The Capital Allocation process

The Capital Allocation process

IF you have missed part one, click the button below to read from the beginning.

The story about Robert and his colleagues continues. Follow them in their endeavor to improve long-term cash flow by fundamentally changing the way their company prioritizes when spending capexes.

(The Characters in this fable are fictitious; any resemblance to real people or facts within the Corporation is pure coincidence only)

The Capital Allocation process – from Asset Strategy to Capex follow up – “We own it!”

Robert was out walking around the lake just outside the offices. As always, he was sipping on a decaf coffee. Mary had, for once, joined him. “Well done, Robert.” “

Thanks, but really it was my group of coworkers…

Mary raised her hand and said, “Stop it. I know what you are about to say: it was really the hard work of all our colleagues, etc., etc., etc. And you are right, of course it is. But you started it! You not only identified the need for change-you acted upon it. You were the one thinking beyond what we normally do. You are the one that initially took a risk.”

Now it was Robert’s turn to raise his hand and stop Mary, “Thanks, I appreciate it but it is a part of my job. The responsibility for the capital allocation process is in my job description and really it was not until now, or very recently, that the tools and process that enabled us to do this was made available to anyone.”

“That’s right,” said Mary, “but we are among the first to move when it comes to this-it will give us an edge for years, maybe many years. But our competitors will follow. And you know what? Maybe that is not so bad. No one benefits from anyone wasting money, not even competitors.”

Robert finished his decaf and threw the paper cup into the green trash bin. Mary did the same with the green tea in her cup and threw it into the same green bin. “Robert, have we implemented the tools and processes properly or are we still in need of help to operate it over a cycle?”

“We own it!” Robert said with a confident smile, emphasizing the word “own.” “From the company-wide Asset Strategy maximizing long term cash flow, down to the routing and follow up of an individual capex. From system administration, user rights and restrictions, to training of new personnel.” Robert continued, “We have fundamentally changed the way we think about capital allocation and capexes. We have changed our mind set. We are on top of it. It is now part of our culture-we have institutionalized it.” Mary could not only hear but also see how Robert, a normally very composed man, could not help but show his enthusiasm when speaking about the new and improved capital allocation process and the system supporting it. Robert continued, “Our ability to use and benefit from the system that supports and ingrains our capital allocation process is not dependent on any one person, group of persons, or consultants.”

Mary raised her right arm and rested her hand on Robert’s left shoulder, still walking. “Good! Because soon it will have to do without you. I’m being put forward as the new Chairman of Board and we would like to offer you the CEO position.”

Later that evening Robert was standing alone looking out over the bay. This afternoon he had felt excited about the news from Mary. And a little stressed. Yet now he felt calm. He remembered a tag line that the authors of “The tail wags the dog” had presented to him when introducing the systems and solutions that Robert eventually had implemented in the company. At the time, Robert thought it was a little silly, but now it came to him. The view of the sea with the mountains in the background was stunning and soothing; he was home early enough to kiss his kids goodnight. He felt calm and confident. He had made the “Weissr” decision.

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The New Capex Process

The New Capex Process

IF you have missed part one, click the button below to read from the beginning.

The story about Robert and his colleagues continues. Follow them in their endeavor to improve long-term cash flow by fundamentally changing the way their company prioritizes when spending capexes.

(The Characters in this fable are fictitious; any resemblance to real people or facts within the Corporation is pure coincidence only)

Robert, who chaired the Capex Committee, looked at his wristwatch. “So, are we in agreement?” he asked the rest of the group. It was more of a rhetorical question than a real one. He knew they were all aligned. And it had been almost friction free. They would all get home in time for dinner. He was not sure everyone appreciated that, though. The thought made him smile wryly.

