. Deeper investigation, however, revealed that a component repair could solve the problem. It worked—for a tenth of the cost of a new machine.

Can the project be deferred?

The timing of an investment affects its financial returns. Deferring a project gives an investor the option value of acquiring more information to increase the certainty of a return. In many cases, large capital projects can be put off for a couple of years without greatly affecting the business; indeed, postponing a scheme may increase its utilization in the early years and enhance returns. For one oil company, deferring a pipeline investment for 18 months while the market grew increased the eventual return by 5 percent, and much reduced the risk.

Are we investing in a marginal asset simply to ensure its viability?

Many companies must decide where to invest in their networks of plants. Should they enhance the profitability of the most productive plants, or invest in weaker plants to shore up their viability? The question gets even harder to answer if transfer pricing issues, inadequate performance measures, or other problems cloud the economic contributions of the plants. A company’s oldest facility may possess sentimental value for its management team, say, yet represent a less attractive location for incremental investment than more modern sites.

Needless to say, decisions to invest should be based on hard facts about past performance and future prospects. But these hard facts depend on accurate and transparent measures that link capital investment to business performance. One company made a point of including the expected returns from a business unit’s requested capital in its business unit financial targets to provide a mechanism for monitoring the performance of investments. Establishing such a clear link helps companies make the painful transition from the dogma that capital is free to the knowledge that they must earn the right to spend. Before investing in a marginal plant, then, companies should review its performance thoroughly to ensure that the investment will both make the plant viable and optimize the total network.

Definition of scope

The definition of a project’s scope affects both overall capital requirements and the value of the investment. Questions about scope fall into four main categories:

What is our investment philosophy?

Are we investing for a short-term business cycle where uncertainty is minimal, or is this a long-term strategic investment that calls for great flexibility? An ethylene producer, for example, might opt for a simple, fast, relatively inexpensive NGL cracker instead of a more complicated, flexible feedstock unit on the grounds that more than 70 percent of its return is made during short periods of soaring prices. This strategy would result in an asset much more capable of capturing price opportunities in a focused segment and is rather like choosing between investing in boosting your car’s raw horsepower or improving its handling capability.

Do we need bells and whistles?

Are all the options desired by the engineering, construction, and operations departments justified, or will a basic plant suffice?

Are all the options desired by the engineering, construction, and operations departments actually justified, or will a basic plant suffice? Before a company knows it, a budget can increase by 30 percent, and the complexity of a project double. Best-practice companies evaluate the basic investment first, then assess each add-on separately.

Could industry specifications and standard designs be used?

Once the basic scope of a project has been decided, it is time to address questions about industry versus company specifications and standard versus custom designs. Many companies insist on implementing their own tailored specifications, unaware of the extra expense involved in moving beyond industry standards.

One leading oil company recently built two coking units, one with an off-the-shelf design that conformed to industry specifications, the other with a custom design. The first project was finished six months earlier than scheduled and more than 20 percent under budget, while the custom project was six months late and over budget.

Have we extracted all the latent value from the project?

Contrary to common belief, capital productivity is not just about reducing the cost or controlling the scope of a project. Too often, companies stop looking for benefits once a project clears its hurdle rate. Yet even where projects are considered as mandatory (for environmental or safety reasons) or maintenance (where zero returns are the norm), closer examination frequently yields unexpected benefits.

In one case, a paper mill was about to install an access door in a vent for safety reasons. Normally, such a project would be viewed as a zero-return exercise and executed without more ado. But this time, the mill scrutinized the plans and found that installing a door with an inspection window would enable it to avoid certain cleaning costs that arose when the vent filled with debris. Though modest, the unexpected payback was better than nothing.

Piggybacking improvements on zero-return projects in this way is often more cost-effective than carrying them out in isolation. Companies whose policy is to go beyond the hurdle rate rather than accept zero-return standards can boast a culture and systems that enable full benefit to be realized from each capital dollar.

Particularly useful at this point is an optimizing tool called project value analysis (PVA), which should be applied to the scope of a project (Exhibit 3). By using PVA, companies have been able to increase the functionality of a project while cutting cost and complexity by a quarter on average.

Project evaluation

Few would deny that project evaluation is essential to optimizing fixed capital investments. Yet many companies repeatedly fund low-return projects, misallocate their capital budget, forgo value-adding projects, and neglect risk. Thorough analysis is required to ensure that all projects are evaluated consistently. The key question for senior managers is, is your evaluation methodology adequate?

