Meeting the challenge of Capital Expense Planning (CAPEX) and Budgeting

22nd January 2007

FSN White Paper

"Capital Expense Planning"

Contents

INTRODUCTION

CHALLENGES OF CAPEX BUDGETING

Coping with uncertain projections

Linking long term projections to financial plans

Promoting multidisciplinary engagement in the process

Record keeping and complying with IFRS and US GAAP

CHALLENGES OF CURRENT PRACTICE

Heavy reliance on manual controls and spreadsheets

Poorly developed processes

Poor audit trail

THE EMERGENCE OF SPECIALISED SOFTWARE SOLUTIONS

SUMMARY

Introduction

Budgeting, planning and forecasting processes are already recognised as some of the most neglected and underserved management procedures when it comes to suitable systems support. So it should come as no surprise that the planning and approval of Capital Expenditure (CAPEX), a more specialised aspect of budgeting generally receives even less attention. Universally acknowledged by management of all levels as a problem area, it is dogged by lengthy timescales, cumbersome approval procedures and inaccurate data, causing many to question the value of a process which absorbs so much management time.

Yet the need to improve these processes is becoming more pressing by the day as management teams seek to shift the emphasis of reporting from a review of historic performance to a more forward looking stance that enables management and shareholders to understand better a company's future prospects for success. Indeed, regulators around the world have urged more relevance, transparency and accountability in business reporting and the preparation of forward looking statements has been a constant theme of the regulatory and political agenda over the last few years. In the United States , public companies have become used to more frequent quarterly reporting and similar measures are planned in Europe with the introduction of the EU Transparency Directive in 2007.

The quality of management information systems is crucial to the delivery of timely and accurate forecasts, yet for many organisations, the CAPEX process is over reliant on a labyrinth of disconnected spreadsheets and manual processes. In recent years, a number of specialised software solutions have emerged aimed at providing specialised functionality and workflow capability in support of budgeting, planning and forecasting processes. These have had a profound affect on improving the speed of budgeting processes, improving collaboration between user communities and enhancing data quality and reliability.

In view of this success and the benefits of broadly based budgeting, planning and forecasting functionality, attention is now turning to the need for more specialised applications such as Capital Expense Planning (CAPEX Planning). This white paper explores the special challenges and demands of CAPEX Planning seeking to explain how a newer generation of emerging solutions will also transform the planning and management of large scale capital projects into a more dependable process.

CHALLENGES OF CAPEX BUDGETING

Coping with uncertain projections

Large scale capital expenditure is almost by definition a special case. It does not conform to 'normal' budgeting routines because the activities are unusual, generally require special funding arrangements and often attract high levels of business risk requiring Board level consideration and approval. What constitutes a 'special case' varies between industries and the scale of the project relative to the size of the companies involved. Furthermore considerations around the acquisition of pre-built assets are very different from the issues surrounding the design and build of a major asset such as open cast mine excavator, a new production capability, construction project or scientific endeavour.

What marks out these projects is their very significant scale, the lengthy (multi-year) timescales for completion and their complexity. Naturally, modelling and planning CAPEX spend in this environment is subject to significant uncertainty, especially if the project is novel and takes the organisation into uncharted waters. Planning expenditure becomes a balancing act between expert technical opinion, financial appraisal and risk assessment. Where projects are of a one-off nature and there are no precedents, then risk assessment becomes a crucial aspect of project evaluation and planning.

Despite better knowledge, experience, training and methodologies around the planning and execution of large scale projects they still have a propensity to go spectacularly wrong from the earliest stages, suggesting that the CAPEX planning process is flawed. For example, the Olympics planned for Beijing in 2008 and London in 2012 have been dogged by budget revisions on a massive scale. Indeed many countries around the world can point to public and private sector projects that have exceeded their planned budgets. It seems that overruns go hand in hand with project complexity and scale.

Glenn McCauley, Head of PFI (Local and Regional Government), Consulting at Deloitte .

The Private Finance Initiative (PFI) is a form of private and public sector partnership in which the risk and rewards of financing long term developments are transferred to the private sector. This usually takes the form of private sector companies building assets on behalf of local and central government using commercially available funding, providing facilities management services, and committing to maintain these assets over their working life in of a service payment or Unitary Charge. They are generally large scale and can often span twenty to twenty five years.

