Capital Expenditures and the Multiple Reasons for Their justification

Published on Friday, 10 January 2014 11:35:02    Written by Marc
People that oversee and approve capital expenditures (in companies) normally get to review the business cases that come with the capital expenditure request. Actually, most companies and organizations request some kind of business case to be done BEFORE giving the green light for any project or capital expenditure that is not already pre-approved. Moreover, even when it is pre-approved, most people still need to justify the capex before they initiate the expense.

capital expenditureIf you are part of the approval process of capital expenditures in your company/organization, you know that all these requests come with a reason. People that seek approval of capital expenses use different reasons for their justification and this in itself is probably one of the most important elements of the business case. However, the process of capital expenditure approval has seen an increase in the number of reasons used for justifying them, and its adding complexity to the process.

Let's Examine Using Historical Reference

Over the past years, companies have typically spent money for capital expenditures for a number of reasons, such as, the need to replace older existing equipment or acquire new equipment to grow their business, or complete some major repairs to a building. Later, when efficiency improvement became more popular (and such equipment became available), companies started to replace current equipment with more efficient ones in order to gain efficiency by reducing man power (by automating processes), waste, and energy.

These are only a few reasons for spending on capital expenditures but they illustrate that reasons have evolved over the past decades to include new ones. Over many years, companies evolved their justification criteria for spending on capital expenditures. If, one hundred years ago, most capital expenditure were justified by replacing old equipment or doing major repairs, new justifications for capital expenses are much more complex and varied today. Reasons today (in addition to the previous ones used in the past) now include legislation, insurance, disuse, energy saving, health and safety, and the environment to name only a few. Of course, the traditional reasons such as replacing equipment, which have reached the end of their life, are still popular. However, we are seeing new reasons relating to fields such as the environment become more popular these days.

The problem for people in a capital expenditure approval position, getting to understand the reasons for the capital expenditure demand, is also getting more difficult because of the evolving reasons for the request. In addition, without a good understanding of the reason for the capex request, many people can take a fallback position (that may seem risk free) of denying the capex request. After all, if we deny the approval, we eliminate the risk that the project or the capital expenditure would have been a bad decision, right? Nevertheless, what about the good projects that are being denied simply because the approvers do not fully understand the reason behind the capital expenditure request? It makes you wonder how much the company and organizations are missing opportunities because of this.

Replacing equipment because it is too old to function properly is a concept that can easily be understood and approved without too much pain. Replacing perfectly good equipment for another one, which will reduce the company’s carbon footprint, is another story. Same thing for retrofit projects whose sole purpose is to save energy. Instead of having to simply compare between keeping an old equipment running and purchasing a new one, the capital expenditure approver now has to understand new concepts.

Questions from the approvers start to fuse from all directions:

  • Can you explain how this retrofit project will help us save energy and reduce our carbon footprint at the same time?
  • How much of this project is saving energy and how much is simply to make us look greener?
  • I do not understand this project, how do we measure the immediate benefits for the company?
  • Do we do use standard methods such as Payback, NPV, IRR?
  • Can we get grants for the project?
  • How many grants are we sure to get and how much are based on your internal guesstimates?
  • Is this is for safety reasons? Why was it safe last year and all of a sudden, it is now not safe? What changed?
  • Are we are replacing because of legislation? Which legislation is it? We just changed the equipment last year; can we continue as we are doing now?
  • Does the insurance company want us to spend? Is this an absolute requirement (if we do not do this we lose our insurance protection); or, is this another one of their nice to have proposals?

These are only a few examples of questions that come up, these days there are many, many more and rightfully so. Nevertheless, how often is capital requests denied because the approvers did not fully understand the benefits behind the request, or because of a perceived risk attached to the request?

Because of the explosion of reasons, getting some projects approved requires that the initiator of the request do more homework than before. No one really expects the capital expenditure approvers to be experts in all fields such as legislation, health and safety, energy saving, insurance, and others, but the approvers need to be able to analyze the capital expenditure request that are initiated for very various reasons.

How can the initiator of the capital request and the approver get to be on the same level so that the good capital expenditure requests are approved and those that provide less value to the company are rejected?

It is up to the initiator of the capital request to provide enough information for the approver to understand fully what he or she is approving. In the capital expenditure request, the initiator must clearly state at a minimum:

  1. What the expenditure request is about, providing as much details as possible on the project, the purchased equipment, the cost, timeline and other elements that are associated with the capex request such as warranty and/or performance guarantee.
  2. The reason or reasons behind the expenditure. This is mainly providing information on the benefits that the expenditure will bring (help to increase production, comply with legislation, save energy, add security to workers…etc.).
  3. The total cost, meaning the cost and all potential additional cost that may arise
  4. The risks (all of them). Capital request that are for more complex equipment or projects should include information on the potential risks, this shows the approver that homework has been done. For example, if there is a risk that the new equipment the capex request is seeking may take more time to install and get running, there might be production downtime because of this.
  5. The benefits to the company/organization. These include the financial benefits (payback, NPV, IRR), quality (improvement of production quality), health and safety, cost reduction, marketing/image benefits (if the project helps the environment for example). The benefits and the reason normally go hand in hand although some capital expenditure might not have much benefit. For example, if a new municipal law requires a company to install something new, say a fence, while this new law will be the reason for the capex request but it might not bring any benefit for the company (apart from getting the city off the company’s back).
  6. The downside of not doing the project. If there are benefits to the capital expenditure that is requested, there is probably a downside by not doing it. It is important to outline the downside or potential consequence that would result from not getting the capex approved. This can range from government penalty (suppose the company does not approve a capex request that was for something related to legislation) to public negative news (suppose the capex request was for replacing a chimney that emitted pollution next to a residential area). These are simply examples and there are many other potential downsides. The important is to provide the information on the capital expenditure request for the approvers to understand fully the consequences of not approving the capex.
  7. Any technical information that the approver needs to understand should be presented in a clear way so that the person (or persons) in the position of approving the capital expenditure can take a sound decision. The more information and explanation that is provided, the more the approvers will understand what the request is about and in many cases, the more they can tend to be favorable to the request (if the request already meets the company’s criteria of course).

I published a blog a while ago on 30 Things Not to Forget When Purchasing a CapEx, that listed items that can be useful to supplement a capex request document.

Bottom line, the process of capital expenditure has evolved significantly over the years. Today, there are more reasons to initiate a request for capital than there used to be only a few years ago, and this tendency is probably going to continue in the future. People seeking to get their capital expenditure approved should consider that the multiple reasons available for their capital expenditure justification only makes the work of the approvers more complex and therefore, they should provide them with as much information as possible in order for the approvers to take decisions that make great business sense for their companies or organizations.