Most companies have started to use discounted cashflow to evaluate projects, yet mistakes still abound. The technique also has at least one intrinsic limitation: it does not incorporate the value of flexibility. The discount rate chosen should represent the weighted average cost of capital calculated using betas (measure of volatility) and the appropriate capital structure for each broad business unit. Our research has identified a range of evaluation practices which incorporate progressively more sophisticated criteria with a decreasing emphasis on traditional budgetary practices (Exhibit 4). Some companies artificially raise the discount rate to adjust for risk or historically low returns; in so doing, they may sacrifice value-adding capital investments or find growth through acquisition impossible.

As well as conducting a thorough financial analysis of proposed investments, companies should consider the option value embedded in these decisions. When the net present value of a project is close to zero using discount rates that reflect the weighted average cost of capital, and it is not clear whether the company should proceed with the investment, option value becomes particularly important. The recent development of analytical tools for estimating option value should encourage still more companies to factor it into their investment decisions.¹

Finally, each project should be examined in the light of a company’s other investments to ensure that they all add up to a healthy capital portfolio. To this end, senior managers should strive to maintain balance while securing the highest possible returns on invested capital over the business cycle.

Project execution and performance measurement

Even after a project has been evaluated and approved, substantial value may still be created in the execution phase. As we saw, scope must be clearly defined and changes kept to a minimum in order to control engineering and construction costs. Yet most companies invest too little time and energy in pre-investment planning to achieve this goal. In cases where scope is well defined, lump-sum fixed-priced bidding can be one good way to transfer cost and schedule risk to a contractor.

A rigorous purchasing strategy is essential at this stage. Our experience shows that modern purchasing methods can boost project savings by up to 10 percent. Research into purchasing and supply management indicates that companies should focus on the total cost of ownership for purchased materials and services, which means looking beyond initial purchase prices to consider internal costs such as quality control, inventory, operations and maintenance, and opportunities jointly to reduce supplier costs.²

While these techniques are frequently applied in manufacturing businesses, where raw materials represent a large part of the cost of goods sold, many companies that make ongoing investments have failed to apply them constructively. Entering partnerships with suppliers may be one way for them to tap into the advantages of cooperation while minimizing the cost of total purchases. Even in the case of one-off purchases, tools such as linear performance pricing (LPP) have helped to cut costs. LPP is a systematic method of creating price transparency in engineered items by focusing on individual price and performance correlations and conducting competitive design-to-cost negotiations with suppliers. The application of this tool alone can drive substantial savings. In one case, the price of electrical transformers was reduced by an average of 25 percent through the use of LPP.

The importance of measuring capital productivity can scarcely be overemphasized. Companies that do it well tend to excel at optimizing fixed capital investments. They scrutinize capital spending as carefully as ongoing operating expenses, and make managers accountable for delivering the required capacity in a cost-effective manner. They also conduct "look back" analyses three or four years after completion to verify project economics and institutionalize the lessons learned.

One essential ingredient in shaping a company’s cultural attitude to capital investment is performance measurement. Progressive companies are moving away from return on capital employed as the main yardstick for employee incentives, and adopting economic value added instead. This is a good measure of capital efficiency and encourages executives to manage capital budgets carefully.

Two types of investment

So far, we have discussed the best practices applicable to all capital investments. There are also certain practices that apply specifically to ongoing capital investments or large, once in a decade projects.

Once in a decade projects

Capital-intensive industries such as refining, petrochemicals, steel, and pulp and paper typically add capacity in large lumps, and are cyclical. Given the scale of their investments in new plant and equipment, most companies make important decisions about capacity additions only once every five or 10 years. The questions they need to answer are:

What is the appropriate timing for investment?

In cyclical businesses, the timing of new capacity investments determines the financial returns they will yield. By tuning an investment to the business cycle, a company can almost double its return. Needless to say, predicting the cycle accurately is difficult. But an asset acquired at the right moment can often be purchased for far less than it would cost to build.

What is the expected impact on industry structure?

In many commodity industries, prices are set by high-cost producers during periods of excess capacity, since it is the marginal producer that defines the intersection of the supply/demand curves. Adding capacity can therefore change the industry’s cost structure, cutting prices and profitability for all participants. A clear understanding of industry structure and the impact of extra capacity is essential to the accurate assessment of a project’s value.

Should risk management tools and techniques be used?