But taking decisions over such a long timeframe is riddled with uncertainty. Decisions have to be made about the asset being developed as well as the services that will be required to maintain them in due course. "It involves an element of crystal ball gazing because the shape of future services may be difficult to define and the public sector often finds it difficult to specify what it wants over the long term," says McCauley.

Also long term plans in the public sector are susceptible to changes in policy. "Many authorities are investing heavily in waste management programmes and facilities for treating household waste. But a change in government policy with regard to bio-degradable packaging for example, could change the overall demand for individual types of treatment facilities overnight."

It means that the planning phase of the project has to consider a number of options and the arrangement have to be flexible to change. "You have to consider the long term risks, and the affect of these on construction costs as well as the likely changes in services and their effect on costs."

But by far the biggest issue is the organisational impacts that add the biggest risk during the planning phase. "It is the cost inputs suggested by technical advisors and experts that create the biggest sensitivities in the project plan. An inefficient financing structure is going to have much less of an impact than flawed assumptions about costs. Evidence shows that for large scale construction projects, like the Scottish Parliament's building at Holyrood, it is the cost of building things that is important. There has to be a robust and transparent process for really scrutinising the initial costs input," adds McCauley.

"Planning long term projects is costly and sometimes public sector organisations are put off by the difficulty of justifying the potentially high abortive costs if the project does not progress Planning and preparatory work are key to a successful outcome. It is surprising how often organisations hurl themselves into long term projects and huge investments with the flimsiest of business cases. The focus should be on getting it right first time," says McCauley.

Promoting multidisciplinary engagement in the process

Projects with contract values measured in the tens of millions almost inevitably span a range of functional expertise. Depending on the nature of the development, building up project costs can involve architects, engineers, and scientists. Similarly, responsibility for revenue assumptions may reside with marketers and commercial management. Whilst each specialism may be responsible for a discrete area of the CAPEX plan it is important that the individual parts are tightly bound so that the overall plan is simultaneously updated for changes in any of the constituent parts and each functional area has an appreciation of the consequences of a change of planning assumptions on outcomes elsewhere within the plan.

The position is complicated further where the CAPEX plan depends on cost inputs drawn from several organisations. Plans not only have to meld different functional viewpoints but they also have to overcome obstacles between organisations operating in different geographies and possibly, time zones as well.

CAPEX planning should be a collaborative effort between finance and the business says Ed Kiernan, head of Business Intelligence at Deloitte Consulting in the UK .

According to Ed Kiernan, a director of Business Intelligence (BI) at Deloitte Consulting it is extremely challenging to plan large scale CAPEX spending in a standard template. "Typically, these projects are too complex for the finance department to simply issue standard Excel templates to the business. The business must do its own local modelling, planning the business as it sees it."

But the disconnect between business and finance is very real. "The chances are that in a very large project a number of finance professionals and bankers will pour over the economic feasibility of the plan, reviewing matters such as interest rates used, taxation and accounting policies. But who is looking at the assumptions made by the business? It is these technical and business assumptions which can really scupper the CAPEX plan."

"Large scale CAPEX planning should not only be viewed as a partnership between the finance function and the business but also involve as many stakeholders as possible to validate the underlying assumptions."

Linking long term projections to financial plans

Managing the financial consequences of the CAPEX planning process is especially challenging. Estimating the state of a balance sheet, say, 12 years out or predicting project cash flows over a decade is inherently subject to doubt. Planned and unplanned changes to project specifications and requirements go with the territory. Senior planners in the public and private sector often describe it as 'crystal ball gazing' since the lengthy timescales introduce considerable fluidity into the planning assumptions and finance professionals often feel cut adrift from the underlying technical assumptions made by other functional areas and technical experts.

As one senior finance professional in the defence sector describes it, "the financial aspects of the plan, for example, the cost of capital, depreciation policy, the timing of funding and exchange rates used may have a measurable impact on the project's outcome but these factors pale into insignificance compared to some of the assumptions made around technical and operational feasibility." The discovery of unhelpful geology on a construction project or the impact of persistent bad weather on the delivery of a North Sea oil rig can have far more damaging consequences on financial outcomes.

