Written by: Richard Frykberg
Capital Project Failure Overview
Capital projects fail due to poor project definition, selection, execution or validation. In this article we look at risk mitigation strategies that can be applied at each of these four stages of capital project delivery.
1. Capital Project Definition
To be successful, all candidate capital investments projects should be well defined to enable management to prioritize the allocation of scarce financial and human resources effectively and efficiently.
a) Align Strategy
Most importantly every new investment should be aligned with corporate goals and strategies. These objectives should be cascaded down through the organization to a departmental level so that even site-based initiatives can be related to the overall strategy.
b) Classify Consistently
To enable comparison, projects should be classified by investment reason (such as sustenance, growth and compliance) as well as asset category (eg fixed, movable and intangibles). The required data collection, evaluation and approval of project definitions should be driven by these dimensions to ensure that relevant expert opinion is garnered, and fair comparisons are made between similar alternatives.
c) Identify Options
Identification of a range of options is one of the most effective ways to ensure an optimal investment strategy. To address any perceived problem or opportunity, there is almost always a range of possible approaches, each with a different cost, benefit, and risk profile. By defining the major options, decision makers can select the option most aligned to their priorities and constraints.
d) Range Estimates
Invalid estimates of both costs and benefits are a primary cause of capital project failure. Whilst detailed analyses can produce sophisticated financial metrics, there is often little attention given to the reliability of the underlying assumptions. Therefore, at the very least, all estimates should be provided as ranges from the worst case to the most likely and best-case outcomes. In this way, potential variability of results can influence the project selection. For example, if two initiatives have similar benefits and costs, but one involves untested technology and suppliers, and consequently has a much higher variability of costs, then the other more certain project should be prioritized.
e) Use Templates
Where project definitions and business cases are freeform, they are likely to reflect significant quality differences. Missing information will require extensive follow-up and procedural delays. Inaccuracies in spreadsheet calculations are rife. Administrative overhead is high to review and standardize inconsistent metrics. These risks can be overcome by utilizing digital templates that adjust based on the nature and value of the investment. They should be easy to use, requiring just the right amount of data collection to enable decision makers to form a valid judgement. To encourage innovation, ideas should be relatively easy to submit. However, as initiatives pass the various evaluation stages on their way to a well-formed business case, additional information should be appended. It is simply not efficient to develop every idea into a business case, and an effective means of prioritizing initiatives is thus required to ensure that resources are expended on initiatives most likely to be approved.
f) Assess Risk
All initiatives involve risk: the risk of not doing (omission), and the risk of doing (commission).
Another way of expressing the risk of not doing is urgency. Replacement initiatives are urgent when the likelihood and impact of failure of a component is likely to be significant. Savings initiatives are urgent when significant opportunity costs are likely to be incurred. Growth initiatives are urgent when failure to act may result in a significant impact to competitive advantage (by not investing in new technology, for example). The assessment of urgency (risk of not doing) is ideally captured via a risk assessment heatmap.
Delivery or implementation risks typically consider aspects such as familiarity with technology, contractual certainty, organization change management, and scheduling inter-dependencies. These risks should be quantified for relative assessment across projects.
Any specific project risks should be explicitly listed, and mitigating actions identified prior to being approved.
g) Score & Rank
To ensure the fair and transparent assessment of proposed investment initiatives, a formalized scoring and ranking methodology is recommended. This won’t stop pet projects being approved by management, as subjective judgement is always part of the evaluation process. But an objective scoring approach, will certainly help focus resources on initiatives that indicate a high-ranking score, and keep debate focussed on the initiatives near the boundary, rather than those at the top or bottom of the list.
