Capital spending decisions have substantial consequences.
- Capital acquisitions and capital projects are, by definition, costly. They command significant portions of the organization's budgets.
- Every capital action, moreover, impacts or alters the organization's three strategic structures: Asset structure, financial structure, and capital structure (capitalization).
For these reasons, every action with capital consequences has—arguably—strategic importance. Businesses everywhere normally authorize capital spending actions individually, and then only after passing each spending proposal through a rigorous capital review process.
Most firms begin the capital review process knowing the upper limit on capital spending for the current budget cycle—the capital spending ceiling. In many organizations, the designated ceiling does not permit funding of all funding requests the Committee receives. With a spending ceiling in place, different capital spending proposals must compete with each other for higher priority positions.
As a result, lower priority proposals are not likely to receive funding after the committee reaches the capital expenditure (CAPEX) spending ceiling with higher priority proposals.
Explaining Capital Review Process in Context
This article further defines and illustrates the capital review process in context with terms and concepts including:
- What is the capital review process?
- Who reviews capital proposals?
- The pool of incoming proposals for review.
- What are the Capital Review Committee's responsibilities?
- What is a capital proposal validation review?
- Business case role in the capital review process.
- How to prepare for your capital review.
Capital budget planning is usually the responsibility of a Capital Review Committee, working closely with the organization's Budget Office.
- In some organizations, the Committee is part of the Budget Office.
- More often, however, the Chief Financial Officer organizes and takes responsibility for the Capital Review Committee. This responsibility is appropriate for the CFO because capital acquisitions and capital projects are true investments, from which the firm expects to earn returns. Investing and otherwise making the best use of the organization's financial assets are the primary responsibilities of the CFO.
- In still other organizations—especially non-profit and government organizations—the Capital Review Committee reports directly to the Board of Directors (or a Board of Commissioners, or Board of Overseers).
The Capital Review Committee normally reviews capital spending proposals from across the organization. As a result, the Committee may face, simultaneously, proposals that differ greatly with respect to:
- Sponsoring Organization. Proposals may arrive, for instance, from different organizations, such as Marketing, IT Operations, Engineering, Customer Service, and Human Resources.
- Business objectives. Different proposals may target different business objectives, such as increasing sales revenues, maintaining service delivery capabilities, providing more office space, or improving employee engagement.
- Funding request. 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 face a diverse pool of current proposals. The pool might include, for instance:
- A $3,500 proposal from Engineering, for acquiring 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 HR software.
Capital Review Committees that receive many proposals each period must establish a set of evaluation criteria they can apply to the complete pool of incoming proposals. Committees usually publish their prioritization criteria 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 the funding request, for each year in the life of the proposal project or acquisition.
- Tangible contributions to meeting the organization's strategic business objectives.
- Evidence of negative consequences that will 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 in the future.
- Costly obsolescence of equipment or other assets that will occur in the future.
- Capital investment financial performance estimates. The Committee will expect financial performance estimates in terms such as Net Cash Flow, Total Cost of Ownership, 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 Financial Metrics.)
- A formal cost-benefit analysis, or business case analysis, comparing the likely benefits of taking action against the likely costs of not taking the proposal 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 the firm must manage to target levels during the life of the investment or project.
- Important risk factors to monitor closely during the life of the investment.
With prioritization criteria in place, the Capital Review Committee's responsibilities are to:
- Reach consensus 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 rules may include instructions for prioritizing large proposals differently from the way the Committee prioritizes small proposals.
- Rules may specify thresholds or hurdle rates for specific criteria. The rules may state, for example, that the investment Internal Rate of Return IRR must exceed the organization's weighted average cost of capital WACC. Or, the rules may merely require a positive ROI (i.e., the investment must promise positive profits.)
- Communicate to all potential proposal sponsors the prioritization criteria and the rules for applying criteria.
- Communicate the calendar period for submitting proposals and a schedule for the next review process cycle.
- Work with individual sponsors as they prepare proposals to ensure that sponsors understand and are prepared meeting proposal requirements.
- Summarize the Committee's review of all proposals in a report to the Budget Office and Chief Financial Officer. The CFO will expect the report to include the recommendations on which proposals to fund. The report should also propose a capital budget spending ceiling.
In some organizations, the Capital Review Committee meets its responsibility to "Work with individual sponsors as they prepare proposals" with a formal validation review process. For this process, members of the Review Committee or their staff meet individually with proposal sponsors, starting when they begin preparing proposals, and continuing through a "validation review" of the in-preparation proposal.
The validation review can provide an 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 turning it in for final review.
In some organizations, proposals must pass a validation review to qualify for submitting for final review by the Review Committee. In other organizations, the validator's judgment simply goes to the full Review Committee as a recommendation.
Validation reviews are especially helpful when each budgeting period sees a large number of diverse proposals. In such cases, validation serves 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 works for proposal sponsors by helping them understand how to provide the Review Committee with the information the Committee expects.
Proposal sponsors can "make the case" for their 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, and assumptions to articulate clearly:
- Tangible links between the proposal action or acquisitions, and progress towards strategic business objectives.
- Credible evidence that the proposal action or acquisition was compares fairly to possible alternatives.
- Major assumptions underlying estimates of investment performance on prioritization criteria. The business case framework shows how projections will follow if the underlying assumptions stand.
- The methodology for producing financial metrics, such as ROI, IRR, and Payback period. Sponsors build credibility for business case results by showing how they apply these metrics.
- Formal, rigorous risk and sensitivity analysis.
- The sponsor's practical guidance for implementing and managing the life cycle of the proposal acquisition or project. This guidance must include practical steps that minimize costs, minimize risks, and maximize returns.
Some Capital Review Committees require that incoming capital spending proposals come with formal business case support. In such cases, the Review Committee and validators will ensure that potential proposal sponsors understand the complete business case framework and principles of business-case-building.
For more on business case principles, structure, and content, see Business Case. For complete coverage of a case-building framework, and step-by-step guidance for creating a proposal support case, see the ebook Business Case Essentials.
In summary, those who propose or request funding for capital expenditure should first understand the following:
- The organization's strategic business objectives, specific targets for objectives, and the value to the organization of reaching targets.
- The organization's criteria for prioritizing capital spending proposals.
- The proposal structure and content that the Review Committee expects(e.g., business case structure and content, financial metrics for prioritization criteria).
- The timing of the current and the next capital budget cycles.
- The current capital budget ceiling, or the ceiling the Committee expects for the next budget cycle.
- The specific reasons the Committee either rejected or approved earlier proposals.