In many commodity industries, forward markets provide certainty about future transaction prices because forward prices represent a level at which people are willing to transact in the future. Because of their certainty, forward prices should be put to use in the analysis of investments; after all, the outlook on price is central to the justification of capital investments for most businesses. If forward prices are not available and there is considerable volatility in raw material or product prices, companies might instead develop scenarios and use probabilistic weighting (based on the probability of achieving the stated returns) to determine an expected value. For example, an investment may have a stated return of $100, but the likelihood of it paying off may only be 50 percent because of market uncertainties. This investment would have an expected return of only $50.

Will risk management methods truly add value to our investment portfolio or merely raise costs while capping returns?

The use of forward markets and other risk management tools can increase the certainty of cashflows and financial returns, as well as enabling a company to raise the portion of debt in its capital structure for a project, thus reducing its cost of capital. But it is important to understand that while these techniques reduce the volatility of returns, they gain certainty only at a price. Companies need to evaluate their natural exposure and hedges carefully to determine whether risk management methods will truly add value to their investment portfolio or merely raise costs while capping returns.

How far should I consider option value in my investment decisions?

Capital investments are irreversible decisions that may include a series of embedded options. One pulp and paper maker had decided to build a recycled pulp plant in response to anticipated demand. The central question was what capacity to build. Instead of creating a minimum-capacity plant that could easily accept 25 or 40 percent additions, management decided to target the full five-year demand forecast. Unfortunately, demand for recycled pulp took much longer to develop than expected and the plant was left with overcapacity for several years.

Delaying a project until more information about the market or the industry structure can be procured may enhance the value of a big capital investment. Option value is also created when companies adopt a phased approach to investments that confers greater flexibility to expand capacity or tailor manufacturing facilities to produce more of a particular product. Such techniques have been widely used in oil exploration and production and are becoming more and more common in other industries.

Ongoing capital investments

Many industries carry out ongoing capital spending in the form of mandatory projects undertaken for environmental or safety reasons, maintenance works, or operational improvements. A large company might conduct dozens of these projects every year, spending hundreds of thousands or even millions of dollars on each and consuming more than half its entire capital budget in the process. It must have the basic capital optimization tools and processes in place and operating smoothly in order to capture value from these projects.

Two questions in particular apply to ongoing investments:

Do we generate value from learning and experience?

Many organizations that perform repetitive tasks fail to harness and institutionalize the benefits of learning

Evidence shows that companies from a range of industries reduce their costs as they move up the learning curve. Yet many organizations that perform repetitive tasks fail to harness and institutionalize the benefits of learning. By developing standard procedures and process improvements, they can improve quality, cycle time, cost, and safety.

In large companies with many plants, establishing a "learning look back" system in place of a conventional audit (that is, a self-generated effort rather than an externally imposed procedure) can be a valuable way to capture best practices and generate new ideas for improving capital productivity. Returns on capital for one company varied from 8 to 15 percent in its four plants. Many of the internal best practices of the most profitable plant could have been shared with the others, but the project-by-project way that investments were made and the absence of any systematic means of capturing benefits meant most ideas were lost.

Are we addressing the underlying causes of repetitive capital spending?

Recurring investments are typically the product of two main factors: maintenance effectiveness and operating procedures. An ineffective maintenance program is often to blame for heavy capital requirements in this area. One electricity utility was considering the replacement of fuel processing equipment that had become chronically unreliable. However, by systematically probing the root cause, a team pinpointed the problem: a maintenance practice of conducting unnecessarily frequent equipment inspections. Reducing the frequency of inspections reduced the number of stop/ start cycles on the equipment (as well as the opportunity for maintenance errors) and dramatically increased reliability, allowing the utility to avoid a $20 million capital investment.

Similarly, changes to operating procedures can reduce demands for capital. One generating plant spent unusually large capital sums on its high-pressure air compressors. Investigation revealed that two compressors were being run continuously even when the load did not justify it; this extra wear meant they had to be replaced more often than would otherwise have been necessary. Superfluous online backup capacity and operator convenience had been built into working practice, but could easily be removed to reduce capital needs without harmful consequences.

Too many companies mismanage their fixed capital investments, condemning themselves to the doom loop of reduced competitiveness. But the cycle can be reversed. Instituting systems to measure and track capital performance accurately and establishing clear expectations and accountability for capital results take companies part of the way. To complete the transformation, they must also promote a system of learning that encourages the continuous improvement of project design and execution, and carefully integrate capital optimization tools and processes. In this way, they can begin to build a more productive capital culture.