Article published by American City Business Journals on May 2, 2022. Revised 8:00 am.
Ongoing investment is the lifeblood of all capital intensive manufacturing businesses. As a former CEO, I believe a focused and disciplined approach to capital budgeting for these businesses is to classify projects into five categories:
Investments in safety and environmental stewardship
Not all safety projects are budgeted, in that they should be undertaken when workplace hazards are identified throughout the year, including those that go beyond state and federal regulations if you believe those regulations don’t meet your company’s internal standards for workplace safety.
Capital projects to meet environmental regulations should be undertaken in the same way as safety projects.
Repair of buildings and equipment
Large repair projects that extend the life of an asset are capitalized, not expensed. If buildings and equipment are not kept in good repair, reliability declines. Repairs are more costly if allowed to accumulate. In cases where the state of the art of technology has advanced, rather than make an in-kind repair, deploy the new technology if it makes economic and operational sense to do so.
Some business leaders believe that capital expenditures to keep a business running should be no higher than the balance sheet depreciation. This may stifle needed repairs. I believe that spending of capital for repairs should be determined by operational needs and not an accounting convention.
Information technology investments
One of the mistakes companies make is not recognizing that every information technology system requires on-going upgrades. Keep your technology up to date by making annual investments in your IT infrastructure. Today, cyber security is a critical part of your IT investment.
Optional profit improvement projects
Unlike the previous three categories of investment, these projects are justified based on their internal rate of return (percent IRR) or the time it takes the project’s savings to pay back the investment. You may set a minimum IRR criteria of 15% or a payback time of three years. This could change annually, depending on the company’s other capital needs. These projects are optional, in that they could be postponed if the need for capital in other investment categories is high.
Expansion of current businesses and investment in new businesses
These initiatives need to meet a return on investment criteria. All initiatives need to generate an internal rate of return above the cost of capital (weighted cost of debt and equity). For example, assuming the company’s cost of capital is 8%, you may choose to invest in these projects if the IRR exceeds 13%, to allow a margin of safety in the event that assumptions about the performance of the investment falls short.
Expansion of current businesses are relatively low risk investments. When investing in new businesses, the higher risk should be weighed against the strategic imperative of the initiative.
Acquisitions are not part of the annual capital budgeting process since you don’t know when an acquisition opportunity might arise. They tend to be opportunistic. The higher the cash flow and long-term strategic benefit to the company, the higher the multiple of EBITDA (earnings before interest, taxes, depreciation and amortization) you would be willing to pay for the acquisition. Acquisitions are typically funded by an increase in debt, whereas projects in other categories are funded by cash flow.
The above framework is useful in communicating to your operating management how they should view their capital spending opportunities. It’s a focused and disciplined approach to managing capital investments.
Stan Silverman is founder and CEO of Silverman Leadership and author of “Be Different! The Key to Business and Career Success.” He is also a speaker, advisor and widely read nationally syndicated columnist on leadership, entrepreneurship and corporate governance. He can be reached at Stan@SilvermanLeadership.com.
