Capital Projects. Barshop Paul
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of the old factory because of the sensitivities of shutting down the old factory where people were about to lose their jobs. The late start caused mistakes in the technical design because of the rush to get the work done. And because the team could not work with the factory operators, they had to make assumptions about how the equipment would be reused – and those assumptions turned out to be wrong.
The root cause of the failure was that the executives never reconciled the conflict in their objectives. On one hand, they wanted to keep the old factory running and delay the announcement of the closing for as long as possible. On the other hand, they wanted the consolidated factory up and running in time for an important seasonal window. The desire to achieve both objectives is understandable. Executives face tremendous pressure to deliver value from capital. Delivering that value often requires meeting targets that are hard to achieve. In this case, the executives should have acknowledged the risk in the objectives and developed a strategy to reduce the risk. The mitigation would have lengthened the payback period but would have still allowed for a profitable project. Instead, the business lost money on the investment.
Background and Basis for the Book
At Independent Project Analysis, Inc. (IPA), we have been studying the problem of how businesses can maximize the value created by their capital projects for nearly 30 years. That is our mission. Our quantitative benchmarking services are used by the world's largest industrial companies as the core of their continuous improvement programs to derive more value from their projects. IPA's empirical research has led to the widespread adoption of project management concepts such as Front-End Loading (FEL) and Value Improving Practices (VIPs). The work of IPA's founder, Edward W. Merrow, has become the de facto handbook for the development and execution of megaprojects.2
For the past 22 years, I have worked directly with IPA clients all over the world evaluating projects and providing guidance on how to improve both individual projects and project systems. About eight years ago, I started a series of studies on the initial stages of capital project development. A capital project starts with an idea that a business need exists. Unfortunately, fully developed, viable projects do not fall from trees. There is hard work to be done to shape and define opportunities into projects that deliver sufficient benefits to justify the cost and risk. I have always been fascinated with these activities and, in particular, how a business and project organization should work together to translate a set of objectives for growth and profit into a doable project. Throughout this book, I will describe the executive's crucial role in capital project development as well as the steps necessary to ensure that the project organization listens carefully and fully to what the business needs.
Capital Projects Create Value
Capital projects are high-risk, high-reward activities for both the company and the executives involved with the project. Project success is critical to the long-term financial success of a company. Projects can be a business's main engine for profitable organic growth by introducing new products or services or by increasing the production capacity of existing products and services. For example, a financial services company may have invented a new algorithm for web-based investment advice but still needs to design the application and deploy the IT infrastructure to handle the expected growth in customers. A specialty chemical company may have struck an advantageous marketing deal with a foreign partner but now needs to build a plant to make the product. A manufacturing company may have spent years developing a new technology that will cut production costs in half, allowing it to undercut its competition and take market share, but needs to build a factory to deploy the technology. Projects can also make a business more efficient or solve nagging problems. For example, a project might purchase and deploy new software systems that make the company's sales force better. Even seemingly mundane projects to upgrade or refurbish existing assets represent significant commitments of capital that need to pay off to keep the company competitive.
Capital projects actually create value when the benefits from the asset created or modified by the project exceed the project cost. The most common method for measuring the added value of a project is the net present value (NPV) generated by the investment. The formal definition of NPV is the present value of future cash flows discounted at the appropriate cost of capital, minus the initial net cash outlay. More simply, NPV is the amount of shareholder wealth created from a capital investment after accounting for the total cost of the investment and the time value of money. For example, a $10 million capital project that generates $1 million in NPV has enriched the company owners by $1 million. Positive NPV from a capital investment is a good thing. Unfortunately, it is entirely possible for a capital project to make shareholders worse off than when they started. About one in seven projects will lose all of that $10 million capital investment.
Most Projects Create Less Value than Expected
Executives approve or reject capital projects based on the project's expected value. The financial gap between what was expected from a capital project when it was approved and what was actually achieved can be measured. The average project delivers 22 percent less NPV than what was forecasted when the project was funded. That is what we at IPA found in a study of 431 completed industrial sector capital projects. The business goal for each project was to increase profits by adding new production or manufacturing capacity.3 The 22 percent NPV erosion means a project targeting profit of $1 million would come out only $780,000 ahead on average.
The good news is that the average project is profitable; otherwise, everyone would be bankrupt! The bad news is that the promised profitability is often missed by a large and highly unpredictable margin.
Results Apply to All Types of Projects
The results of this study of industrial projects are important to you even if you are not an executive involved in a multimillion-dollar project to build a new factory. The conclusion that capital projects often fall short of delivering the expected business value applies to any type of project. It does not matter whether the project is to construct a new office building or to develop new software. In fact, the performance of capital projects done by companies with less experience and less infrastructure for doing projects is probably a lot worse. The industrial companies in my study are capital intensive, spending hundreds of millions and in many cases billions in capital every year to build new or to refurbish their assets. Despite the importance of capital to their long-term success, these companies still struggle to consistently deliver the expected business value from their projects. Imagine the challenge for the executives of a company that only does the occasional capital project!
Sources of Value Erosion are Not Limited to Cost and Schedule Overruns
Value erosion occurs when what was actually delivered by a project is lower than what was promised when the project was funded. Cost and schedule overruns are usually thought of as the main culprit of value erosion, and they do indeed make a significant contribution to lower NPV, but the largest source of value erosion for these industrial projects has nothing to do with how the project was managed. The breakdown of value erosion falls into three categories in order of importance: (1) demand for the product was lower than expected, (2) the cost and/or schedule were overrun, or (3) the facility did not operate as expected. Any single project may have done well in one or two areas but fell short in others. These are just the averages for each category (see Table 1.1).
Table 1.1 Average Value Loss by Category
Some of the reasons people gave for the lack of demand include:
● “Lost our biggest customer.”
● “Orders were lower than expected.”
● “Prices were not high enough to keep the plant running.”
Changes in economic conditions, competitor actions, and shifting customer preferences are outside executives' control, and they make demand and price forecasts inherently uncertain, especially in the short term. Yet overconfidence in the market forecast by executives is a common source of value erosion, especially for projects that destroyed all the capital invested.
Edward W. Merrow,
The projects were from 64 different companies in 11 different industrial sectors, located across the globe, and ranging in size from $100 million to $20 billion.