Capital expenditures or ‘capex’ are at the heart of any industrial company’s future. Unfortunately, though, based on our work with leaders around the world, we have found that the way their companies make capex decisions is completely wrong. The problem is that companies analyze capex projects the same way they have since the 1960s. In other words, nothing much has changed in more than half a century.
Here’s one of the most important factors that companies get wrong: they fail to make capex decisions based on long-term strategy goals, or within the broader perspective of their total production footprint, their customer expectations and the overall marketplace.
Instead, when a given site or plant makes a capex request, that request is judged only in terms of the anticipated change in cash flow of making—or not making—the investment in isolation. As a consequence, capital is likely to continue to flood into a site that may barely be breaking even without anyone considering that site’s long-term future. At the same time, investments in sites that are newer and more efficient is less likely because the capex project’s incremental increase in cash flow as the result of those investments is smaller. This is how poor companies go bankrupt. They spend their last dime on their worst assets because that’s where they believe they will get money back the fastest.
Compounding the problem is that leadership often mis-categorizes production sites—for example, perceiving the worst sites to be better than they are, and even viewing star performers as dogs. These errors stem from using conventional performance measures, rather than a more holistic lens. It is simply not possible to understand the system contribution of a specific production site by looking at its profit and loss or cash flow statement in isolation.
Moreover, as John Williams, CEO of Domtar Corporation points out, “a lot of capital allocation is based on emotion. It’s not fact-based. There are capex analyses but those are seen as just a tool, if you will, as part of the decision-making process.” He calls this the “sordid little secret,” and we wholeheartedly agree.
So what is the answer, instead? The solution is a coordinated, top-down strategy built on an economic model of the company’s entire production system instead of looking at capex decisions in isolation. By looking at capex holistically, leadership will be better positioned to identify value-creating opportunities and to avoid those that destroy economic value. Leaders will be able to determine which project combinations will result in the greatest amount of long-term company cash flow.
We have worked with dozens of companies to implement this approach, which has increased clients’ cash flows a minimum of 20% and, in some cases, as much as 100%. Our method views production as something a network of sites does—rather than something a site “does on its own.” Instead of seeing mills, plants and factories as independent assets, we view them as tools to accomplish the aim of the system: sustainably maximizing company operating cash flow.
Another way to look at this is this: Instead of a reactive approach to capex needs (which is, by and large, how most companies operate), a company should be driven by a proactive, long-term strategy designed to take advantage of the unique opportunities within (and often outside of) an existing portfolio of facilities. Our approach to capital budgeting decision-making doesn’t view whether a capex project is a good decision or a bad one. That’s too simplistic a view, and companies lose substantial amounts of money with that perspective. We create an economic model of the company’s entire production system, then rank whole collections of capex decisions against each other. Instead of asking whether the company should pursue a capex project, we embed the project in a larger series of capital allocation decisions, then ask, “Does this chain of decisions make the system perform better or worse than another chain?”
It’s also important to assemble the right project teams that will be able to make these kinds of strategic capex plans. These teams must include experts from engineering, supply chain management, raw material procurement, controlling, marketing and sales. Depending on the industry and company, the project team might also include energy experts, sustainability experts, logistics, etc. Key leaders must be involved as well. Experience has taught us that this team must absolutely include the CEO of the business in question; otherwise, the often-controversial findings will not be implemented, and no value will come from this process. Our method only works effectively with buy-in all around.
Ultimately, companies cannot afford to invest to keep all their sites competitive when in truth a site has become a financial drain and lost its ability to compete. Allocating capital is at the heart of a company and the way it’s spent now is like slowly building up plaque in your arteries year after year. In contrast, using the correct, counter-conventional approach can uncover vast opportunities. Capex decisions are more than simply approving and prioritizing projects. A true capital allocation strategy transforms the core of the company, impacting every other facet of the organization. Companies that succeed in the long-term implement capital allocation decisions that consistently generate net value creation, overall.