Only last year he had dreaded these meetings. Someone had jokingly called it B.C.T. – Before the Capex Tool. Even though the requests were supposed to use the same models and templates, they had often been “tweaked” or sometimes even manipulated. They had changed hands many times and the end result was something akin to a game of “Whisper.” What ended up at the capex committee was often unrecognizable to the original author and no one could understand the, at best, manually kept change log. Therefore, it was also difficult, with certainty, to say who changed what and when. And that had been the easy part to handle. The real challenge had been agreeing on the capexes to commit to and which ones to deny or potentially postpone. Robert had previously, B.C.T., always left the Capex Committee meetings with a feeling of being out of control, of being forced to accept capexes in sites and machinery on which he really, really did not want to spend any money. However, the requests always looked so good. He knew the site was using outdated equipment and that the numbers showed a very short payback and a very good NPV. On top of that, the sites’ ROCE was way above the company average and target. How could he say no? In fact, before this year he could not. So, the money went to wherever the shortest paybacks were found. It just so happened that they were seldom found in the sites and machinery that were state of the art. Too little of the money had ended up being spent on the sites that they would still operate in ten, fifteen years. On that, Robert would bet his right arm!

Now, the model, templates, strategic rational, classification, users, change logs, approval routing, the process, you name it, were all standardized and transparent. Very important in itself, but Robert suspected that many modern Capex Management Tools could help out with that. What set their chosen solution apart was how it interconnected with the long-term Asset Strategy that they had established. How ranking based on payback took the second seat compared to how that particular capex interplayed with the Asset Strategy-was it aligned? What did the Asset Strategy say about the long-term survivability of the asset? What was to be expected over the next five, ten, or even fifteen years when it came to reinvestment, investment, or compliance needs?

The Capex Committee was looking at a “dashboard” summarizing the coming year’s capital budget; a budget that Robert and Mary, the CEO, would present to the Board of Directors at the upcoming meeting. Once a year, every fall, the board reviewed the three-year investment plan and (usually) approved next year’s capital budget. Sonia, a senior controller, raised her hand as if she was still in school. “Yes, Sonia?” Robert said.

“I think that we are all aligned, but will the board be?” Sonia asked and continued, “The total limits we ask for are not that different from what we have used historically, but the allocation…it is…how should I say it…a lot more active. Some businesses get a lot, others very little. I believe, no, I am convinced that is right but will the board stomach it?” Sonia looked at the others and the others looked at Robert. Robert had expected a question like this; he was rather surprised it had not come earlier. It was very true what Sonia said, the capital allocation was much more active-between businesses and between sites and machinery-historic capital budgets were no longer any argument for getting money going forward, neither were egalitarian principles of a certain sum per capacity or sales. Egalitarian principles are very noble when it comes to people but not when it comes to machinery – not all machines and businesses are created equal. And it meant that they, as the leaders of this company, had to take responsibility not only for the fun things such as installing new machinery or updating older lines and machines, but also responsibility for active choices of machine, site, or even whole business closures. Not all liked that. Most people never said that they did not like taking responsibility, more often they pointed at someone else that they imagined would not like it such as the CEO, the board, an owner, the union, media… That is why Robert now felt so good about having started at the right end, with the asset strategy and then following it up with the capex plan and budget.

“I would not worry more than normal about the board,” Robert said, “They are already in the know.” He continued, “Both they and the senior leadership of this company is prepared to take some heat regarding a number of the upcoming decisions, but hey, that is our job. If we cannot stomach it, well then maybe we should be doing something else.” Robert felt that his tone may have been unnecessarily harsh, but he meant every word he said. He would be damned if they as a company could not take responsibility for the tough decisions when they all agreed it was the right way to go.

In the car on his way home, Robert was thinking about the meeting. Overall, it had been great both in terms of outcome and in terms of how they had gotten there. However, at the end he realized that they still had one thing to do regarding the job he and Mary started last year. The supplier of the systems and services they had used had tried to get his attention regarding this, but Robert really did not think it was necessary – yet the last few minutes of the meeting had made him change his mind. They now had the strategy, the tools, and the processes in place. A lot of people had been through some training and especially the select few that participated in the original Asset Strategy project last year had changed their mindset and learned to better understand how the Asset Strategy and how individual capex decision interlink with long-term cash flow and enterprise value. Now, Robert wanted that understanding to go beyond the select few. Alright, it was not for everyone in the organization, but definitely more than the selected few needed to get that extra training and understanding for him to honestly say that the mindset they strived for was now a part of the company culture.

