3 Key Disciplines of Effective Capital Allocation

Capital allocation is the process of distributing finances to company stakeholders to achieve an investment goal that meets the overall organizational strategy; wise decision-making is a crucial part of this process. Yet, many companies have adopted a habit of reducing CapEx spending, holding money on the sidelines, or returning it to shareholders.

Between 1995-2015, CapEx levels were at an all-time low. However, successful companies were successful precisely because they were making smarter decisions into where to allocate spending.

And, although the world saw modest GDP at this time, investors were looking for new value-creation strategies. After 2015, they realized that capital allocation was a key priority – the process of setting the moving parts of an organization together in such a way as to make the best investments decisions.

Making decisions on which investments to move forward with, and which to discard, means looking at where to invest money. So, how are leading companies doing so? They are achieving this by looking at three key disciplines, that in conjunction, ensure that the best investment decisions are being made. Let’s explore these disciplines.

Capital budgeting

During the time of low CapEx spending, successful companies were rigorously translating their strategic priorities into resource budgeting. Resource budgeting is investment into facilities, equipment, and technology. Capital budgeting (planning) was a way to set a foundation for a plan (3-5 years ahead). This is done to make better decisions today, as they will impact the company’s future.

Companies that take time to budget and plan into which key areas to invest in are making wiser CapEx decisions. They translate portfolios into guidelines and strive for achieving balanced investment portfolios.

For example, IBM was able to reorient its portfolio from hardware to cloud-based services, because they created a long-term plan, and saw the opportunity for the future. Another example is when Tata Consultancy Services, invested in a call center operation to free up management capacity to push into value-added services.

Balancing the investment portfolio is also a way to tie corporate strategy to capital allocation. Is the investment portfolio consistent with the company’s strategic priorities? Is it balanced among internal and external teams and stakeholders?

Creating a budget will push you to set out a plan, and give you a fuller picture of what you need to do, today, to achieve success in the future.

  1. Investment project selection

Top performers are making smart decisions concerning which projects to choose, and which to avoid. Leadership and CFOs are performing investment evaluations to have a view into considering which projects to invest in. By being selective with potentially investable portfolios, they employ a methodology by which to ensure that the best decisions are being made.

To determine whether or not to invest in a potential project means considering if you have the financial means to invest in it. It’s important to understand the project’s financial profile – the quality of the estimate, cash flows, and payback over time.

There is a rule for choosing one investment project over another, which is the process of creating a list into a project based on its expected rate of return.

It’s critical to also look at criteria beyond financial returns. Things like growth potential, expected project return, payback time, and fit with existing capabilities is the criteria to take into account.

If you are looking to invest in equipment upgrades or digital technology, you need to weigh investments by strategic attractiveness and prospective longer-term options.

Here are several tips for considering a particular investment:

Establish an investment committee that will act as a “final safeguard” for the final stages of investing.

Push for cross-departmental inclusion into the decision-making process. Have a next-best alternative.

Establish a culture of “constructive disagreement” to help prevent confirmation bias.

  1. Investment Governance

Active capital allocators establish governance mechanisms to choose, support, and track investments. The implementation of best practices and governance helps make wiser investment decisions.

Top performing organizations understand the importance of applying the right mechanisms to choose and support investments and work to establish accountability and feedback loops where wiser judgments are made. The process of continuing to learn is in large part the result of companies making smarter choices.

Feedback into decision-making means reviewing not only projects but also past decisions. Experienced companies say that their most significant losses come from moves that weren’t acted on. That’s why expectedly reviewing opportunities can avoid costly mistakes.

A systematic review process includes a root cause analysis of the specific data, decision criteria, and steps involved in an original investment decision.

In conclusion…

Investing in capital requires careful allocation decisions to reduce error, and, ultimately – wasted money. You need to take into account that you are investing in the time and talent of your resources. This also includes operating budgets and IT capacity. This is important to consider as it will hurt you financially if you don’t make sound investment decisions.

Undoubtedly, capital in most cases has the most significant impact on company finances. The above three mechanisms make it possible to avoid making critical investment mistakes. The primary disciplines of capital allocations listed here provide a rigorous framework into this process, while the best practices within each discipline can give your company a good set of guidelines. We have to do everything to avoid wastefulness. And, when we make better capital allocation choices, it becomes possible to execute on the right investments.

 

 

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