Similar issues affect long range planning once construction of an asset is complete and the project transitions into a long term services contract. The timing of maintenance cash flows (both expenditure and revenue) could be very difficult to forecast especially where the services are novel and ill-defined. Technology itself changes so quickly that assumptions around methods of service delivery, such as maintenance of aircraft or operation of complex network infrastructure can be obsolete before they come into effect.

After the success of its planning process for IT projects and capital equipment, The University of Texas M. D. Anderson Cancer Centre is extending its reach into CAPEX planning for buildings and large scale renovations.

The University of Texas M. D. Anderson Cancer Centre is one of the world's most respected facilities devoted exclusively to cancer patient care, research, education and prevention. It's a major centre, providing care to around 78,000 patients a year as well as investing approximately $400m in research. Furthermore, the size of the institution, which employs more than 16,000 people has increased about 50% in the last five years and includes, for example, three research buildings, an outpatient clinic building, a cancer prevention building and a proton therapy center.

Clearly, managing a patient care, research and educational driven facility on this scale involves considerable attention to capital expenditure planning. Juan Castro, Director of Financial Forecasting & Analysis, is a member of the finance team responsible for the coordination and planning of the annual $400m CAPEX budget within the context of long range strategic plans.

Typically, three quarters of the yearly expenditure relates to new buildings and renovation with the rest divided between IT investments and equipment such as linear accelerators and MRI scanners. The latter are handled within the existing Hyperion budgeting and planning systems but expenditure on buildings requires a different approach.

"The facilities department uses a specialised project management tool for planning at a detailed level. It is great for traditional budgeting and allows project managers and engineers to build up the costs on an account by account basis, but it does not recognise the cost drivers, nor the revenues associated with the expenditure and so it is difficult to plot a Return on Investment (ROI) or to carry out any sensitivity analysis. So the financial consequences of capital expenditure are not obvious," says Castro.

To overcome these limitations, the centre deploys finance staff within the facilities department to assist in the preparation of the plans and communicate the results to the centre. Nevertheless, the process relies on intermediary spreadsheets which Juan Castro would like to see replaced by proper applications. "There is always the risk that something will fall down the cracks," he says.

"Ideally, you should have finance and operations personnel working in the same environment and sharing the same model. At the moment we rely on an embedded finance function and good communications to paper over the cracks in systems."

Juan Castro believes the way forward is to build on the success of the existing Hyperion system that project managers use for IT capital expenditure planning. "Project managers understand project phases such as 'analysis and planning', 'execute and control' and 'roll out' but do not necessarily appreciate the different accounting policies required for each phase. Using a driver based approach project managers simply drop their costs into operating expense lines and the system does all of the work behind the scenes capitalising costs where appropriate. When considering new building facilities we could build in revenue drivers based on number of patients served, incremental operating beds and vehicle parking requirements."

Another existing system allows budget holders to rank proposed CAPEX equipment spending – something which Castro and his department are keen to see in any further development of a CAPEX planning system. Departments can rank their equipment requests and these priorities can be re-worked at the divisional level until various committees review and approve or reject the proposed spending. The new equipment requests and known replacement cycles are then built into the long term (10 year plan). Castro is keen to build this capability into the CAPEX process for buildings but is also conscious of the need for more sophisticated functionality around performance metrics, depreciation schedules and ongoing operating costs such as renewals and maintenance.

Even though the planning is complex he is confident it should be possible to define core requirements for CAPEX planning - provided there is some flexibility. "Large scale CAPEX planning is definitely on our road map," he concludes.

Record keeping and complying with IFRS and US GAAP.

One of the challenges of CAPEX projects is the need to plan at a detailed level of granularity because complex assets are multi-faceted and involve different accounting treatments. Between them, IFRS and US GAAP cover most of the global 2,000 companies and since most national standards around the world tend to be based on either of these two major standards, no attempt is made in this white paper to consider accounting treatments beyond this.

IAS 16, "Property, plant and equipment", is the main international standard that deals with tangible fixed assets. In addition IAS 23, "Borrowing costs", deals with the capitalisation of borrowing costs and IFRIC 1, "Changes in existing decommissioning, restoration and similar liabilities," deals with changes to decommissioning liabilities and the effect of such changes on the carrying amounts of tangible fixed assets. Also IAS 38, "Intangible assets", briefly sets out the treatment of software development costs and other intangibles contained in or on assets that have physical substance. IAS 11 deals specifically with the recognition of costs and revenues around construction contracts.