 

To be continued.

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Interested in reading from the beginning?

You are wasting capexes – but you don’t have to…

Asset Strategy – Check! Tools – Check! Buy-in? 100%

Asset Strategy – Check! Tools – Check! Buy-in? 100%

IF you have missed any part, click on the buttons below to read from the beginning.

The story about Robert and his colleagues continues. Follow them in their endeavor to improve long-term cash flow by fundamentally changing the way their company prioritizes when spending capexes.

(The Characters in this fable are fictitious; any resemblance to real people or facts within the Corporation is pure coincidence only)

Robert, the CFO, was in the middle of his presentation to the board. Mary, his CEO, sat amongst the rest of the board, next to the chairman, and listened. Robert and Mary had been through the presentation in detail several times in preparation for today. Mary had also prepped the chairman of the board and she felt confident. Still, the rest of the board had not been along for the ride. They had not gone through all the discussions, all the details, all the alternatives, all the scenarios, and sensitivities. They had not seen the entire project group, including senior management, go through an emotional, yes emotional, roller coaster of facing up to the industry’s long term realities. The members of the board had not seen how the group had not only accepted, but come to embrace the responsibilities of both creation and destruction that come with running a major company. Today, however, the board would see the outcome, the asset strategy that Mary’s team supported and believed in 100%.

Mary remembered how the project group, together with a team of specialist consultants, had created a so-called Base Alternative, an alternative where they just carried on, running all businesses as going concerns. The outcome, evaluated from a long-term cash flow and enterprise value perspective was thorough. Many sites were in dire straits already and would, if nothing were done, have to be closed over the next decade. Many participants did not, at first, believe the outcome of the Base Alternative. However, it soon became obvious to everyone that the future that the Base Alternative depicted was no worse or different than the history had been, and they had all been through it. The consultants and the specially designed software had guided the group throughout the process, from detailed model building to analyses of outcomes. Every participant of the project had their personalized interface with the tool and the consultants facilitated a collaborative process that still made all assumptions, calculations, and inputs transparent and possible to challenge and easy to test from a sensitivity point of view.

Once the Base Alternative was established, the real work got started. Assume that nothing is a going concern. What happens if we expand Mill A? And close Mill B early? Can we convert Machine 10 to produce something else? Is there an opportunity to rebuild the back-end of Mill D? Can we close two mills within three years and rebuild Mill F and G, etc. All in all, the group had constructed 25 different Strategic Building Blocks, individual strategic initiatives. These had then been combined into 97 different whole business Strategic Alternatives. Out of these 97 alternatives, one had panned out. One selected Asset Strategy that maximized the long-term discounted cash flow and enterprise value of the business. One Asset Strategy, which the entire team supported, even if not all were happy about all the decisions it meant implementing. They supported it from the point of view that it was the best way forward for the company. It was not necessarily the best way forward for each individual mill. They had learned in the process that the sum of what is best for each mill is seldom or never what is best for the whole company.

From a cash flow point of view, the result was very interesting. Historically, they had spent around 400 million USD per year in capexes. Interestingly, that number would slightly decrease on an average over the next decade. Yet they would spend it very differently. It would be much more concentrated. And they would get a lot more cash flow back, definitely more “bang for the buck.” The difference in enterprise value between the Base Alternative and the selected Asset Strategy was roughly 30%, or 800 million USD! Mary believed it. Of course, numbers would be different going forward. Neither they, nor the consultants, nor the tool was a crystal ball. Still, all the tests with sensitivities and scenarios had convinced her and the team-the value was in that ballpark. Not only that, for the first time since Mary had been in a senior executive position, she had a team running the company that was in alignment regarding the major asset decisions going forward. It would certainly make her life easier! Sure, things would change, things that they had not tested for. They would come up with new ideas. Good! Robert was just talking about how the tool would be used in the ongoing strategy process. How different users are responsible for updating data, how new Strategic Building Blocks can be created and allowed to challenge the current Asset Strategy.

Mr. Anderson, the chairman of the board, asked Robert and Mary, “So do you expect us to make a decision on this entire strategy as one piece? We cannot do that!” Mary had expected this question.

