Most capital budgeting processes are out of control. On the big decisions—the major investments—disciplined analyses of expected returns do, of course, get done. But on the countless smaller capital requests that flow up the decision-making channels of most organizations, such discipline is usually lacking. What's missing, however, is not a top-down commitment to using net present value techniques. The problem is not methodological. What's missing is a consistent management focus at the grass-roots level on identifying all opportunities to generate and capture value by using capital more efficiently.

The chief financial officer of a large, regulated company recently noticed a problem. He was seeing increased demand for capital to fund new projects at the same time that his company was suffering from a shortage of internally generated funds. Because conditions in the capital markets were unfavorable, he was not prepared to issue new debt or equity in the necessary amounts to keep the company's capital structure unchanged. So he proposed to raise the hurdle so that fewer projects would be accepted.

A reasonable solution—but somehow the CFO felt uncomfortable. Would raising the hurdle really cut the number of requests? Or would the numbers simply be "cooked" to show higher forecasted returns? The CEO was uncomfortable too. Was this, at best, only a superficial fix that neglected a much deeper problem?

The company's capital budgeting process was fairly standard in its approach. All capital requests above $2 million had to be approved by the CFO's office and had to show an expected 12 percent rate of return. Every year about 200 requests were submitted for review. Despite the formal review process, however, only a few dozen of these actually received careful attention.

Moreover, in most cases the CFO's staff lacked the time and/or expertise to challenge the underlying technical assumptions or design of the proposed projects. The staff were no match for the seasoned engineer who could rattle off technical details and compellingly link just about any project to higher-order issues such as safety, reliability, or customer service.

The CFO had little confidence that the best skills had been applied in finding least-cost options or alternatives to what had been proposed. Rumors from the field suggested that projects were often gold plated, and external benchmarking confirmed that invested capital levels were well above best practice both within and outside the industry. Field personnel had strong incentives to overengineer because they got into trouble only if there was a shortage of supply to customers. Design engineers were criticized only when something went wrong with a piece of equipment. In addition, about 60 percent of total expenditure was approved automatically because it fell below the $2 million limit and policy dictated that such projects were not reviewed by the CFO's office at all. They fell into the category of "blanket" spending: small outlays, too numerous to analyze in detail, that were part of routine spending.

Whether the CFO was aware of it or not, capital budgeting at his company was seriously out of control.

Managing value

Using proper analytic methods does not, and cannot, by itself ensure real capital efficiency

Finance textbooks wax eloquent about capital budgeting methodologies as if the use of theoretically correct techniques inevitably results in an optimal allocation of capital. From time to time, academic surveys of CFOs look to see how many of their companies regularly use DCF, IRR, or NPV when evaluating significant investment decisions.¹ But using proper analytic methods does not, and cannot, by itself ensure real capital efficiency—the greatest possible enhancement of free cash flows by making sensible reductions in the need for working and/or physical capital.

Capital efficiency starts with a managerial understanding of the ways in which capital-dependent projects get defined and implemented at the front lines

In other words, capital efficiency is not the product only, or even primarily, of methodological choice. It starts, instead, with a managerial understanding of the forces that drive the demand for capital and shape the ways in which capital-dependent projects get defined and implemented at the front lines of an organization. And it rests on a management process that aligns the day-to-day behavior and mindset of the employees who plan and execute such projects with the organization's overall value-creation objectives.

There is nothing magical about a management process focused on value. It simply recognizes that the greatest part of capital spending is controlled by decision makers at the grass roots of an organization. These people have the information required to improve capital efficiency dramatically but—if they are to share it effectively—need top management support in the form of better understanding, more feedback, and, especially, appropriate guidelines and incentives.

The potential impact of improved capital efficiency is enormous. Companies can often cut their capital expenditures by between 10 and 25 percent without any change in revenues or in the quality of services provided to their customers. At the same time, they can often reduce maintenance costs and implementation times (as projects get simplified) and improve interfunctional cooperation (as the new approach gets embedded in general managerial practice). One company, for example, reduced its working capital by $500 million in one year. This dramatic improvement had nothing to do with budgeting methodology, but everything to do with developing a value-based approach to capital management throughout the organization.

