Written by: Richard Frykberg
CAPEX challenges are not new. Capital Expenditure budgets have always been under pressure. The budgeting cycle has always been painful and approvals have taken frustratingly too long. Complex projects will always take longer, cost more, and deliver less than promised. And it’s just got a whole lot worse.
Around the world CAPEX controllers are scrambling to revaluate, reprioritize and reschedule their capital project portfolios because of simultaneous pandemic, war, technology upheaval and extreme weather events.
Here we examine the impact of these events on capital expenditure budgeting and portfolio planning. And look at modern solutions leading organizations are applying to use this period of extreme uncertainty to their competitive advantage. Ultimately, this requires a radical transformation of CAPEX management objectives, systems, and processes.
12 Contemporary CAPEX Challenges
The current challenges impacting effective deployment of capital resources caused by external factors has never appeared so daunting, here we look at each one in detail.
Rapid Rise in Interest Rates
Following a period of extremely low rates as governments sought to mitigate the effects of the pandemic, interest rates are now being raised faster than ever before by central banks around the world. This has two direct impacts on the capital budgeting process: calculation of Net Present Value (NPV) and capital constraints.
All growth investments now require revaluation of their business cases based on a necessarily higher discount rate in the calculation of the NPV of future cashflows. This should improve the relative assessment of shorter-term investments over investments with longer payback periods.
Higher interest rates raise the cost of both debt and equity capital. The pool of available capital funding may therefore be reduced as organizations re-asses their funding arrangements. This will require re-balancing of portfolios, and re-assessment of investment options and budget allocations.
Inflation Impact on Capital Allocation
Interest rate rises are primarily motivated by an urgent need to temper raging inflation expectations in a global economy that was running too hot. Inflation has been driven by temporary pent-up demand and supply side constraints, but also excessive quantitative easing in economies awash with pandemic induced payments and exceptionally low interest rates. It is unlikely to subside any time soon, with inflation expectations the highest in decades.
The impact on capital allocation is felt in the re-evaluation of both input costs and returns. What are the realistic labor costs of the project likely to be now? Will we be able to increase the price of this new product offering? Where inflation expectations have been factored into all business case assumptions, the revaluation of the portfolio may be easy. But many of us have forgotten to take inflation seriously, and that oversight is now coming home to roost as many projects begin to experience cost blow-outs.
The Impact of Increased Energy Prices
Disrupted oil and gas supplies from Russia, and heightened demand from post-pandemic travel, have had a particularly large effect on energy-intensive industries (such as smelters) and at the fuel bowser. Gas prices in many parts of the world have more than doubled, with the supply-side impacts still to be felt in the Northern Hemisphere winter. Increases in operating and transport costs quickly reflect in the cost of everyday items and major equipment.
The dramatic increase of energy costs has impacted many consumer choices (maybe we should have another look at the Electric Vehicle model) and preferred major capital project investments. Oil and Gas projects that previously appeared marginal, may suddenly appear extremely profitable. Solar panel installations are now much more economically justifiable.
Assessing CAPEX Risk in a Recession
Booms can quickly turn to busts. No one is quite sure of whether the Federal Reserve will be able to navigate a soft landing for the US economy, and consequently for much of the world. Uncertainty about the future translates to greater sensitivity to risk, and more conservative investment decisions. Some of those high risk, high potential investments may now be deferred. Rebalancing the capital projects portfolio based on a reassessment of economic conditions and operating risk effectively requires that the inherent risk of each project has already been assessed. Too often, with current spreadsheet-based systems, this is not the case.
Exchange Rate Turbulence
In rough waters, investors prefer bigger boats. This is a major driver of the strength of the US dollar. Conversely, unstable political environments, can lead to a rapid devaluation of a country’s currency as witnessed by the UK with the change in leadership and unexpected lowering of tax rates. These factors are beyond the control of any project sponsor but can still have a significant impact on the cost of any imported capital components or services.
Capital Project Shifts in Supply Chain Disruption
Consumers and businesses alike are well-aware of the supply chain constraints caused by pandemic lockdowns in China and elsewhere. Everywhere deadlines are shifting. Capital projects are starting late and finishing even later. Ironically, this is actually opening up opportunities within the capital projects portfolio. Projects with a quick ramp-up are now being brought-forward as major capital project expenditure shifts to next year.