No. We will ask for decisions on individual capexes and closures just as before, but we want to relate and evaluate all decisions in relation to the current long-term Asset Strategy. We no longer evaluate any strategic capexes or asset decisions in isolation. We ask for decisions on them just as we have done before, but we evaluate them and present them in the context of the long-term Asset Strategy. If you will, you can say that we are putting the horse in front of the carriage or giving the dog control of its tail.” Mary looked at Robert and smiled. She had started to appreciate his sometimes-stupid metaphors.

To be continued.

Interested in reading the next episode?

Interested in reading from the beginning?

You are wasting capexes – but you don’t have to…

We are losing three hundred grand every single day!

We are losing three hundred grand every single day!

IF you have missed any part, click on the buttons below to read from the beginning.
The story about Robert and his colleagues continues. Follow them in their endeavor to improve long-term cash flow by fundamentally changing the way their company prioritizes when spending capexes.

(The Characters in this fable are fictitious; any resemblance to real people or facts within the Corporation is pure coincidence only)

Robert started his second lap around the artificial lake just outside the offices, walking and sipping on a decaf coffee. This morning he had been through a number of meetings with the “usual suspects” when it comes to management and strategy consultants. All of the tools and processes that they had discussed regarding improving the allocation of capital between sites, machines, acquisitions, and dividends did not seem to address the fundamental question – what to do differently? Not just more of, or improvements on, the same – but fundamentally different.

Robert could not stop thinking about the series of articles he had read on the plane, “The Capex Process-the tail wags the dog”. He had read them all, several times, just weeks before that conversation in the car with Mary. Those articles had inspired him when answering Mary’s question, “What should we do differently?” Since then he had also used a little tool that he had found on the internet to try to answer the last question Mary had asked in the car-how much would it be worth to fundamentally and sustainably improve the effect of investments and capexes? The group spent around 400 million USD on capexes every year. The authors of “The tail wags the dog” claimed that any company should expect a minimum improvement in capex efficiency of 10% when tying the capex process to a whole business asset strategy. Testimonials claimed much higher percentages. Robert himself sincerely believed that, if successful, a 20% efficiency improvement was possible. It would not necessarily mean a 20% reduction; it would just mean a different, sometimes very different, view on how to allocate capital and resources over time. Twenty percent would mean 80 million USD every year in lost cash flow due to less than optimal decision making on capex. Or more than 300,000 USD per working day! There was no question in Robert’s mind that there was real value in trying to take control of the capex process from a longer-term and holistic point of view…and the “usual suspects” would be of little help. Time to go to the source. Robert determined to call the authors of the series of articles he’d read and ask for help.

The senior consultant Robert contacted had made a real impression on Mary and Robert. If before their meeting they had little doubt about the need to change the whole regime regarding capex allocation, they were now absolutely convinced. And they knew where to start. Not with the capex process, but with the long-term asset strategy.

When Robert returned from his walk, Mary called him into her office and said, “Robert, I want you to look into that list of requirements on an Asset Strategy Tool that the guy talked about. Do we agree? Are they the only ones providing such a tool? Can we do it ourselves? How would we work with such a tool and how would we change our processes?

Ok – I am on it.

And don’t linger…we are losing three hundred grand every single day!”

To be continued.

Interested in reading the next episode?

Interested in reading from the beginning?

You are wasting capexes – but you don’t have to…

What the **** is wrong with our capex process?

What the **** is wrong with our capex process?

IF you have missed part one, click the button below to read from the beginning.

The story about Robert and his colleagues continues. Follow them in their endeavor to improve long-term cash flow by fundamentally changing the way their company prioritizes when spending capexes.

(The Characters in this fable are fictitious; any resemblance to real people or facts within the Corporation is pure coincidence only)

Glen, who had worked as a process engineer in the pulp mill for 20 years, did not understand it. A group of corporates had just finished a short speech to the employees at the mill. The mill was shutting down. Not temporarily, but for good. Only a couple of years ago, more or less the same group of people was giving a very different speech after having spent close to $100,000,000 on replacing digesters and upgrading the bleach plant. Glen remembered the enthusiasm; he himself had crunched much of the data behind the decision to invest. The payback was less than 24 months and the mill’s return on capital employed that year before the capex decision was reported at 20%-well above the group average and target. The project had, for the most part, been successful and was implemented more or less according to plan. Yet, here they now stood, only a couple of years later, facing a closure.

