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Six Tips to Improve Your Firm’s Capital Allocation Process

  • By Nilly Essaides
  • Published: 2/3/2016
For more insights on financial planning and analysis, check out AFP’s FP&A Guide series.

alloc8A study published Tuesday in the Wall Street Journal revealed that a little over 50 percent of companies failed to generate project returns above their cost of capital in 2015. The study, by Aswath Damodaran, a finance professor at New York University’s Stern School of Business, shows that the median return for companies was in fact 3.1 percent under their cost of capital. How can financial planning and analysis (FP&A) help make sure companies make the right investment choices?

Capital allocation best practices

Have standard criteria
. “There’s always some concern with regard to underesti¬mating cost and overestimating the benefit,” commented Jason Logman, principal, EPM Transformation Practice at The Hackett Group in an AFP FP&A Guide, Making Capital Allocation Decisions: The Role of FP&A. “What we’ve done from an FP&A capital planning perspective is to say that you should have some standard criteria, a gating process that cuts across multiple projects. The key is to set up a much defined set of metrics to evaluate the project and then check those.”

Keep it dynamic. Don’t just do the evaluation once at budget time and then put the analytics tools in the drawer. Experts suggest that FP&A keep running the project through the same gating process at each budget period or at significant project milestones. According to one finance executive, this should be an ongoing process, not a one-time shot. That way if a project is headed south, the company can cut its losses and invest its capital elsewhere.

Run through multiple scenario analyses. Most companies have a baseline, best and worse-case scenario. To add more value, FP&A should run the numbers through more advanced analytics that take into account multiple possible risks to produce a more nuanced range of possible outcomes. According to Mark Pellerin, a principal with Oliver Wyman, what’s important is for companies to work on improving their forecasting through disciplined scenario analysis. “No single scenario would be right,” he said. “You want to understand the directional outcome.” One of the shortcomings is that these scenarios are not revisited as more information becomes available. According to this risk expert, the question FP&A should ask is: “How is the project performing against these multiple scenarios? Given these factors, make the decision change the slope of the cash flow forecast.”

Don’t jump into the business case too soon. Too often, business analysts jump too quickly into making the business case, focusing on what they know and avoiding what they don’t know and other factors that are hard to predict.  Experts suggest FP&A takes a step back and frame the project within its multiple risk factors before looking at costs and benefits.

Minimize bias. The trend toward driver-based modeling and data-driven decision-making should help FP&A and the business minimize human subjectivity and management bias in the capital-allocation process. Trying to reduce gut-feel decisions and introduce more information, using big data, competitive information and potential risks into the forecasting process can help increase forecast reliability.

Conduct a post mortem. Finally, the NYU study showed many companies fail to recoup their cost of capital repeatedly. To prevent repeated mistakes, FP&A needs to do a post-mortem at the end of the project to assess whether it yielded expected returns and if not, why. “Go back and have a real hard conversation about where the project ended up,” the Hackett Group’s Logman said. He suggested FP&A executives initiate a serious conversation with business leaders and management about the cost and benefit estimates.

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