Allocation of capital can be critical to the long-term success of your company. How can you know you are doing the best projects when your company your capital expenditure (capex) is limited?
A recent report from Credit Suisse indicates that the capex of large U.S. companies dropped last year. The top 1,500 listed US companies allocated only 6.1% of revenues to capex. However, a company that spends capital wisely has a tremendous opportunity to build value.
Company cultures where managers are driven to compete for what’s best in their own area of responsibility often do not make the best use of capital resources. I’ve seen plant managers that routinely pad their capital projects. Say installation of a new cartoner cost $400,000 but the potential savings justified spending $500,000. The plant manager might adjust project scope to get the other $100,000. However, that $100,000 likely could be used elsewhere in the company to generate additional savings.
THE THEORY OF CONSTRAINTS
Eliyahu Goldratt’s Theory of Constraints states that any system has a specific constraint that limits increased throughput. On the shop floor, that might be a specific piece of equipment. To get the most out of the system, one must maximize the throughput of the constrained resource.
When capital investment is a constrained resource, projects compete for a limited amount of capex. If a company wants to get the best possible return for capital, every project should be examined to be sure it is giving the best payback per capital dollar invested.
MAXIMIZING Return on Investment
To maximize Return on Investment (ROI), evaluate every project first on its most basic stand-alone component(s). Evaluate every incremental increase in scope separately to see if the incremental cost passes hurdles for approval.
The basic scope and incremental components must always meet minimum standards. These days you wouldn’t buy a car without anti-lock brakes and GPS. Likewise, your company may have minimum expectations for safety, for reliability, for equipment controls and interfaces, etc.
When calculating ROI, every knowable financial impact over the life of the project should be part of the cash-flow model. Life-cycle costs for buying a car would include purchase price, taxes, licensing, gas mileage, insurance, maintenance, offset by trade-in value.
If I were buying a car to commute to work, I might look for a car that gives me the lowest life-cycle cost for one person driving 300 miles per week. That would be my most basic stand-alone component.
An incremental increase in scope might be upgrading to a car I could use for weekend family trips. I’d evaluate the incremental cost to purchase a larger car against the savings not renting a larger car every weekend.
SCOPE IS CRUCIAL
Getting the scope right can make the difference between a project that won’t fly at all and a project that is wildly successful. I had the experience a few years ago of leading a project team with a goal to consolidate contract packaging from multiple third parties into a single location. When analysis was complete the return on investment for the equipment did not meet company hurdles. Internal support was fading fast. Key support functions were ready to drop the project and move on.
We broke the project down into several components that could stand each stand alone, if necessary. By analyzing these components separately, we identified a reduced scope that significantly exceeded company hurdles and was easily approved. The project was implemented and generated significant benefits.
CONCLUSION
Setting the optimal scope for every project will help make sure your company is doing the best projects to maximize ROI. Shive Supply Chain Solutions LLC can help. E-mail us if you are interested in more information.