Capital and Human Resource Constraints
Due to travel constraints and lockdowns, there has been a seismic shift in employment patterns. Vast numbers of employees have exited the travel and entertainment industries, for example, and refilling those positions is proving challenging. The endless supply of technical skills from Asia has dried-up with many technology companies desperate for staff. Good projects tend to fail for one of two main reasons: lack of capital or lack of resources. Human resource capacity is now more constrained than ever. Where the project portfolio does not identify the demand on key resources (eg project managers, business representatives) it is extremely challenging to optimize the portfolio on this key dimension.
Remote Work Drives Digitalization
A lingering aspect of the resourcing changes caused by the Pandemic is the propensity of many professional staff to work from home, even once lockdowns and vaccination restrictions have ended. The practical implication of remote work to effective CAPEX management is in the project presentation and approval process. Boardroom presentations are now virtual and rely more on high-quality business case submissions. Approvals can no longer be given on bits of paper and electronic signatures are now required. Urgent digitization of processes has occurred without digital transformation. For example, the old paper forms have been converted to pdf documents, that are emailed to approvers to sign ‘electronically’. The form is mainly static, the workflow is still effectively manual and sequential. The consolidation and integration of data to back-end systems is still manual.
Technology Spurs Digital Transformation
The pace of technology innovation never slows. For both good and nefarious purposes. We are well and truly in the era of big data and artificial intelligence. Almost everything is available ‘as a Service’. Automotive companies no longer sell cars, but ‘mobility as a service’. Computer manufacturers now provide ‘infrastructure as a service’. Organizations are more ‘virtual’ than ever before. Airbnb provides more ‘accommodation as a service’ than any hotel chain. Capital investments are now less about buying and building things, and more about assembling services. But just when we thought we could ‘lease’ everything as OPEX, new accounting standards require the capitalization of these ‘controlled services’. This really has caused challenges in the preparation of business cases, identifying appropriate delegation of authority roles, and accounting treatment of all these procured ‘services’.
The benefits of all these new technologies are also, however, now available to CAPEX controllers themselves. With the most organizations in the process of transitioning their internal Enterprise Resource Planning (ERP) systems to the ‘cloud’ (such as SAP S4/HANA) the time is right for a digital transformation of the CAPEX process itself. The challenge for these CAPEX controllers is that they are so busy addressing the other pressing challenges of today, they believe they don’t have the time to design and build a better system for themselves.
Security in an Online Workplace
With the devolution of organizations from bricks and mortar premises with dedicated on-site employees, to virtual service networks sustained by technology, security is no longer simply a lock and key. Astute criminals and rogue nation states are deploying advanced technologies to hack into organizations of all sizes to extract commercially sensitive information. Stakeholders have become highly sensitized to the risk of unauthorised disclosure of strategic projects. The challenge for stakeholders is in combining an open culture of innovation and collaboration, with rigorous authentication and authorizations to ensure that everyone has access to all they need to contribute positively, whilst protecting that same information from bad actors. Spreadsheets in a shared folder that are emailed about are not secure.
Weather Impacts Capital Investments
Is it just the media, or is earth experiencing more extreme weather conditions? From heatwaves, to deluges, it appears that earth is struggling to accommodate a massively expanded human population. Extreme weather patterns and inevitable rising sea levels is directly impacting the nature and location of capital investments. From agriculture to accommodation, investments are being reassessed in light of these environmental impacts.
Environment Social Governance
If extreme weather is the consequence, greenhouse gas emissions are the likely cause. From our diet to energy choices, human activity is threatening global warming. Governments are responding with emissions abatement targets. These targets cascade down to organizations to deliver through a combination of mandatory compliance laws and incentives.
Where organizations fail to meet social and community expectations, catastrophic loss of goodwill and clientele can result. Active investors demand that organizations adopt best practice governance principles including gender pay equality, employment diversity, and decision-making probity.
