Making sound investment decisions is a perennial top-of-mind issue for CFOs—made even more so now given the potential effects of tax reform and cash repatriation. And, due to the pressure to make the right investments, it is not surprising that many finance chiefs are also reexamining their capital allocation processes.
It is no easy task. Comparing projects on a uniform basis is complex, as is quantifying the risks and potential benefits. Globalization, advances in technology, shareholder activism, and the push for greater social impact make capital decisions even more difficult.
Many finance managers also point to time-consuming manual analyses, the challenge of aligning capital expenditures with strategy, potential biases in decision-making, and the difficulty in holding people accountable for results.
There is a better way to approach capital allocation. It starts with the development of a “value architecture” that details how to evaluate investments in terms of strategy and risk appetite
Given such obstacles, a case can be made that before companies invest in another project, they should invest time and energy in determining how they make such decisions to begin with.
Fortunately, there is a better way to approach capital allocation. It starts with the development of a “value architecture” that details how to evaluate investments in terms of strategy and risk appetite. The value architecture also serves as a framework for how everyone involved in the process thinks about capital allocation, including trade-off decisions and the project portfolio management strategy.
In this issue of CFO Insights, we’ll explore some of the key steps needed to create a value architecture and explain why CFOs are well-positioned to lead such efforts.
Focus on value
Capital allocation decisions inevitably involve trade-offs. Companies need to strike the right balance between investments that serve business-as-usual needs, investments that drive growth, and investments that may—albeit with considerable risk—result in substantial returns.
Faced with dozens if not hundreds of proposals that span those three buckets, however, it can be extremely difficult to make the comparisons needed to develop a portfolio that creates the most value.
That’s why developing a value architecture is important. The “value” is based on the principles that determine how a company is evaluated in the marketplace in terms of its strategic, financial, and risk aspirations and achievements. The “architecture” describes how corporate objectives are translated into criteria, metrics, business case templates, and portfolio dashboards.
When developed using a multi-stakeholder process (explained below), a value architecture can provide both a comprehensive definition of the goals and KPIs for projects and a top-down portfolio view of financial, risk, and strategic issues. The result gives decision-makers a big-picture view of how all proposed projects compare to one another.
By way of illustration, consider the example of a public utility that was under pressure to reduce capital spending while carrying out its obligation to serve the community (see Figure 1). In order to do more with less, the utility needed to be able to compare and trade-off different types of investments across different business units.
To get the most value out of scarce resources, the utility developed an enterprise-wide value architecture to evaluate projects based on energy generation, transmission, and distribution.
The utility identified four overarching criteria for investing and further defined each by listing three to five goals and priorities. While every greenlighted project did not tick all the boxes, the architecture allowed decision-makers to better understand the trade-offs that went into the investment decisions.
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