Capital investments deliver ongoing business benefits through either reinvestment in depreciated assets (sustenance) or by making new investments for growth. For most organizations, managers are invariably presented with more applications for funding than the time and money available to commit. It therefore becomes essential to apply a process to the relative scoring and ranking of these investment initiatives. One way is through influence: the exertion of positional power and persuasive argument. A better way is a standardized and rigorous scoring and ranking methodology. Whilst ultimately decisions will be based on experience and intuition, the more transparent the project evaluation, the greater the confidence and perception of equity will be for all participants.
Classifying Appropriation Requests
As investment initiatives evolve from an idea to a fully-fledged business case, additional data, insights and calculations are assembled to enable an optimal selection from the list of candidate projects. The recommended methods for classification and scoring of budget appropriation requests are outlined below.
In the same way that financial planners will guide your investment strategy first by asset class (eg government bonds, international equities) and sector (eg financial services, natural resources) before attempting to pick individual investments, so to should this approach be applied to your capital project initiatives. It would not make sense to compare a regulatory requirement, critical plant replacement and strategic initiative in the same funding request list. Organizations will typically start a budgeting cycle with some stakeholder guidance to the available funding allocation to these high-level budget buckets, and then consider the priority of the projects within each category. These investment categories are typically referred to as Investment Reasons, and would include substance, growth, saving, regulatory and strategic motivations as a minimum. The applicable scoring dimensions and the weighting of these dimensions to generate a project ranking will vary by investment reason. For example, the urgency of replacement may be most important for sustenance initiatives and the benefit quantification may be most relevant to growth and saving initiatives.
Most initiatives can be addressed in a variety of ways. Whilst the urgency for doing something may apply to the initiative as a whole, each option or variant may have a slightly different cost, benefit and risk profile. To maximize project benefits, and to facilitate timely and confident evaluation of competing projects, the full identification of alternative approaches should be considered. There is typically at least a minimum viable and a premium option to consider. Depending on organization constraints, the preferred option may vary over time so it is recommended to provide the options to the decision makers so they can make more nuanced selections – for example, it may be more valuable for the organization to execute two minimally viable projects, than a single premium project.
Each option should be assessed on a standardized basis, scored and the preferred option identified. This preferred option for an initiative is ultimately what will be considered relative to the preferred option of other initiatives. The assessment score itself will be determined based on the scoring model defined for the project’s Investment Reason, and will typically factor in the following evaluation dimensions: Benefit, Strategic Alignment, Risk of not doing (urgency), Risk of doing (delivery confidence).
Every investment initiative option should be consistently scored in accordance with the following dimensions:
Capital investments are ultimately assessed in terms of the business benefits to be derived. The nature of the benefits will vary depending on the investment reason, but would include risk mitigation, other qualitative benefits, and financial return.
Risk Mitigation – The primary driver of most replacement initiatives is to mitigate the risk of component failure impacting overall operations. This benefit is articulated as a residual risk assessment, and all else being equal, the initiative that most reduces the inherent risk would score the highest.
Qualitative Benefits – The expected benefits of Environment, Social and Governance or Health and Safety compliance initiatives are not readily expressed in financial or other quantitative measures. These initiatives may be more effectively assessed in terms of simple rating scales. The criteria and evaluation ranges should be tailored to the organization’s specific needs.
Financial Analysis Metrics – For larger scale investment initiatives undergoing multiple years of development and expected to incur operational expenditure and produce organizational benefits for many future years, simply considering the nominal cashflows is misleading. Firstly, the time value of money needs to be considered. An appropriate discount rate must be applied to future cashflows to represent the equivalent current cost or PV (present value) for comparison purposes. For example, one hundred thousand dollars to be spent in two years’ time could be funded by approximately ninety thousand dollars invested today at a five percent risk free rate of return.
Secondly, when two initiatives both project future business savings/benefits, clearly the initiative with the highest NPV (the net present value of all future inflows and outflows) is preferred. When it comes to discounting at-risk future cashflows, it is appropriate to apply a risk adjusted discount rate relative to each item.
Thirdly, whilst theoretically all positive NPV initiatives should be pursued, the ultimate selection of initiatives will need to consider organizational constraints. Typically, these constraints include funding capacity. Therefore, to efficiently utilize available funding, the IRR (Internal Rate of Return) of the various initiatives should be compared. The PI (Profitability Index is the present value of benefits divided by investment amount) is a similar common metric and has the key benefit of always being measurable, whereas IRR can be indeterminate (including for all negative-return projects). It should be noted that an initiative with a negative NPV (and indeterminate IRR and PI < 1) may still need to be undertaken for other reasons (such as regulatory compliance).
Finally, as most management teams have short-term incentives, a very common financial analysis metric is the Payback period. This is the time it is expected to take for an initiative’s cashflow to turn positive. Payback period is at best a rough measure of return and risk but is very intuitive to interpret, thus underpinning its longevity as a common financial analysis metric.
