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Spending Capital as if It Mattered

Infrastructure challenges are redefining utility capital-planning methods.

Fortnightly Magazine - May 2007

persuasively calculated in advance, and few projects of any description come with ironclad performance guarantees. Promising innovations can be justified in many cases only on their option value—a legitimate basis for funding—so long as the downsides are understood, the exit strategies are identified, and the options are managed in a timely way. A portfolio of capital initiatives ideally will comprise ideas in various stages of viability. Gating criteria will set standards for moving projects from one stage to the next, jettisoning expired or negative options while nurturing those whose option value grows. Smart companies revisit the capital budget throughout the operating year to reassess current needs and priorities compared with those established under circumstances prevailing months earlier.

The Performance Dimension

The value created by the capital plan is a function of both the choice of projects to fund and the manner in which those projects are managed. Yet once the capital allocation process has assigned a given budget to a given project, the responsible executive committee normally assumes that its work is done and that the budget will be spent fully. To the extent that managers subsequently are held accountable, it is to the budget, not to the value created. Going forward, the implementation of the capital plan needs to be much more closely aligned with the strategic and financial expectations that have shaped the plan.

Once it is understood that the capital plan is not simply a set of discrete budgets and timetables, but a portfolio of value-creating initiatives, it follows that the capital-management process should encourage project managers to focus on value creation. All else being equal, every acceleration of cash inflow, and every delay of cash outflow, adds value. Project managers should be rewarded for creativity and success in finding alternative methods for accomplishing tasks—in searching for unit-cost reduction opportunities, exploring least-cost methods, designing “fit for purpose” standards rather than gold-plating, and sharing resources with other projects.

In most companies, the primary constraint on capital planning is not availability of funds; it is the organizational capacity to manage capital projects. While managerial “bandwidth” can be expanded over time, it is relatively fixed in the short term. Credible forecasts and informed feedback are difficult to achieve when the managerial pipeline is choked with an over-ambitious schedule of projects. The company needs to ask itself: How much spending activity can we effectively manage and track? Who will be providing financial control, forecasting cash outlays, and monitoring progress against initial value assumptions? What is our track record for meeting project deadlines, and how should that shape our expectations and commitments? Do we need to take special steps to revive and enhance our project management capabilities or possibly utilize third parties?

Feedback loops need to be constructed between project management and portfolio decision makers—not just for annual “lessons learned,” but for ongoing portfolio monitoring and adjustment. Option value is purely academic unless options are supported by a willingness to exercise them when circumstances indicate an economic advantage in doing so. That willingness implies openness to mid-cycle course corrections, the kind of flexibility that