There are many pitfalls in the process of capital budgeting. Firstly, this is a strategic process, and the disciplines and culture related thereto must be maintained as in the development of strategy. The process of capital budgeting is also important to understand, especially the method used in evaluation and the principles to be applied. Lastly, as always, there must be an open review of all long-term projects progress to ensure the objectives still meet the original scope and objectives. Allowing failing projects to continue is a classic ‘sunk-cost’ pitfall that results from emotional commitment.
Strategic Review Objectives
The disciplines of business strategy lie in the five key review objectives. These are to ensure consistency, consonance, competitive advantage, feasibility and minimize risk. (See A Common Fail-point) New projects should meet all of these objectives. This is the first step in both evaluation and prioritizing of capital commitments, before looking at the technique used and potential returns.
Spot the difference
Companies often fall into the operational mindset of setting up rules for prioritizing, and let it end there. The strategic process cannot and should not be all about rules. The ‘spirit of the law’ cannot be lost in a bureaucracy. This is the graveyard of all initiative. Remember that the keys underlying business performance fall on innovation and productivity, and how these efforts best meet the five strategic objectives.
The Strategic Change Cycle clearly shows that a company must have two levels of thinking, strategic and operational. These are opposing in nature and are as necessary as the left and right brain functions. The culture related to these two mindsets are also opposed. The pitfall of trying to ‘operationalize’ this strategic process with fixed rules and parameters is commonly found. The focus must remain on flexibility, sound process, and objective decision-making by the owners, based on the right principles. Again, the confusion that arises in the bid for budget, the emotional confrontation that results, and the watering down of due process as a result is a strong reason for using a facilitator. If not, the result is often totally unprincipled. Heuristics, assumptions, ego and divisional protection, and hype are emotional flaws in the decision-making process.
In a business development environment, those involved in the capital budgeting process are unlikely to be accountants. As such their application of the principles will tend to be limited to their understanding. Enter ROI. Using ROI as a priority indicator is a common pitfall, and revolves around the easy understanding of the calculation involved. This is the first level of error but may not be critical if all projects are short-term and measured consistently. The more important aspect involves the make-up of the proposal and justification. Without going into detail, this should include the following: income generated, capital costs, direct related costs only, opportunity costs and savings, tax and depreciation, recoupment and working capital changes, while excluding financing costs. Evaluations of larger projects should be based on cash flow using the accrual method.
Much to the accountants’ dismay not all projects can be measured in profitability and thus be lowered in priority due to a lower potential return. Again, this points to the fallibility of using ROI and an incomplete cash flow analysis. The importance of competitive advantage and risk are fundamental to strategic development, but in the case of capital budgeting, which is often taken down the line, these key criteria are lost in the consideration of priority. The importance of sins of omission can be as important as those of commission. Because acts of commission are easily visible and thus measureable, they remain the focus. However these are often merely symptoms and the treatment of symptoms is expensive and unproductive. We tend to focus on offensive expansion relative in income growth at the expense of defensive projects. It is easy to make the ‘operational’ assumption that business will run as usual, until you are hit by the ‘wanna cry’ virus and your systems come to a standstill. What costs are involved in restoring lost systems? How does that affect overall productivity and for how long? Do you lose market credibility (competitive advantage) as a result of a lack of due process as happened with Enron. Will you ever forget Arthur Andersen LLP?
Understanding and protecting your SCA and/or market differentiating factors is essential. It is difficult to estimate opportunity costs to these situations, but that does not negate their significance. These are strategic concepts and require a different mindset. Strategic issues in the first quadrant must have priority. (See Strategic Change Cycle). These opportunity costs are often catastrophic and must be factored into the equation in a defensive strategic plan.
Probably the most common pitfall is the sunk-cost error. This highlights the importance of a time-based cash flow projection of a project, and continuous go, no-go milestones by which each project is evaluated. Rational decisions should be based on comparisons between future gains and future costs, not their original price. This relates to an improper drawing of mental boundaries (operational thinking). The correct decision is the same as a share trader: you cut your losses once you hit your stop-loss. This pitfall often occurs in large IT projects where the real costs reside in the time invested but are shown below the line, not in the cost itself. Because the potential savings is not classified as ‘income’ in the original evaluation, the cut-off determination point is missing. Project over-runs continue in the absence of a clear project protocols. Again this shows the importance of a cash flow breakdown of all costs involved and the ongoing strategic monitoring of projects.
As in all strategic decision-making and process, the ability to be able to reflect objectively from within the box is difficult. (See Leveraging your Performance). The use of an experienced, independent facilitator to ensure due process and objectivity is the best way to build in a devil’s advocate, ensuring due process and overcoming decision-making pitfalls.