Academic journal article The McKinsey Quarterly

How to Trim Capital Spending by 25 Percent

Academic journal article The McKinsey Quarterly

How to Trim Capital Spending by 25 Percent

Article excerpt

Do you have a culture of capital entitlement?

Driving up hurdle rates won't fix the problem

We offer some ways out of the "doom loop"

Want to know if your company is using its capital productively? Then ask yourself (or better still, your business unit leaders) a few questions. Do your business units rely heavily on capital spending to improve performance? Are rates of return below what was promised during project evaluation? Do divisions have to spend all of this year's capital budget to ensure funding for next year? Is there any explicit accountability for capital spending? Do big capital projects receive less scrutiny than ongoing operating expenses? And is capital spending linked with strategy?

The management of capital investment has an enormous effect on profitability and competitiveness, yet few companies do it effectively. We believe that the use of evaluation tools, disciplined processes, and best practices can help companies trim capital spending by up to a quarter without reducing capacity or functionality - and improve their operating costs and revenues through better investment decisions.

So for those who answered yes, yes, yes, yes, no, yes, hmm . . . maybe not, here follows a guide out of the capital "doom loop" in which senior management loses faith in the capital allocation process, sets project hurdle rates above the cost of capital, limits investment, and ultimately undermines the company's competitive position [ILLUSTRATION FOR EXHIBIT 1 OMITTED].

The stages of capital spending

The road to capital productivity begins with a tight link between capital spending and business strategy. It is paramount that companies understand at the outset a capital project's impact on cost structure, profitability, and competitive position. Early definition of scope and rigorous project evaluation are essential to maximizing financial returns and managing risks, yet few companies put in the time and effort required to perform these tasks (Exhibit 2).

[TABULAR DATA FOR EXHIBIT 2 OMITTED]

If a project goes ahead, execution must be world class to maximize the value created. This typically calls for ruthless control to stop the project escalating, along with superior project management. Any deviation from the approved scope should be treated with the same rigor and return requirements as the original project. In addition, mechanisms should be put in place so that individuals constantly challenge the myriad decisions that can affect the total installed cost of a project. Areas often overlooked include order expediting, built-in equipment redundancy, and equipment purchasing practices. Finally, proper performance measures are needed to optimize spending and to encourage and reward the right behavior in employees.

Pre-investment planning

Pre-investment planning is about justifying the need for investments and deciding on their timing. This may seem obvious enough, yet few companies are able to articulate the strategic value of their capital investments or recognize the latent capacity in their existing plant and equipment. Devising a facility plan that specifies a plant's technical capabilities, intended markets, and future strategy creates a clear link between corporate strategy and capital investment, and is especially useful when a company has many plants. The facility plan provides the basis for making fact-based tradeoffs concerning capacity and product mix investments between plants. Such a plan also provides a framework for organizing and ranking large capital expenditures.

Before they invest, companies should ask themselves three key questions: Is there a real need for this project?

Establish that there is a genuine business need for the investment, that it supports corporate strategy, and that it will enhance the company's competitive position. Consider alternative solutions and "debottlenecking" options. One pulp and paper manufacturer planned to spend $500,000 to replace a winder machine identified as the cause of many stoppages. …

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