As well as generating millions of dollars of value for shareholders, improving capital budgeting has a real, direct impact on a company's overall economic health. For example, in 1990, capital spending in electric utilities and telecommunications—two industries where capital budgeting problems often arise—was $110 billion, fully 21 percent of all capital spending in the United States. A disciplined value-based approach typically pares yearly budgets between 10 and 25 percent. That means adopting it in these industries alone could free up tens of billions of dollars a year for investment in new and useful enterprises.

The attention that does get paid to capital efficiency usually comes from far too high up the chain of command

Today, capital efficiency represents such a huge and largely untapped source of value because only limited attention is usually paid to it. And what attention does get paid usually comes from far too high up the chain of command.

Why does it matter?

The advantages of improved capital efficiency for unregulated companies are obvious. Those that can do more with less are rewarded by the capital markets. If the same operating cash flows can be achieved by using less working capital or less physical capital, a company's free cash flow increases, which is reflected in a higher market price for its shares. A company that generates a dollar of earnings by spending twenty cents of capital will enjoy a higher share price than a competitor that generates a dollar of earnings by spending fifty cents of capital.

The rationale for capital efficiency at regulated companies, such as utilities and telecoms, is different, especially if the rate of return on their capital base is regulated. Even in this situation, though, capital efficiency has compelling benefits.

First, the regulatory environment is improved: regulators typically benchmark across jurisdictions and reward companies that provide higher-quality service without cost overruns and other inefficiencies. Second, being regulated does not mean that a company can afford to be uncompetitive. Electric utilities, for example, can lose their power contracts with those businesses able to switch to alternative forms of energy, generate power for themselves, or gain access to other electricity supply options such as municipalized service. Telecommunications companies that use their capital inefficiently can lose traffic volume if business customers find it more efficient to build their own systems. Finally, regulated companies that spend capital more efficiently will find that they do not have to go to the capital markets so often.

Exhibit 1 compares Alltel and Rochester Telephone, two regulated telecommunications companies. Between 1987 and 1991, Alltel had lower growth in earnings per share (3.4 percent for Alltel; 10.2 percent for Rochester), but the share price of Alltel grew at 19.3 percent annually, while at Rochester Telephone growth was only 11.2 percent. The difference between them was primarily capital efficiency. Rochester's return on invested capital (ROIC) declined from 14.5 percent to 4.6 percent in the same period, and its ratio of sales to invested capital (capital turns) fell from 0.62 to 0.54. Over the same five years, Alltel's ROIC rose from 8.8 percent to 10.4 percent, and its capital turns improved from 0.54 to 0.76. Clearly, the market was responding to capital efficiency as well as to earnings.

Locating inefficiencies

In general, improvements in capital efficiency result from eliminating non-value-based drivers of demand for capital, promoting creative exploration of lower-cost options, and intensifying attention to day-to-day project execution. Although most CFOs and line managers would agree that additional effort along each of these dimensions will produce incremental benefits, few anticipate the magnitude of savings that can actually be captured. When realization finally dawns, their first reaction—after the initial shock—is to question the motives or intelligence of field personnel. Surely they must have been aware of these inefficiencies?

As the following case examples show, however, most inefficiencies are grounded in "legitimate" past practices, hidden constraints, or misaligned incentives. Left undetected, these subtle influences will continue to deprive companies of significant capital improvement opportunities for years to come.

Focus on value

Eliminating non-value-based drivers of capital spending requires careful analysis of the root causes and assumptions that lead to capital requests in the first place. Deferral or elimination of projects is often the greatest source of savings, but it is not always readily apparent where the opportunities lie. Take, for example, the determination of how much capacity is required to meet projected demand. Measurement of capacity utilization can be tricky, as an example from a telecommunications company demonstrates.

Exhibit 2 shows a hypothetical cable that is 67 percent used, according to the following "logic": the large cable carries three smaller cables, only one of which is not used. Partial use of a smaller cable counts as full use. Therefore, the large cable is operating at two-thirds capacity. Note, however, that if we turn to the basic unit of transmission, the smallest cables, we see that only 8 out of 33 cables are actually carrying traffic. The real capacity utilization is thus only 24 percent. Anomalies like this cannot be easily discovered by the CFO from his or her vantage point at the top of an organization.