2. Capital Project Selection
A primary source of capital project risk is selecting the wrong projects or neglecting to do the right projects. In this section we look at risk mitigation techniques for effective project selection.
a) Efficient Frontier
As with any financial planning portfolio, a capital project portfolio should contain an appropriate mix of large and small, high-risk and low-risk initiatives. Without including a few high-return projects in a portfolio, an organization is unlikely to achieve its target growth rates. Without investing in new technology, the organization will lose its competitive advantage. Organizations cannot avoid risk, and indeed must take on an appropriate degree of risk to succeed. What is important is that they have an appreciation of the risk profile of a project, and that their portfolio of projects lies on the ‘efficient frontier’, in that the anticipated potential return cannot be achieved at lower risk with a different portfolio of projects. In a well-balanced portfolio, unique project risks can be diversified, and the systematic risk of the portfolio can be determined with reference to market benchmarks for projects of a similar nature.
b) Optimize Funding
Cost is typically the key constraint in selecting a project portfolio. Consequently, projects should be compared based on their projected return on investment, and not simply their net present value. It is essential that the cost of capital is factored into the funding evaluation and that all cash flows are appropriately discounted. A PI (Profitability Index) can be determined for each project by the ratio of its net present value to the project investment. The greater the PI, the more efficient is the return on capital. The key benefit of PI over IRR (internal rate of return) is that risk adjusted discount rates can be applied to the individual investment and return cashflows. Practically, a PI is aways calculable, whereas IRR cannot be determined for all projects.
c) Optimize Resources
Whilst several smaller projects with high PI’s may provide an optimal return on scarce capital than a single large project, the next dimension to portfolio optimization to consider is the demand on scarce internal resources. Internal resources include people, plant, materials, and equipment. Many projects fail because key internal resources are overloaded. A more confident project portfolio outcome can be achieved by limiting the number of projects undertaken to ensure that the demand on all internal resources is carefully balanced with their supply.
d) Optimize Time
Active scheduling of projects is essential to optimize funding and resourcing constraints. Capital funding may be bound by fiscal year. Human resources take summer vacations. An optimal project portfolio considers funding and resourcing over time to accommodate these constraints most efficiently.
e) Reprioritize Regularly
Ideation doesn’t happen in neat annual cycles. Health, safety and environmental conditions are inherently unpredictable, as the recent pandemic and extreme weather conditions have taught us. Technology marches forward relentlessly. Thus, an optimal portfolio requires active management. Lower priority projects should be suspended when higher value opportunities present themselves. The only relevant timeframe for planning is the future. So, whilst money, effort, and reputations may already have been invested in a specific initiative, these must always be considered as sunk costs. Typically, remaining costs decrease over the project lifespan, increasing the anticipated PI accordingly. Unknowns are addressed, and risk should reduce throughout the project. Good project definition and selection should result in successful execution. But if ever a new initiative promises an even greater return under the same constraints, that new initiative should be seized in preference to an existing initiative without qualm or favour.
3. Capital Project Execution
Well defined projects, that have been appropriately selected for execution can still fail to deliver the expected benefits, at the expected cost, in the expected time frame. Techniques for risk mitigation of project execution failure are outlined below:
Successful capital project execution relies on effective monitoring to identify issues early and to enable risk mitigating action to be taken. Poor quality analytics are a result of data collation delays, inconsistent classifications, and unmanaged data sources. In one word: ‘Excel’. Any capital project analytics solution that relies on spreadsheets for data collection, aggregation, storage and presentation is extremely high risk. Spreadsheets are littered with formula errors. Re-keying data inevitably results in errors. Spreadsheet data sources are easily corruptible. Realtime actionable detail is typically unavailable. Therefore, a critical control to ensure effective project monitoring is a single source of truth. This should be an organization’s SAP ERP system.
Manual application of business rules is similarly error prone, unreliable, and inefficient. Wherever possible, business rules such as data entry validations, classifications and workflow approval policies should be automated to ensure continuous operation and effectiveness.
Manual rekeying is fraud and error prone. Your capital project management should thus be deeply integrated with your financial control (eg SAP ERP), project planning (eg Primavera), procurement (eg Ariba) and Contractor Management (eg Fieldglass) systems.
The maxim ‘trust the experts’ is particularly relevant to high-value capital project investments. Executive management are unlikely to have the relevant expertise to assess cost, benefit and risk assertions contained in an investment proposal. Consequently, it is imperative to obtain technical endorsement from the experts: domain (eg IT), financial, procurement, engineering, people and culture. Ultimately it is the endorsement of experts that executive will rely on more than all the technical data captured and presented.