When comparing financial returns, it is imperative to also consider risk. When estimating assumptions provide a range of potential outcomes, statistical techniques and simulations can be performed to assess the likely range of expected outcomes. Standard deviation is a useful measure of variability from the expected return. When comparing initiatives of different sizes, the coefficient of variation (the standard deviation divided by the expected return) allows for ready comparison of risk between projects.
Successful organizations are guided by strategy. Having a clear articulation of an organization’s overall direction and priorities helps all departments align their activities accordingly. The cascade of organizational strategies to departmental goals and objectives should be formally defined. Initiatives are required to deliver these goals and objectives. Thus, when assessing the merits of a business case, its alignment to achieving the benefitting area’s objectives, and indeed the degree of alignment should be explicitly stated. This will help managers pick those initiatives that fulfill their area’s objectives, and therefore underpin the organization’s strategic outcomes and long-term success.
Risk of Commission (Delivery)
Every initiative involves a degree of risk. These include project risk, estimating accuracy risk and systemic risk. When evaluating an investment proposal, management should be alerted to its inherent riskiness.
Project risks are usually identified by a risk register, identifying the nature, likelihood and impact of inherent but controllable project risks. Each risk should then be assessed after the implementation of mitigating controls.
Estimating risk arises from predicting future cashflows. Sponsors are typically optimistic, and statistical techniques need to be applied to ‘worst’, ‘best’ and ‘most likely’ estimates provided to generate realistic cost and revenue distributions.
Systemic risks can be accommodated by applying an appropriate Beta to the organization’s Weighted Average Cost of Capital when discounting the expected cashflows. Strategic initiatives that deviate significantly from an organization’s core business may require an adjusted Beta value to reflect the systemic risk applicable in that market segment.
A consistently determined risk score encompassing all risk elements should be assigned to initiatives so that lower-risk initiatives are prioritized.
Risk of Omission (Urgency)
In addition to the risk of doing, it is also important to consider the risk of not doing. Failure to replace a critical piece of machinery in a production plant, for example, could have significant operating impacts. Failure to invest in new technology could result in a terminal decline of competitive advantage. Failure to invest corporate social responsibility initiatives, may result in permanent loss of support amongst the community.
Urgency is typically represented as a heatmap with the two dimensions of likelihood and impact. The nature of the primary risk will vary by initiative, and urgency assessment risk categories would include: production stoppage, financial cost, opportunity cost, environmental impact, customer service, and obsolescence.
Evaluating Appropriation Requests
All proposed initiatives should be evaluated with reference to their relative ranking score and consumption of financial and human capital.
All scoring dimensions including urgency, cost, benefit, risk and strategic alignment need to be considered when evaluating requests. For most managers, this multi-dimensional analysis is very hard to evaluate conceptually. Consequently, a formulaic approach is required to distil the various dimensional scores into a ranking score. Based on this ranking, the optimal portfolio can be constructed: simply by sorting by rank and drawing a line, or by using more sophisticated theory of constraints based mathematical models.
The recommended method of achieving a comparable ranking score is to assign each dimension a standardised score, and then apply a weighting to each score based on the investment type. For example, a sustenance initiative, will likely focus on urgency of replacement given the risk of failure of the component to be replaced. Growth investments would normally weight benefits highly and include mandatory financial analysis metrics. Strategic initiatives will most like be focussed on both benefit assessment and strategic alignment.
What is certain is that your classification of investment reasons, scoring methodology and weighting criteria for ranking will evolve over time. Whatever methodology is applied, should be easy to maintain, easy to understand, and deliver effective outcomes.
Capital and Overhead Costs
Every investment will incur financial costs, both internal and external. Most of these costs will be fully capitalized from an accounting perspective and depreciated over their useful life. The tax savings of these capital investments will also typically only be recouped in those future years. Many initiatives also have upfront and ongoing operational expenditure requirements to be considered. Whilst these ‘opex’ costs may not be included in the ‘capex’ budget, it is important that they are included in the selection of investment initiatives, as from an economic perspective they comprise the total cash outflow. At the most basic level, once the initiatives for an investment reason (eg sustenance) are ranked in terms of utility to the organization, funding would be distributed in order until the budget (eg for sustenance) for the period in question was consumed.
Human and other Resource Constraints
All initiative should be evaluated in terms of their demand on internal human and other resources (such as facilities and equipment). Whilst not necessarily impacting the final approval decision, awareness of these impact will invariably impact the prioritization and scheduling of initiatives based on these internal constraints.
SAP Investment Management provides basic functionality to record appropriation requests including the rationale for the investment, cash requirements, expected annual return, financial analysis metrics, and relative assessment by investment variant. No standard functionality is, however, provided to calculate these assessments scores or inputs.
IQX CAPEX, however, provides a flexible framework for scoring budget appropriation requests. Scoring templates are highly customizable to an organization’s requirements. Digital collaboration and review ensure the accuracy, consistency, and fairness of assessment of all submissions. Based on the quantified scoring methodology, IQX CAPEX then assists executive management with approving the budget for your most valuable initiatives annually and throughout the year as circumstances change.