Capital spending (CAPEX) in most organizations is planned and controlled through a Capital review process. In the process, a Capital Review Committee reviews, evaluates and prioritizes funding requests for capital acquisitions and capital projects.
The primary outcome of the process is the organization's capital budget for the budgeting period. The capital budget, moreover, specifies a capital spending ceiling,which typically does not permit funding all funding requests that are submitted for the period. This means that different capital spending proposals must compete with each other for favorable prioritization by the Review Committee. As a result, lower priority proposals may not be funded after the CAPEX spending ceiling is reached with higher priority proposals.
Explaining Capital Review Process in Context
This article further defines and illustrates appreciation and related terms as they appear in financial accounting and business generally. Terns such as the following have to do especially with the value of assets:
- What is a capital review process?
- Who is responsible for the Capital Review Committee and where is the Committee located in the organization?
- How do Capital Review Committees evaluate and prioritize capital spending proposals?
- What is the role of the business case in the capital review process?
- What must those submitting capital spending requests understand?
Capital budget planning is usually accomplished by a Capital Review Committee, working closely with the organization's Budget Office.
- In some organizations, the Committee is in part of the Budget Office.
- More often, however, the Capital Review Committee is organized by, and responsible to, the Chief Financial Officer. This is because capital acquisitions and capital projects are viewed as investments, from which future returns are expected. Investing, and otherwise making the best use of the organization's financial assets are primary responsibilities of the CFO.
- In still other organizations—especially non-profit and government organizations—the Capital Review Committee is reports directly to the Board of Directors (or a Board of Commissioners, or Board of Overseers).
What does the pool of submitted proposals include?
When reviewing capital spending proposals from across the organization, the Capital Review Committee may be facing, simultaneously, proposals that differ greatly with respect to:
- Sponsoring Organization.Proposals may be received, for instance, from different organizations, such as Marketing, IT Operations, Engineering, Customer Service, and Human Resources.
- Business objectives addressed. Different proposals may target objectives such as increased sales revenues, maintaining service delivery capabilities, providing more office space, or improving employee engagement.
- Funding amount requested. Competing funding requests may be as small as just a few thousand dollars, or they may represent multi-million dollar capital requests.
In other words, a Capital Review Committee may be faced with a diverse pool of current proposals. The pool might include, for instance:
- A $3,500 proposal from Engineering, for acquisition of test equipment.
- A $30,000,000 proposal for building a new heating plant.
- A $55,000 proposal from Human Resources for an upgrade to the software.
Capital Review Committees that receive many proposals each period must establish a set of evaluation criteria that can be applied to the complete pool of very different proposals. Prioritization criteria will be published, with detailed explanations, to the entire organization long before the proposal submission deadline for the next funding period.
Review Committees typically itemize prioritization criteria such as the following:
- Level of funding requested, for each year in the life of the proposed project or acquisition.
- Tangible contributions to meeting the organization's strategic business objectives.
- Evidence of negative consequences that would result from not funding the proposal. These might include such things as
- Violation of, or non compliance with, laws and regulations.
- Inability to maintain normal operations, either immediately or at some point in the future.
- Costly obsolescence of equipment or other assets that will occur at some point in the future.
- Estimated financial performance of the capital investment, measured in terms of financial metrics such as Net cash flow, Total cost of ownership, Cash flow Net Present Value NPV, simple return on investment ROI (profitability), Payback period, and Internal rate of return IRR. ( For more on these metrics, see the Encyclopedia article Financial Metrics.)
- A formal cost-benefit analysis, such as a business case analysis, comparing the likely benefits of taking action against the likely costs of not taking action, or taking a different action.
- A risk analysis estimating the risk of investment failure and the likelihood of specific outcomes better or worse than the most likely outcomes.
- Sensitivity analysis showing
- Critical success factors and contingencies that must be managed to target levels during the life of the investment or project.
- Important risk factors that should be monitored closely during the life of the investment.
With prioritization criteria established, the Capital Review Committee's responsibilities, then, are to:
- Reach consensus among Committee members on the relative weight, or importance to grant each criterion in the overall prioritization.
