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Sep 23, 2002
Increased discipline in the capital budgeting process
Value management icon Tom Copeland has an interesting article "Cutting Costs without Drawing Blood". He analyzes that very often value creation by reducing headcount or cutting large projects is less powerful than simply redesigning a corporation's capital budgeting process for small items. Even when this is an expected result (just think of yourself and how you could save the most money in your private life: by driving a smaller car or simply by spending less discretionary money?), the framework he proposes is a good guideline for managers. Read the following summary.
Reasons for Redesigning the Capital Budgeting Process
- First off, a disclaimer, so we avoid some misunderstandings. Tom Copeland defines small items as items involving less than $5m. In the end, this is less important as it seems, small items always have to be defined in terms of overall company size. Furthermore, a pencil is also less than $5m. :-)
- Oftentimes, management focusses on the large projects and cost items, although those usually only involve 20% of corporate costs. Thus, small items (which involve 80% of corporate costs) are usually not controlled at all. Concluding, they can be optimized.
- No consistent controlling of the small items leads to engineers overspending. Most people responsible for small items are engineers and their natural tendency towards highest quality will lead them to always buy the best (read: most expensive).
- Risk-aversion at middle-levels in general will lead to overspending. First, failures at base items will be blamed upon them, but costs are usually accepted. Second, spending less this year might lead to less budget next year.
- Duplication of base items across corporate divisions and departments is not considereed, and thus double-spending often happens.
A New Process for Capital Budgeting: Eight Questions
- Questions to the operations managers submitting proposals
- Is this your investment to make?
Or is perhaps someone else in the company suited better to do the investment?
- Does it really have to be new?
Have the managers at least run alternative investment proposals with used equipment and measure risks vs. cost savings.
- How are competitors meeting compliance needs?
Benchmarking helps to understand what is really necessary.
- Is this your investment to make?
- Questions to the managers reviewing the proposals
- Are there duplicate investments?
Operations have a tendency to create excess capacity. But in a connected company, excess capacity by various departments will often needlessly multiply overall corporate excess capacity.
- Are the trade-offs between profits and capital spending well understood?
Example: "... the engineers replied that the cost of trimming would reduce the company's profitability, while the extra capital investment would not, since it wouldn't appear in the earnings statement!"
- Are there signs of budet massage?
Reductions often won't happen for fear of getting less when really needed. Also, year-end loading of expenditures happens to fulfill the originally requested budget.
- Are there duplicate investments?
- Questions at the end of the process
- Are we using shared assets fully?
Extensive paper trails often discourage sharing of resources across corporate divisions.
- How fine-grained are our capacity measures?
By fine-graining more, oftentimes more assets can be uncovered.
- Are we using shared assets fully?
- Postmortem: Regular audits of units' capital spending
- Include employees from the departments into audit teams.
- Finish each audit with clear recommendations for change.
- Uncover systematic problems by grouping small items.
- Include employees from the departments into audit teams.
Source: "Cutting Costs without Drawing Blood" by Tom Copeland, in: Harvard Business Review, September/October 2000, p. 155-164
Posted by Stefan Smalla on Sep 23, 2002 at 11:27 | Permalink