So building up a CAPEX plan for a complex project requires the correct categorisation of each major component so that it is treated appropriately in financial forecasts integrated to the CAPEX plan. For example, each part of an asset of an item of property, plant and equipment that has a cost that is significant in relation to the total cost of the item should be depreciated separately. A good example is an aircraft and its engines, or alternatively, a blast furnace and its lining. The appropriate "cost" is the purchase price plus any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. It also includes estimated costs of dismantling and removing the asset and restoring the site on which it is located.

When planning for CAPEX, care has to be taken that where appropriate, costs that are directly related to employees, such as, site preparation, assembly and professional fees which can be capitalised, are included. It can be seen that confirming the appropriate accounting treatment in the CAPEX plan for these complex assets depends heavily on expert technical (engineering and scientific) knowledge as well as financial expertise.

As is well known, there are differences between US-GAAP and IFRS but in broad terms these affect the basis of measurement rather than the detail of what should be recorded. Whilst IFRS allows assets to be valued at historic cost or on a revaluation (fair value minus accumulated depreciation and impairment losses) US GAAP generally requires the use of historic cost. The other big difference is that IFRS allows major inspection or overhaul costs to be included as part of the cost of an asset whereas US GAAP expects these costs to be expensed.

CHALLENGES OF CURRENT PRACTICE

Heavy reliance on manual controls and spreadsheets

Current CAPEX planning and forecasting practice relies heavily on the use of spreadsheets which although ideally suited to complex calculations performed on behalf of an individual, were not designed as a substitute for a complete application.

Furthermore, as everyone knows, spreadsheets can represent a serious risk of error. Unnoticed errors in logic and inadvertently overwritten formulae are just two of the conditions that can give rise to serious adverse consequences. Thankfully, many mistakes are spotted early or contained within the boundaries of the authoring company but on many occasions the problem 'escapes' into the public domain and can cause serious financial loss or reputational damage. This is particularly true of large scale CAPEX projects. Take for example the 2012 London Olympics preparations which failed to properly account for VAT, adding unexpected millions to the latest estimate.

Poorly developed processes and audit trail

More importantly, spreadsheets provide very limited support for the CAPEX planning and approval cycle. In the main, different aspects of CAPEX planning tend to be carried out in functional 'silos'. For example technical and engineering costings and assumptions tend to be carried out separately from the financial plan covering depreciation, funding, cash flow and projected balance sheet with the result that changes in one area are not automatically reflected in the other. This lack of visibility and collaboration around CAPEX plans seriously jeopardises the integrity of the plans and introduce unwelcome delays into the planning process.

Similarly, the lack of process support which characterises a spreadsheet bound process makes it difficult to monitor changes and trace them back to individuals.

VeriSign seeks stronger links between CAPEX business case and planning

VeriSign operates the systems that manage .com and .net, handling as many as 18-billion Web and email look-ups every day. VeriSign also provides managed security services, security consulting, strong authentication solutions, and commerce, email, and anti-phishing security services to organizations all over the world while securing 3,000 enterprises and over 500,000 Web sites worldwide.

Furthermore, it runs one of the largest telecommunications signaling networks in the world, enabling services such as cellular roaming, text messaging, caller ID, multimedia messaging, and mobile media management. Unsurprisingly, CAPEX Planning is a key aspect feature of its business and therefore a key aspect of its planning process.

When VeriSign's business units generate requests for capital expenditure each year, each request requires a fully worked business case with justifications and expected return on investment (ROI). The planning process usually occurs prior to the development of these detailed business cases and therefore during the planning process, the Financial Planners create multiple "placeholders" for anticipated CAPEX expenditure pending the development of a detailed business case. Whilst the planning and CAPEX systems are manually linked, the biggest challenge is reflecting the projects' realistic anticipated ROI in the detailed financial plan.

