4/23/2014 | Chuck Leddy

Allocating capital expenditures for your middle market business, also known as capital budgeting, is never easy. There are always multiple investments that seem eminently worthy, such as new equipment and new hires, that are all promising to return your investment at different rates, both short-term and long-term. Budgeting is inherently future-oriented, based on underlying assumptions about your market, your company's ability to properly execute, compliance issues, and much more. Before we examine how to allocate capital expenditure properly, let's look at what not to do.

No Assumptions

Many companies in the middle market allocate capital expenditures fairly consistently over different business areas, making only incremental annual budget changes under the umbrella of the same, broad investment pattern. A more active company, on the other hand, continuously reevaluates its prior budgeting choices, making no assumptions based on the last year's budget, and adjusts investments based on emerging market opportunities and the data-driven monitoring of results. Over time, which model of budgeting decision-making will achieve higher return from its capital expenditures?

Research performed by consulting firm McKinsey suggests that after a period of fifteen years, a company with a more dynamic, flexible budgeting process will be worth an average of forty percent more than a company that sticks to the status quo. McKinsey also found that a massive majority of companies follow the same investment patterns year after year without making active adjustments. As the McKinsey report sums up, "in those [companies] where capital and other resources flow more readily from one business opportunity to another, returns . . . are higher."

The first action to take is to simply stop basing your capital expenditures on the previous year. The process must be shifted to focus on analyzing market opportunities and investing in areas of growth while getting out of areas of stagnation. Every budget decision needs to be justified from the ground up through a brand-new process that makes no assumptions based on the past. Blow up the defaults.

Here are four other tips for adjusting your budgeting process:

  1. Have a deep understanding of your strategy, and be flexible in adapting it to the dynamics of your market. Budgeting must serve strategic goals first. Once you have a strategy and have developed goals, then start determining how to achieve them. It's not enough to say that "we want to expand into Asia." Put together a detailed strategy. Which markets in Asia present the best opportunities for growth for your offerings? In those markets, how do you plan to enter? With a partner, a joint venture, with production, or distribution only? Start developing project ideas and estimating required capital expenditures. Once you've created a portfolio of potential projects, initiate a from-the-ground-up process of due diligence by examining the risks, making potential valuations, and starting to consider resource allocation. Have a system to rate each investment.
  2. Develop a process to estimate future return and cash flows. Stick with your determination processes so you can make comparisons from year to year and across different projects. There are a number of methodologies available for making decisions about capital budgeting. You need to understand the project's payback period, or how long it will take to get a return on your initial investment. Another common and effective measuring tool is net present value (NPV), where future cash flows are discounted to compensate for the inherent uncertainty of those cash flows. Yet another tool is internal rate of return (IRR), which is technically the discount rate that occurs when a project is at its break-even point, or when NPV is zero. For example, if the cost of capital is 5 percent and the IRR is 4 percent, you will likely reject the project. If the IRR is 8 percent, however, and assuming a 5 percent cost of capital, you will likely move forward with the project if no better projects exist. No matter which methodology you use, understand it and use it consistently to enable comparisons.
  3. Promote a process of information sharing. Share information about the budgeting process throughout the organization, which not only promotes internal engagement on projects but also helps make decision-making better. Ask people to put the company's strategy first when they provide input rather than worrying about their particular business area. You might even need to create new internal structures to fight against the internal politics that can hopelessly warp the budgeting process for so many middle market companies. To do things right, you'll need a lot of help in understanding your markets, your own capabilities, and aligning all of it with your strategy. You may need to break some departmental silos to get things right if departmental loyalties are getting in the way of aligning capital with overall strategy to maximize return.
  4. Measure, monitor, and adjust. Capital allocation should be a focus of your middle market company every single day, not just during budgeting time. You need to know quickly, for example, when the execution of a project is going badly and be equally fast in getting it back on track. Sometimes the market assumptions that you made as the foundation of a strategic decision change over time, and you'll need to revisit that initial decision and adjust it according to new realities. You don't want to be the inflexible company that gets caught flat-footed when the market changes. Being aware of how your strategic goals connect with your capital expenditures needs to be a constant priority for everybody. Budgeting is never easy, of course, but it may be the most important activity that you take part in for your middle market business.

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Boston-based Chuck Leddy is an NCMM contributor and freelance reporter who contributes regularly to The Boston Globe and Harvard Gazette. He also trains Fortune 500 executives in business-communication skills as an instructor for EF Education. Circle him on Google+ .