The purpose of budgeting is to set hard procurement limits on an initiative. This ensures that any variation in expenditure levels is assessed and authorized. Budgets should be set by fiscal year, as it is not only the amount, but the timing of the delivery that should be monitored. Budgets should also be devolved to a practical level of control. Whilst it is typically unfeasible to budget at the lowest level of a work breakdown structure, as estimating necessarily results in offsetting variances, distributing budget to level two or three of a project structure is typically considered best practice to balance tight financial control and the flexibility for efficient project execution. Additional budget requests, or budget transfers, need to be able to be efficiently handled and appropriately authorized. Supplementary budget distribution approval levels should balance materiality (this is only small adjustment) and the inherent risk of ‘scope creep and death by a thousand cuts’ – a lot of small variations ending up as a big one.
Forecasting is a critical aspect of capital project execution. Looking backwards doesn’t help: only the future can be changed. Making it easy and efficient for the person responsible for a project to maintain the project forecast is vital to enable mitigation. Where projects are being delayed, it may be possible to bring other projects forward. Where projects are over-running, it may be appropriate to assign additional resources. Where anticipated project benefits are diminishing, it may indeed be necessary to stop the project and reallocate cash and human resources elsewhere.
g) Project Performance Indicators
In addition to financial measures, qualitative project health indicators should be updated. These include quality, scope, risk, and human dimensions. Only a balanced scorecard of financial and qualitative measures can really help mitigate project risk effectively.
4. Capital Project Validation
Business cases all contain rosy assertions of anticipated business benefits. Costs and risks, due to our human nature, are frequently underestimated. Project validation ensures that project outcomes are formally assessed, and lessons learned. And simply, knowing that a project will be assessed, keeps all participants honest.
a) Conduct Post-Investment reviews
Have a policy and process for conducting post-investment reviews. Ideally this includes 100% of projects, but even a value-weighted random sample is an important start. To be measurable, benefit exertions should be explicit and quantifiable. Even ‘qualitative’ benefits can be measured. Consider customer and internal surveys or time and motion studies to validate the anticipated benefits. Of course, with a thought to validation, these metrics need to be gathered both before and after project delivery. Therefore, the measure and assessment technique should be plainly documented in the proposal.
b) Validate Risk Mitigation Outcomes
Financial outcomes are typically easier to measure. Qualitative outcomes can be surveyed or studied. Risk avoidance is far harder to assess. If the project was intended to mitigate risk, and it never happened, was the project successful or lucky? Due to this difficulty of measurement of actual occurrence, the best measure of risk-based sustenance measure is a residual risk assessment. If this can be independently assessed, then the value of risk mitigation can be determined. The reduction in likelihood of occurrence or the reduction in impact of a risk can then be evaluated and compared to the cost incurred.
c) Learn and Adjust
Where outcomes are not achieved, organizations should learn where they went wrong. Was it the assumptions? Was it the scoring? Was it the approval process? Was it this execution? Was it the risk management? Continuously learning from experience is the most effective way of avoiding making the same mistake again in the future.
The business case for improving your capital project system is typically based on reducing project failure. Understanding and mitigating the underlying source of failure in your portfolio will assist with prioritizing your risk mitigation strategies.
SAP ERP provides excellent core capabilities for investment management and project control. Often the system is not, however, fully leveraged due to usability, workflow optimization or licensing cost constraints. Project definition and portfolio management is often performed in third party systems, including spreadsheets. Investment reviews are seldom systematically supported.
IQX CAPEX closes these gaps by providing a seamless and fully integrated capital management solution from idea to value realization. Project definition, selection and validation are performed in the online Stratex component which is both ready to run and highly flexible to accommodate your unique methodology. Project execution is managed close to your SAP system leveraging a suite of Fiori Apps that work out of the box and can also be highly tailored to your unique interface, workflow and integration requirements. Together, IQX CAPEX will greatly mitigate the inherent risks of project failure to ensure that your business strategies are efficiently and effectively delivered.