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Cranfield School of Management

New research looks beyond the application of financial appraisal techniques to examine the efficacy of other elements of the process.

The adoption of the discounted cash flow (DCF) approach for evaluating capital investment projects has been one of the major advancements in management accounting in the past 75 years. Much of the credit for its emerging popularity since the 1950s has been given to Joel Dean, whose 1954 Harvard Business Review article first stimulated application of the technique in preference to the commonly applied return on investment (ROI) method developed in the early 1900s by DuPont Corp.

However, the approaches used by firms to appraise capital budgeting proposals must be one of the most over-researched areas of the application of management techniques. A plethora of surveys, especially in the United Kingdom and the United States, have exhaustively researched and analyzed the techniques most commonly applied and have identified the adoption trends over time. Our research of the literature identified 19 such studies.

Survey after survey, over the past 30 years, has essentially demonstrated the ascendancy of DCF-based methods, predominantly the net present value (NPV) and internal rate of return (IRR) techniques. Whereas this trend is true of large companies as a whole, there are significant variations in the level of take-up among smaller companies and within different industries and countries. Simple payback (which excludes the time value of money and the cost of capital) is still an extraordinarily popular method.

Many companies also apply multiple techniques to the problem, which would imply that they have not yet settled on a standardized, let alone optimized, format for evaluation. For smaller companies, too, much store is still set in the application of intuitive managerial judgment. Where broader-based surveys have been conducted, an emerging trend is the application of nonfinancial measures to supplement the financial numbers.

Despite its popularity, DCF isn’t perfect. Our literature research uncovered some critical dilemmas. One significant problem is that of forecast accuracy and the tendency of managers to game the system in order to come up with the right answer for project approval, regardless of whether they believe their forecasts are achievable. Head office countermeasures to this tendency typically include the setting of artificially high hurdle rates, which may also mean that genuine opportunities to add shareholder value are missed, and the conduct of post-investment audits, which may be perceived to be bureaucratic but, when regularly applied, seem to have a positive psychological effect on the overly optimistic biasing of cash flow projections. More importantly, focusing on only a return on capital measure can constrain growth or destroy shareholder value.

Furthermore, some organizations approach different kinds of capital investment in different ways. In particular, there are consistency issues surrounding so-called strategic investment decisions (i.e., top-down initiatives, as opposed to bottom-up proposals), including those for information technology systems and investments in the development of longer-term organizational capabilities.

Sound risk management principles are an essential component of the capital planning process. Uncertainty risk — e.g., business cycle, commodity prices, foreign exchange, and interest rates — is the most usually heeded category of risk. The most widely used technique to assess its potential impact is sensitivity/scenario (what if) analysis. However, it is a matter of some concern that the second category, implementation risk, appears to be seldom addressed. Organizations tend not to assess whether they are well-equipped to deliver their projects.

Despite the hubris surrounding the use of DCF-based techniques, their adoption is clearly not the panacea to developing excellent capital planning processes that some of the prior research might lead you to believe.

Identifying Research Gaps

So, why conduct yet another research survey on the subject of capital planning? As we have noted above, the problem with the majority of the research done so far is that it focuses excessively on the application of formal financial methods instead of the process itself.

Perhaps the most obvious untilled, or at least only partially cultivated, ground are the questions of:

• The relevance of non-investor stakeholders to the process;
• The use of nonfinancial measures to aid project appraisal;
• The use of alternative approaches for capex timing and project staging;
• The consideration of critical implementation (as opposed to just uncertainty) risks; and
• The application of post-implementation audits toward continuously improving the capital planning process.

We’d like to know, too, for example, to what extent company executives are satisfied with their existing capital planning processes and what specific aspects they would most like to see improved. Further, what are the factors that most differentiate the best from the mediocre?

The Capital Planning Framework

We first developed a conceptual framework of best capital planning practices. This framework is intended to aid understanding of the whole capital planning process (see Figure 1).

Figure 1: The Capital Planning Process Framework

The left side highlights some of the most common stakeholders that organizations need to consider in formulating strategies and operating plans and how they will go about satisfying their future wants and needs. Clearly, capital planning must be closely linked to strategy implementation in relation to an organization’s multiple stakeholders.

The right side shows some of the most common outputs from capital investment programs that have been designed and implemented to satisfy these various wants and needs. In between is a schematic that illustrates the essential input and output components of the capital planning decision-making process. Finally, post-implementation audits should drive continuous improvements of the capital planning process.