Elysse Hack, VeriSign's Director of Planning, explains that "Whilst the incremental expense side of the approved CAPEX projects flows through to the detailed plan it is challenging to get accurate revenues and expense savings. Businesses can sometimes be more optimistic about revenues or cost savings than turns out to be the case. Naturally, when the business cases are prepared, the detailed analysis of revenue or cost savings is validated but since the planning process occurs prior to the business case development, the initial ROI created by the Business Owners is used and this ROI may not reflect the validated revenue or cost savings that have been determined during the business case process."

It is also difficult to confirm the strategic alignment of CAPEX spending. "Capital expenditure is generally strategic in nature but this information is currently not captured in the plan. Similarly, the detailed financial plans give no sense of the priority of the different projects or the correlation of the CAPEX spending to revenue," she adds.

In common with other large companies, VeriSign has considered automating the link between the CAPEX approval system and its planning system but creating such a unified system is hampered by the need to budget at very different levels of detail and an understandable reluctance by business units to base their Plan on benefits that have not been fully determined at the time of the planning process.

THE EMERGENCE OF SPECIALISED SOFTWARE SOLUTIONS

As the market for budgeting and planning products matures, specialised solutions dealing with CAPEX planning are starting to appear. Building on a solid web based planning process this new generation of products provides a platform for collaborative CAPEX planning at a detailed level which is nevertheless integrated with the financial plans. This coupling of financial and operational CAPEX planning overcomes the significant limitations of spreadsheet based systems and ensures the financial and operational integrity of proposed expenditure. Furthermore, technical and financial experts within the company and from the outside (if required) have full visibility of the financial consequences of changes in operational planning assumptions.

Many of these systems also provide specialized (but customisable) functionality designed to support common CAPEX planning tasks, such as categorisation of assets, depreciation calculations, funding and cash flow options over the duration of the whole project. In some cases, existing assets can be brought into CAPEX planning via a fixed assets register where partial additions and disposals can be recorded and depreciated or re-valued as required after taking into account impairments. Some packages also provide the ability to plan for capital asset related expenses such as costs of maintenance, repair and insurance.

One of the most welcome features of modern software solutions is the guided workflow that governs the approval process for CAPEX spending. Plans can be reviewed at critical stages and successive reviewers can normally accept or reject plans, proposing or making adjustments as required. Automating the approval chain in this way accelerates the process whilst maintaining a full audit trail of changes, who made them and when.

SUMMARY

CAPEX planning is a complex process often involving considerable levels of expenditure and exposure to risk. Large scale projects such as these have a propensity to go off the rails, a situation encouraged in the planning phase by spreadsheet bound processes which are prone to error and do not afford sufficient opportunities for collaboration between technical and financial specialists.

However, a new breed of solutions is emerging, which building on successful web based implementations of more straightforward budgeting and forecasting applications, provides the specialized functionality necessary for CAPEX planning combined with guided workflow and process support.

These systems provide the ability to plan for large CAPEX spending in a collaborative environment which ensures that financial and technical plans are inextricably linked covering all phases of an assets' useful life from planning and construction through to maintenance and decommissioning. In this environment, operational matters are automatically reflected in financial outcomes and management can assess the impact of different scenarios on cash flows, taxation and projected balance sheets spanning several years. But collaboration on this scale also brings benefits in a more tightly controlled approval process with greater visibility for decision makers and a faster decision cycle.

CAPEX software, specifically designed for the task and the process has the ability to transform an important and high risk endeavour into a controlled and dependable process.

About FSN Publishing Limited

FSN Publishing Limited is an independent research, news and publishing Organisation catering for the needs of the finance function. The report is written by Gary Simon, Group Publisher of FSN and Managing Editor of FSN Newswire. He is a graduate of London University , a Chartered Accountant and a Fellow of the British Computer Society with more than 23 years experience of implementing management and financial reporting systems. Formerly a partner in Deloitte for more than 16 years, he has led some of the most complex information management assignments for global enterprises in the private and public sector.

Gary.simon@fsn.co.uk

www.fsn.co.uk

Whilst every attempt has been made to ensure that the information in this document is accurate and complete some typographical errors or technical inaccuracies may exist. This report is of a general nature and not intended to be specific to a particular set of circumstances. FSN Publishing Limited and the author do not accept responsibility for any kind of loss resulting from the use of information contained in this document.

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