Don't cut capital costs

There is an old adage that goes like this: "Be careful what you wish for, you might get it." Consider the case of that all-too-frequent occurrence, the drive to cut capital expenditures. The dictum comes down: "We need to reduce our capital spending by 15% this year." Or "We need to limit capital spending this year to $10,000,000.

01/10/2005


There is an old adage that goes like this: "Be careful what you wish for, you might get it." Consider the case of that all-too-frequent occurrence, the drive to cut capital expenditures. The dictum comes down: "We need to reduce our capital spending by 15% this year." Or "We need to limit capital spending this year to $10,000,000." From a business standpoint, it is the wrong thing to do, and if you "succeed," the old adage will apply to you.

On one hand, capital projects represent a relatively large expenditure of company funds that result in an asset that is depreciated.

This is the "bricks and mortar" definition, but no company buys bricks and mortar. Companies buy the means to meet a business need. This need usually shows up in the executive summary or justification that accompanies the request for funding. A major pharmaceutical company is spending several million dollars on an additional production line. Not really. The company is spending several million dollars so it can produce several million more units of a product per year. To meet that need, a new line is required. This concept of meeting a quantified, defined business need is important as it plays a crucial role in the definitions to follow.

Capital project spending parts

Any capital project's total spending is a mix of three parts.

  • Effective capital — Funds spent to meet the business need as defined

  • Waste — Funds spent for which there is no return to the company. This is the classic definition of the word. This also includes the incremental additional cost of meeting a need with a noncost optimal solution

  • Ineffective capital — Funds spent for which the company arguably receives a benefit or return that is not part of the defined business need.

    • Production line model

      Let's say management has determined there is a need to produce X units per year, and this requires a line with a rate of Y units per minute and appropriate support facilities. The spending to provide that capability is effective capital. If halfway through the design someone decides that the line should be on the west side of the building instead of the north, the engineering and any other efforts expended on work on the north side is waste. If the project team or the local customer decides that a line that can produce 1.5 Y units is better and that is done, then any funds spent on getting the larger line are an ineffective use of capital. That the additional line capacity may have been the right thing to do is irrelevant. The defined need was Y, and that need was not reviewed, adjusted, and approved.

      Before getting into the details of the argument, I want to put two more observations about waste and ineffective capital on the table. First, nobody plans for waste. In our example, the switch of location well into design did not occur because someone maliciously withheld the need so he/she could spring it on the team. If you have the very rare person that acts like that, rid yourself of that individual quickly. Secondly, what is to you ineffective capital may be to me an absolute necessity.

      Bad business

      Why is capital cost reduction a bad business idea? Because the greatest impact is on effective capital. You will meet fewer business needs. The effective capital portion of overall spending is by far the greatest portion of spending, so on one hand this is not unexpected. On the other, if you look at it from a percent reduction point of view, typically effective capital is hit harder than either waste or ineffective capital. This is exactly the opposite of what we all agree is desirable.

      Waste

      Since we said it is not intentional, just saying "stop waste" will be ineffective. Nobody is trying to waste in the first place. Waste results from systemic faults in our processes. In my example, it resulted from a lack of planning and communication in the project development phase. During periods of cost cutting, the pressure is on to do less planning and engineering, which can make the problem more severe.

      Ineffective capital

      Ineffective capital is not in the project by accident. It is there because someone wants it and believes it is truly needed and justified. What is happening here is not so much waste as management's duty to control capital being usurped. Capital is a finite resource. Senior management has a fiduciary responsibility to maximize the beneficial use of that resource. There may well be other, more profitable uses for those funds.

      The problem here is very human. The person who wants this is almost always much closer to the project and truly believes in the validity of the expenditure. In addition, it is in this person's backyard. They will fight for what they believe is right.

      The cumulative result is a squeeze placed on effective capital. Sometimes, this manifests itself as a failure to meet a project's business needs, but more often as projects not done and opportunities lost.

      Path to resolution

      Now that we have stated the issues, let's look at what can and should be done.