Using the framework as a basis, we designed a questionnaire survey. Then, between September 2002 and January 2003, Cranfield’s Centre for Business Performance and the Accenture Finance & Performance Management service line collected data relating to European respondents’ perceptions of their organization’s capital planning process. The questionnaire sought (mostly finance) executives’ views of various key aspects of capital planning and asked them to confirm whether they conducted post-investment audits and, if so, for what purpose. They were also invited to comment on future initiatives and recent innovations.

Survey Results Analysis

Overall, firms gave their capital planning process a score of 5.8 out of 10; and all respondents gave their organization a score of between 3 and 8.

The elements that respondents like most about their firm’s capital planning process are:

• The capital planning process is aligned to strategic intents;
• The capital planning process is linked to the firm’s budgeting and other performance management processes;
• The focus is on building longer-term capabilities for sustainable performance improvement, rather than always on short-term returns; and
• Financial discounted cash flow techniques (like NPV, IRR, etc.) are used to appraise and evaluate capital investment project proposals.

Conversely, the elements that respondents disliked most are:

• The level of gaming involved;
• How IT investments are handled;
• How executive incentive bonuses impact on investment decisions; and
• The way implementation risk and uncertainty risk are treated by the project appraisal process.

About 44 percent admitted their firm seldom conducts post-investment reviews. Only 10 percent believe that their firm always conducts them, while 46 percent said that they are usually conducted. When they do get done, the primary intentions are perceived to be to learn lessons from investment decisions and to improve forecasting. Fewer respondents think it’s intended to help improve the firm’s capital planning process.

We also found a wide spectrum of financial evaluation techniques are applied by companies, with broadly equal application of the most popular payback, net present value, and internal rate of return methods. These were closely followed by the only slightly less popular return on investment, earnings impact, and discounted payback techniques. Many firms apply multiple methods.

Best Practice Comparison

Absolute satisfaction scores are one aspect of this study, but what are the key contributory factors that most distinguish the overall perception of firms with the highest level of satisfaction (i.e., the upper quartile) from the rest? What are the biggest differences? Is there less gaming involved in the better companies? Do they have better approaches toward IT investments? Do executive incentive bonuses have a less overt impact on investment decisions?

The answer is no. These factors are essentially common to both groups (i.e., there is some differential, but it is relatively low). The top five factors that appear to differentiate the perceptions of good capital planning processes are:

• The way that all capital spending proposals are evaluated consistently (i.e., rather than so-called “strategic investment decisions” being treated separately).
  
• The way that uncertainty risk is treated by the project appraisal process.
  
• The way that the capital planning process addresses the wants and needs of multiple stakeholders, not just those of the shareholders.
  
• The way that nonfinancial measures (such as customer satisfaction, employee attrition, and market share) are appropriately used to support proposals.
  
• The breadth of what is included (e.g., inclusion of brand investment and other intangibles) in the capital planning process.

There is also a significantly greater tendency to conduct post-investment reviews — 78 percent of the upper-quartile firms always or usually apply them versus just 50 percent for the rest.

Anecdotal Evidence

The survey also allowed respondents to freely select and describe the aspects of their firm’s capital planning process that they would most like to improve. It provided an optional facility to describe what their firms had already done to improve their process, too. While these inputs produced a wide diversity of opinion and activity, some clear themes did emerge.

Among the wish list of things executives would most like to improve, the most frequently mentioned categories (with relevant quotes about each) were:

Linking the Capital Planning Process to Strategy

• “Better align capex planning to strategic plan.”
• “Make it into a strategic decision level rather than simply a budget artifice.”
• “Link the capital planning process to business improvement and strategy initiatives.”

Ensuring More Rigorous Reviews

• “Improve project selection to prioritize the best-for-business projects — often suboptimal decisions prevail because they are better presented.”
• “Get people to acknowledge that the financial appraisal is a desktop model based on individual assumptions — the assumptions can be formed to influence the outcome.”
• “Vigorous challenging of commercial assumptions.”

Evaluating Risk in Different Ways

• “Evaluation of risk — both making the investment and in not making it.”
• “Nonfinancial factors need to be appraised.”
• “Look at measures that are not just financial.”

Improving the End-to-End Process

• “Streamline decision-making process.”
• “Improve post-implementation reviews.”
• “Get a more consistent groupwide process — with fair rationing.”