In an electric utility system, the proper sizing of transformers is an important element in ensuring adequate capacity. At one company, design en- gineers were responsible for specifying transformer requirements, though the funding came from operation's capital budget. People barely noticed the engineers unless the transformers became overloaded, causing reliability and quality problems. Then they got yelled at. Consequently, the engineers took the initiative to forecast circuit and customer load patterns in an attempt to assess future capacity requirements.

To protect against unforeseen requirements, they scheduled projects for installation up to two years in advance, and added an extra safety margin of 50 percent to the rated capacity of the equipment, which was already lower than its actual capacity. Sometimes, of course, the projected demand failed to materialize, and the net result was that the utility had a number of transformers in place capable of carrying an overload of about 80 percent. By adding reliability and capital efficiency to the criteria used to select and prioritize projects and by shortening installation lead times in order to improve forecast accuracy, the company was able to reduce its capital expenditure budget by 20 percent.

Opportunities also exist to reduce the appetite for capital consumption by addressing the underlying drivers of "blanket" spending. Anyone who has controlled a blanket budget knows the temptation to underspend during the first three-quarters of the fiscal year, then load up during the fourth quarter. Exhibit 3 illustrates one company's pattern of spending by quarter. The fourth quarter shows levels 25 to 50 percent higher than in each of the previous three. Management had many explanations, but two were particularly compelling and worrisome:

"If we don't spend it this year, we lose it, and our budget for next year will be lower."

"I'm out of operating budget, but still have room in my capital budget, so I need to find capital jobs to assign my people [read: labor costs] to."

These statements reflect the organizational reality of most capital-spending programs. The result is that projects of lower value are taken on, and work is conducted in less efficient ways—for instance, by expediting materials or working overtime. Thus, actions that attack the attitude of fundamental entitlement in setting annual budgets and that evaluate performance on the basis of demand, productivity, and management of input costs can have dramatic impact in bringing blanket programs under control.

Focus on costs

Promoting creative exploration of lower-cost options involves examining opportunities for improvement on a "total system," rather than a component, basis, and undertaking a value-based review of projects on a line-item basis. Taking a total system view of projects can help identify, upstream or downstream of the proposed fix, lower-cost alternatives that are capable of delivering equal or greater impact.

For example, a company might be about to invest in a project for removing impurities from the downstream phase of a process. By reviewing total system costs, it might discover that there are cheaper options that prevent impurities from entering the system in the first place, perhaps through investment in better maintenance of equipment upstream. Such lower-cost options are, however, often overlooked when individual operating units seek ways to reduce annual operating budgets. But if the distinction between operating and capital funds is relaxed, creative ways to reduce total costs are more likely to be uncovered.

Conducting a value-based review of a project's line-item features is analogous to the "line-item veto" privilege often sought by heads of government in dealings with their respective legislatures. In business, however, the challenge is less to master the politics of the situation than to get the necessary expertise in place to review projects effectively on a disaggregated basis. As one steel company discovered, the payoff for doing so can be significant: involving field personnel in generating, evaluating, and selecting ideas for project simplification led to a 27 percent reduction in the capital required to complete 20 projects (Exhibit 4).

Focus on execution

Intensifying day-to-day attention to project execution can be a source of improvement for most companies. Frequently, the opportunity manifests itself in the form of chronic budget overruns. These are always a problem, of course, but we have found that overruns in blanket spending are more frequent and add up to a larger overall figure.

Exhibit 5 shows the evolution of one company's blanket capital spending during the course of a year: actual expenditures ended up 38 percent higher than initially forecast. Nor was there any follow-up audit that held people responsible for overspending. Not surprisingly, interviews with managers indicated that they tended to emphasize timeliness rather than capital efficiency:

"My task is to get the job done by the deadline."

"I don't care what planning says the estimated cost is; I just know I have to get the job done."

"I estimate the cost of a specific task, but I never see what the actual cost of doing the job was. Nowhere in the system do we compare estimated and actual job costs other than in aggregate."

Even where jobs do get completed on budget, opportunities for improvement frequently exist. More insightful balancing of cost with time, more accurate reporting of performance to front-line personnel, and more careful removal of barriers to implementation can usually add 5 to 10 percentage points to gains in efficiency already realized.