These ESG considerations all present challenges to the traditional methods of project evaluation and selection. NPV of the financial returns is no longer the sole criterium for project selection. Project evaluation and ranking models now need to formally consider the implications for the environment, the community and governance objectives when assessing investment options. Learn more about Capex that supports Net-Zero Emission Targets
Solving Capex Challenges
Whilst the contemporary challenges to a more effective CAPEX management process may seem overwhelming, those same challenges also present opportunities to implement modern solutions. The key features of a modern CAPEX solution are described below.
True Digitalization – Not Just Digitizing
It goes virtually without saying that a modern CAPEX solution needs to be fully digitalized from idea to post-implementation review. This ensures real-time data collection, collaboration and control.
Simply digitizing the process by converting traditional processes to electronic formats is however not sufficient. True digitalization involves harnessing the power of modern technologies to transform the entire process. The nature of the data that is collected. The collaboration and approval processes. The evaluation and scoring models. Portfolio optimization including resource constraints. And, of course, moving from an annual cadence to near real-time agility.
Automate Capex Workflow
A modern CAPEX management system will automatically route CAPEX requests for approval in accordance with delegation of authority policies to ensure compliance. Furthermore, a modern CAPEX management system will enable effective collaboration and endorsement by functional experts. In most organizations, senior executive decision makers rely heavily on the endorsements of these experts and their input should be enabled early and efficiently in the Capex approval process.
Advanced Scoring Models
Organizations need to address the needs of a variety of stakeholders including governments and communities. Investment proposals can no longer be assessed on singular dimensions such as NPV. A modern CAPEX management system will allow for a muti-dimensional assessment and include dimensions such as:
- Urgency (the risk of not doing anything)
- Confidence (the risk assessment of execution)
- Balanced benefit assessment (including both financial and ESG components)
- Strategic alignment (the degree to which a proposed initiative meets the strategic objectives of the benefiting area)
Project and Portfolio Risk Analysis
Project risk analysis is determined by the variability of the expected cost and benefit outcomes of the project. All cost input and return components should identify critical assumptions and provide ranged estimates. Simulations should then be able to be conducted at a project level to determine the likely variation in outcomes.
Portfolio risk analysis will consider the variability of an entire portfolio based on these ranged estimates and variations in common assumptions. This will provide management with insight as to the likely cost and benefit outcomes under a range of exchange rate, interest rate, and GDP growth assumptions, for example.
Transparent Resource Demands
The key constraints to capital project selection are time and money. A modern CAPEX management solution should provide for capturing the demand for both of these components (ideally by month) so that the capital project selection can be prioritized accordingly.
Dynamic Portfolio Optimization
Multi-dimensional analysis is complex for humans. Optimizing portfolio selection considering the dual constraints of time and money is particularly challenging – and unlikely to ever be effectively performed in a boardroom setting. A modern CAPEX management solution will apply advanced algorithms to determine the optimal portfolio (efficient frontier) under a range of potential funding levels. Informed accordingly, management boards can identify both an optimal funding level, and the constituent projects this would entail.
Realtime and Secure Data
Finally, a modern CAPEX solution is based on centralized real-time and secure data. As most project execution activity including procurement, service entry and asset accounting occurs within an organization’s ERP system, it makes sense for the CAPEX management system to be housed in that same environment. This ensures that budget monitoring is in real-time to enable mitigating and remediating actions to be taken early when required. Being based in the core ERP system, also ensures that existing authentication and data access authorizations can be enforced. Learn more about Capex Software and why you need it.
Overcoming Capex Challenges
Spreadsheet-based capital budgeting and portfolio management solutions are simply inadequate in an era of such extreme change. People and data need to be seamlessly connected. Objectives need to be more broadly defined and new measures calculated and aligned. Capex can no longer be planned on an annual cadence but needs to be constantly monitored through the entire idea to asset lifecycle.
Real-time, reliable and secure information is required to reprioritize new urgent initiatives, halt wasted expenditure, and ultimately to optimize strategic outcomes from highly constrained human and capital resources. Ensure you have a deeply integrated and highly tailored CAPEX solution for CAPEX management that will help your organization succeed and prosper whilst your competitors flounder in disarray.