A number of organizations said they’d made significant progress in improving their capital planning process. The types of initiatives that dominate are:

Centralizing Group Capital Planning

• “Started to plan centrally rather than each department constructing their yearly wish list.”
• “Set up a groupwide investment review panel and group delegated powers.”
• “Business process leaders allocated at board level with responsibility for total process — removes structural barriers.”

Standardizing Approaches and Formats

• “For capex over a certain limit, we require a business case which must include NPV calculations and earnings impact summary prepared on an agreed format/assumption basis.”
• “Having common rules for all divisions concerning the profitability of an investment.”
• “Standardization of financial techniques used to appraise investments.”

Implementing New Procedures

• “Implemented a ranking tool for all types of capex — a good way for applying limited resources.”
• “Introduction of peer reviews of project from other division/corporate.”
• “Post-investment appraisals are now carried out on all investments over $1 million. This has proved to be an invaluable exercise.”

One company claimed it had reduced the level of gaming but, unfortunately, did not elucidate on how it had managed to achieve this elusive prize.

Conclusions From Field Research

Clearly, most organizations are not particularly satisfied with their capital planning processes (generally low satisfaction scores) and many recognize that there is room for improvement (witness their current initiatives and wish lists).

However, it appears that the things that executives dislike most about their capital planning process are, perhaps not surprisingly, also the ones that are most difficult to rectify. For example, those that rate their capital planning process relatively highly tend to register only low gains in the level of gaming and the approach to IT investments.

Coming to grips first with some of the basic elements of the process that seem to make the most difference would seem to offer the best route to process improvement. Evaluating all capital spending proposals inclusively and consistently, treating risk management more rigorously, taking into account multiple stakeholder requirements, applying nonfinancial measures to support the traditional financial ones, and institutionalizing post-investment reviews are all relatively straightforward improvement initiatives to implement.

The evidence indicates that such initiatives make the most impact toward improving process effectiveness. Nevertheless, we still have some issues relating to optimizing the efficiency of the process. For example, it concerns us that so many different project appraisal techniques are being applied in parallel — this cannot be efficient.

The initiatives that some organizations are currently applying go some way toward achieving these aims: centralizing and segregating the process from local budgeting decisions; standardizing approaches; implementing new procedures; and improving risk analysis. However, from the evidence we have assembled through this survey, such initiatives appear to be sporadic and far from universally applied.

Excellence Principles

Through this pioneering study of the capital planning process, we now do have some clues as to what major elements of the process make the most difference. We suggest that, as a starting point for setting the agenda for further research and development in this field, some fundamental principles need to be established. As a minimum, we believe that these should include the following essentials:

1. Capital planning decisions must be guided by and be closely integrated with corporate and/or business unit strategy execution;

2. Capital project proposals must be subject to rigorous risk-assessment processes before final investment decisions are taken. Forecast uncertainty testing and implementation capacity review are foremost among these. All types of capital spending projects should be included in this process (“strategic” and IT investments not excepted);

3. Most such project proposals will need to demonstrate positive cash flow returns over a given period of time and, therefore, the cost of capital and the value of money over time need to be included consistently in this financial modeling calculation;

4. Other project proposals (e.g., for infrastructure items) may need to be evaluated on the basis of the risks — and, therefore, negative cash flows — they realistically could attract if they were not implemented. These may be no less important to creating and maintaining the firm’s reputation;

5. Capital planning needs to address multiple stakeholders’ points of view (not only the short-term demands of investors alone) and, therefore, project proposals should be supported by relevant nonfinancial data and forecasts;

6. For larger investments, the alternative options for capital spending timing and project implementation staging need to be properly evaluated, too.

7. All capital plans need to have measurable outcomes (however difficult this might be) so that progress and value realization can be tracked over time both during and after implementation. These should be defined as part of the capital planning process.

8. Continuous process improvement and learning from past mistakes isn’t optional — it’s a necessity. This needs to be documented and, where appropriate, included as part of staff training materials.

Capital expenditure planning is a vital process for almost all organizations. Its proximity to strategy execution needs to be fully recognized and, therefore, the need for good risk mitigation fully appreciated. The opportunity for improvement appears to be considerable. This essential process can deliver more predictable benefits realization and so, ultimately, create better value for the organization’s stakeholders over time — not least of which are its investors and providers of capital.

About the Author

Title: 

Director of the Centre for Business Performance

Cranfield School of Management

Andy Neely is director of the Centre for Business Performance at Cranfield School of Management, professor of operations strategy and performance, and managing partner of The Performance Practice. He has authored over 100 books and articles.