Summary by Christina Witkowski
Master of Accountancy Program
University of South Florida, Summer 2001
Capital Budgeting Main Page | Investment
Management Main Page
Once a year, the capital needs of major corporations are compiled into a list made by lower management. The division managers look over the list and then forward the list to corporate headquarters. After looking at these lists, it becomes obvious that the needs requested exceed the capital funding for that year. Corporate management finalizes the total capital spending target for the coming year and then allocate the total capital spending target to the various divisions.
Central Question
The author asks the question, "How many times have you heard the saying you have to spend money to make money?" Unfortunately, most companies do not earn a return on net assets equal to or greater than the hurdle rate they set for their capital investment projects. A company’s hurdle rate, ignoring present value, is one divided by the payback period the company requires for its capital investment. The return on net assets at most companies probably does not come close to that number either. The continuing return on assets that manufacturing companies earn rarely exceeds 60% of the hurdle rate they set for approval.
Why is this so? The spend money to make money theory is conservative. A company’s actual return on net assets only considers the factors that can be bought with capital. For example, it is the employees who initiate and execute projects for cost reduction, revenue, enhancement, and capital recovery that are funded out of current expenses.
Return of Capital Investments
If factors unrelated to capital increase profits, what kind of returns are capital investments actually yielding? What then happens is that the financial corporate headquarters increase hurdle rates because they say that the capital projects are riskier. Then the lower management responds by inflating the forecast.
The Solution?
Unhappy with the games between financial office and lower management, top management develops a central project auditing function. The audit function is in charge of 2 functions:
1. Insuring consistency - making sure that the operational people follow policy when preparing cost justifications.
2. Follow up - compare actual to projected project costs and benefits.
The Real Issue
Unfortunately, there are 2 root problems.
1. Operational and financial inexperience - The technical specialist who conceives the project. Ideas tend to be technically sophisticated but operationally or financially inexperienced.
2. Technical and operational inexperience - Those who control cost justification policy tend to be financially sophisticated but technically and operationally inexperienced.
A New Standard
A problem is that technical specialist spend X hours thinking up new ideas and then spend 10X hours on financial analysis. As a result, much valuable analysis time is wasted on projects too weak to survive even basic screening. Today, the requirement is that implementing the idea must improve something, usually standard cost or quality. Maybe the new standard of performance should require that proposed operational improvement projects should make something better without making something worse.
Obstacles to the Proposed New Standard
Cost justification manuals that define allowable costs and benefits too narrowly.
Operational managers with an incomplete understanding of the systematic drivers of costs to benefits.
Technical specialists who do not understand the relationship between technical choices and operational issues.
Troublesome Scenario
Cost and revenue pressures at the general management level points out the need for operational improvements. After reviewing a couple of spreadsheets, the general manager asks the technical specialist to submit a couple of projects. Once the general manager picks one of the projects, he/she tries to get it past the financial stage. This leaves little time for questioning the assumptions and reasoning behind the original idea.
Here are some issues that need to be investigated:
Do your technical specialist understand how their company’s operating capabilities, cost structure, and capital structure can limit or enhance its competitiveness?
Are your technical specialist sufficiently knowledgeable about cross functional interactions to look beyond 1 or 2 obvious direct impacts of a proposal on their company’s operating capabilities, cost structure, and capital structure?
Conclusion
Even though companies go through rigorous financial analysis of future capital projects, most do not make their required hurdle rate or even payback period. The choices that the technical specialists make can either improve or limit a company’s competitiveness. The technical specialist can do this by understanding the details of cross-functional operations.
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