In some cases, for example, the budget may have been achieved, but the project was not completed on time or in full scope. In others, costs have been transferred between projects to "average out" performance reporting, in the process distorting and obscuring opportunities for leveraging best practices or addressing problem areas. Finally, unless there are explicit rewards for bringing projects in below budget, employees have little incentive for extracting efficiencies from a project that is unlikely to exceed its budget.

Value-based management

Disciplined efforts to achieve capital efficiency must, therefore, start with a management commitment to value creation and a managerial process for getting all levels of an organization, particularly the front line, to act in ways consistent with that commitment. Such an orientation is especially important for companies that need to take a long-term view of their business and have relatively high capital intensity. For large projects, the analysis of investment decisions should follow traditional textbook NPV methodology.² But for the thousands of smaller decisions that arise from the design of property, plant, and equipment, or from blanket spending, there is need for a consistent but less cumbersome way of thinking. We call this process value-based management.

Value drivers are the specific, easily tracked metrics that link micro-level decisions to capital efficiency

Detailed net present value calculations do not work here. The scale is all wrong. Value drivers do. Value drivers are the specific, easily tracked metrics—cost per foot of installed cable or pipeline, peak-load transformer utilization, or time to completion of a project—that link micro-level decisions to capital efficiency.

Nurturing and leveraging grass-roots awareness of such drivers of value are, thus, essential parts of any process genuinely focused on value creation. At one company, for example, engineers hoarded vital equipment, in violation of policy, as protection against a breakdown in operations. The resulting excess inventory of components amounted to virtually a year's supply. Only when the engineers, together with procurement and stores personnel, were able to establish a guaranteed 24-hour delivery time for replacement parts could this wasteful practice be corrected—and capital efficiency improved.

Similarly, following the destruction of facilities in south central Los Angeles in 1992, PepsiCo experimented with a rapid construction concept and learned how to build a new Taco Bell in 48 hours from start to finish. The company determined that rapid construction was a value driver because its incremental cost was offset by the acceleration of the revenue stream, and because start-to-finish construction time was easy both to communicate and to measure. PepsiCo is now working to implement rapid construction as a key program throughout its whole organization.

Whatever form they take, value drivers can help unlock many hidden sources of improvement in capital efficiency. Exhibit 6 details a general management change process for identifying and tapping these and other types of capital-related improvements.

The value-based management process starts with a diagnosis. Does the company exhibit any of the tell-tale symptoms of inefficient capital management? (See the insert.) How much potential is there for capital efficiency improvements? How valid are the existing performance metrics, such as capacity utilization? How accurate a database is there for reviewing levels of blanket spending? How do decision makers at grass-roots levels actually make blanket spending decisions? What incentives do they have to improve capital efficiency?

Having gained a better understanding of how decisions are actually made, an organization can move to the second step: developing a new process that focuses on grass-roots activity, but with good support from the top as well as across functions on such tasks as developing benchmarks. Bottom-up activities include careful identification of value drivers that can be monitored for continuous improvement, coupled with revised reporting requirements to focus on them. At the top, there must be a review process that centers on a two-way dialogue about both blanket spending and major projects. Its purpose is to make all levels of management smarter about where—and how—value gets created. Senior management needs better to understand the design of projects and the reasoning behind blanket spending; grass-roots managers, the importance of efficient capital spending.

Perhaps the most important part of the VBM process is the third step—changing the mindset of the organization. Workshops should be conducted at the grass-roots level to identify value drivers and brainstorm new capital efficiency ideas. Step 4 then reinforces the change in mindset by revising guidelines and incentives. Incentives are always a thorny issue. It is important, for example, to understand tradeoffs between customer needs and potential equipment failures, then to work toward agreement on guidelines that concentrate on capital efficiency and indemnify field engineers against sporadic equipment breakdowns.

Boosting capital efficiency is a "piano tuner" problem. The task is never finished

There is always a tendency to slip back into bad habits after an initial capital efficiency program has achieved its first success. The final step, therefore, is follow through. The goal is to have ongoing advances in value-driver performance via continuous improvement programs. Post-audit reviews of major projects enable learning about what went wrong and how to do things better next time. Boosting capital efficiency is a "piano tuner" problem. The task is never finished. But the benefits are clearly worth the continuous application of energy and attention. Value-based management pays.