- Create and publish rules and a process for using these criteria to create a prioritization score for each proposal.
- These may include rules for prioritizing large proposals differently from the way small proposals are prioritized, for instance.
- Rules may specify thresholds, or hurdle rates for specific criteria. The rules may state, for example, that the estimated Internal rate of return IRR must exceed the organization's weighted average cost of capital WACC. Or, the rules may simply state that the proposed investment must project a positive simple ROI (i.e., the investment must promise a positive profit.)
- Communicate to all potential proposal sponsors the prioritization criteria and the rules for applying criteria.
- Communicate the calendar period during which proposals may be submitted, and the schedule for the next review process cycle.
- Work with individual sponsors as they prepare proposals, to ensure that sponsors understand and are capable of meeting proposal requirements.
- Summarize the Committee's review of all proposals in a report to the Budget Office and Chief Financial Officer. The report should include the Committee's recommendations on which proposals should be funded, and it should propose a capital budget spending ceiling.
In some organizations, the Capital Review Committee chooses to implement its responsibility to "Work with individual sponsors as they prepare proposals" by establishing a formal validation review process. This means that members of the Review Committee or their staff work as validators, meeting individually with proposal sponsors, starting when they being preparing proposals, and continuing through a preliminary "validation review" of the in-preparation proposal.
The validation review can provide early warning that a proposal will probably not score high in credibility with the Review Committee, or that it will score poorly on some of the prioritization criteria. In such cases, the proposal sponsor may or may not be able to improve the strength of the proposal before it is submitted for final review. In some organizations, a proposal must successfully pass a validation review before it can be submitted for final review by the Review Committee. In other organizations, the validator's judgment is simply communicated to the full Review Committee as a recommendation.
The validation review process is especially helpful In organizations where each budget period sees a large number of diverse proposals. In such cases, validation can serve to make the Committee's final review simpler and clearer.
- Validation helps the Review Committee by "filtering out" low quality proposals that would needlessly absorb Committee member time.
- Validation helps the Review Committee by enforcing consistency in the structure and content of incoming proposals.
- Validation helps proposal sponsors, by helping them understand how to provide the Review Committee with the information it is looking for.
Proposal sponsors can "make the case" for their own funding requests very effectively by packaging the proposal scores on prioritization criteria along with a narrative in a formal business case analysis. A solid business case can build reviewer confidence in the credibility of sponsor estimates and forecasts. The business case framework uses analysis results, descriptions of assumptions and methods, and discussion text to articulate clearly:
- Tangible links between the proposed action or acquisitions and progress towards strategic business objectives.
- Credible demonstration that the proposed action or acquisition was compared fairly to possible alternatives.
- Major assumptions underlying expected results (expected investment performance on prioritization criteria). The business case framework shows how expected projections will follow if the underlying assumptions stand.
- The methodology for producing expected financial metrics, such as ROI, IRR, and Payback period. The credibility of such results depends heavily on the sponsor's ability to show how the metrics were developed.
- Formal, rigorous risk and sensitivity analysis, as described above.
- The sponsor's practical guidance for implementing and managing the life cycle of the proposed acquisition or project, so as to minimize costs, minimize risks, and maximize returns.
Some Capital Review Committees, in fact, require that incoming capital spending proposals be supported with a formal business case. in such cases, the Review Committee and validators will ensure that potential proposal sponsors are provided with the complete business case framework (an explanation of the expected business case structure and content), as well as a simple description of the Committee's prioritization criteria.
For complete coverage of a business case frame work framework that has become standard in many companies and organizations, see Business Case Essentials.
In summary, those who propose or request funding for capital expenditure will want to be sure they first understand
- The organization's strategic business objectives, specific targets for those objectives, and the value to the organization of reaching targets.
- The organization's criteria for prioritizing capital expenditure proposals.
- The proposal structure and content expected by the Review Committee (e.g., business case structure and content).
- The timing of the current and the next capital budget cycles.
- The current or expected capital budget ceiling.
- The specific reasons the earlier proposals were either rejected or approved by the Review Committee.