Mary, the CEO, was also thinking about that $100,000,000 capex. She had been the group CFO at the time and she had endorsed the decision. Mary bitterly regretted it now. Not only did the money invested go to waste, but maybe more importantly-they had not spent that money in the mills that they still operated and that they hoped to operate for many decades to come. Still, she did not know if she would act differently if faced with a similar decision now. How could she avoid making the same mistake again? The numbers-the net present value, the payback, and the mill’s return on capital employed-all pointed her in the direction of making the decision to spend the money. Additionally, the mill management had easily convinced her of the technical and market need for improving brightness and quality. Yet here she was-communicating the permanent closure of the mill. When in the car with Robert, the current CFO, she asked, “Robert-how can we avoid spending large amounts of money on sites only to see them go down a few years later? What the **** is wrong with our capex process? Why could we not see this coming?” She was now talking more to herself than to Robert. “It is not the first time, and I bet it is not the last time. Don’t even get me started on acquisitions! How many of those have we lived to regret? Robert, I know I am upset now, but tell me how on earth I, with a straight face, can tell my board when they ask critical questions on our capital expenditures or acquisitions that it is all different now, that we have learned our lesson. We are not different! We continue to do the same thing, over and over again. And it’s not only us. It’s the whole industry! Robert, tell me – what should we do differently?

Robert was quiet for a short moment. He had spent a large amount of time over the last six months, when agonizing over the closure decision, pondering that exact question. “Mary, I don’t think it is the capex process as such that is at fault. I think it is a case of putting the carriage before the horse, or the tail wagging the dog.”  Robert could see Mary opening her mouth to say, “What?” but he raised his hand and pleaded, “Bear with me.” He continued, “I think that our capex process is so strong and institutionalized that it has taken precedence over any long-term capex allocation strategy that we may have. The capex process should be there to help administer and implement a long-term asset strategy or capex allocation strategy. I am not talking about a three-or five-year plan, but something much longer in scope. After this closure, we have 12 sites with a capacity of around four million tons of packaging, pulp and paper. If we disregard acquisitions for a while, do you think that we will have all 12 existing sites operating 15 years from now?”

There was a moment of silence. “No, we won’t,” replied Mary.

I agree. I don’t think so either,” said Robert. “If I had to guess, it will probably be closer to seven or eight sites still producing more than four million tons-or even more.” Again, he paused. “We know that we will be facing closures. Continuously. We also know that we will need to expand other sites.

I think you are right Robert, so what should we do?” Mary asked again.

Robert continued, “I have the feeling that closures are something that “happens” to us, something we are “forced” to do. It should not be like that. We should take responsibility and plan for closures and exits, long before they happen. We should choose, based on the long-term cash flow for the whole system of mills, where we should be long term and where we plan to exit three, five, and ten years from now and how to coordinate that with expansions and volume moves to the remaining system.

Robert paused for a second, thinking. “Go on, I’m listening,” said Mary.

“I think in such a capex regime no decision can be made in isolation. Each and every capex decision needs to be tested against the larger and system-wide asset strategy. Does it fit or does it change or challenge the current strategy? In short, we need to put the horse in front of the carriage and give the dog control of its tail….”

I am not sure I like your lousy metaphors, but **** it, you are right,” said Mary. “Robert, I want you to look into this now. I mean it. Now. I am not making any large strategic decision before we sort something out. We need a long-term asset strategy and we need to connect that to the capex process. And Robert…this cannot be a financial exercise. We need to involve market, business owners, energy, engineering, controlling, raw material supply, etc. I don’t want this to be a one-time thing. Who can help us? Where is the external expertise? Where are the tools? How can we get this into our DNA? And also, how much would it be worth to us?

To be continued.

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Interested in reading from the beginning?

You are wasting capexes – but you don’t have to…