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CAPEX Excellence
Optimizing Fixed Asset Investments
Dr Hauke Hansen
Dr Wolfgang Huhn
Mr Olivier Legrand
Dr Daniel Steiners
Dr Thomas Vahlenkamp
A John Wiley and Sons, Ltd., Publication
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Publishedin2009
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CAPEXexcellence:optimizingfixedassetinvestments/HaukeHansen...[etal.].
p. cm.
Includesbibliographicalreferencesandindex.
ISBN978-0-470-77967-5(cloth)
1.Capitalinvestments. I.Hansen,Hauke.
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Contents
Acknowledgements ix
AbouttheAuthors xi
PARTI WHYINVESTMENTSMATTER 1
1 Introduction 3
1.1 Investments:theforgottenvaluelever 3
1.1.1 Theearlybirdcatchestheworm 4
1.2 Abird’s-eyeviewofthebookcontent 6
1.2.1 PartI:Whyinvestmentsmatter 6
1.2.2 PartII:Gettinginvestmentsright 7
1.2.3 PartIII:Rightallocation:Managingacompany’s
investmentportfolio 9
1.3 Whyinvestmentsmatter:theimportanceandstructureofcapital
investments 10
1.3.1 Therelevanceofcapitalinvestments 10
1.3.2 Thestructureofcapitalinvestments 16
1.3.3 Timedependenceofcapitalinvestments 21
1.3.4 Thefutureofcapitalinvestments 26
1.4 Summary 27
Appendix1.1:Waveletanalysis:Extractingfrequencyinformationfrom
investmenttimelines 27
References 29
PARTII GETTINGINVESTMENTSRIGHT 31
2 RightPositioning:ManaginganAsset’sExposuretoEconomicRisk 33
2.1 Preface 33
2.2 Assetexposuredeterminestheachievablereturnonaninvestment 33
2.3 Fivelevelsofprotectiondeterminetheassetexposure 35
2.4 Asimplescoringmetrictomeasureassetexposure 37
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vi Contents
2.5 QuantitativeassetexposureanalysisshowshighcorrelationwithROICat
alllevels 42
2.5.1 Usingexposurelevelanalysisforbenchmarking 45
2.6 Strategiestoreduceassetexposure 47
2.6.1 Strategy1:Createpublic-private,win-winsituationsinnatural
monopolyenvironments 48
2.6.2 Strategy2:Fosterregulatoryconditionsthatenablesufficient
investmentlevels 49
2.6.3 Strategy3:Createtherightstructuralconditionsandensurefair
accesstoscarceresources 49
2.6.4 Strategy4:Establishprotectionforintellectualproperty 50
2.6.5 Strategy5:Achieveastrongcommercialposition 50
2.6.6 Strategy6:Minimizefixedcapitalcostsoroutsourceasset
ownership(go“assetlight”) 52
2.7 Summary 53
3 RightTechnology:HowtoOptimizeInnovationTimingandRisks 55
3.1 Capitalinvestmentsintechnologyinnovation 55
3.1.1 Technologyanalysis 57
3.1.2 Assessrisks 63
3.1.3 Mitigatingtechnologyrisks 67
3.2 Summary 69
4 Right Timing: How Cyclicality Affects Return on Investments and What
CompaniesCanDoAboutIt 71
4.1 Howcyclicalitydestroysvalue 71
4.2 Industrydriversofcyclicality 73
4.2.1 Impactofinvestmentleadtimes 77
4.2.2 Slow-to-nomarketgrowth 78
4.2.3 Highpricesensitivity 78
4.2.4 Investmenttimingwithrespecttothecycle 79
4.3 Developinganeconomicmodelofcyclicality 81
4.3.1 Afundamentallawofeconomiccycles 81
4.3.2 Baseparametersofsimpleeconomicoscillations 83
4.3.3 Reactionofcyclicalsystemstoexternal“excitation” 85
4.3.4 Economiccycleswithmorethanoneplayerpresent 87
4.4 Measurestocopewithcyclicality 90
4.4.1 Reactiondelay 91
4.4.2 Reactionstrength 92
4.4.3 “Jokers”thatcanhelpbeatthecycle 92
4.4.4 Wherenojokerisavailable 95
4.5 Summary 98
Appendix4A:Adifferentialequationforeconomiccyclicality 98
Reference 100
5 RightSize:BalancingEconomiesandDiseconomiesofScale 101
5.1 Introduction:Theroleofscaleindeterminingprofitability 101
5.2 Assessingeconomiesofscale 103
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5.2.1 Fixedcostleverage 104
5.2.2 Decreasingunitcosts 105
5.2.3 Equipmentutilization/chunkinessofcapacity 106
5.2.4 Criticalsize 107
5.3 Determiningdiseconomiesofscale 107
5.3.1 Costelements 109
5.4 Riskelements 111
5.4.1 Utilizationrisks 113
5.4.2 Marketreactionrisks 115
5.4.3 Technologyrisks 116
5.4.4 Timingrisks 116
5.5 Anapproachforfindingthe“sweetspot” 117
5.5.1 Scaleeffectmodel 117
5.6 Real-lifeexamples 118
5.6.1 Automotiveindustrycaseexample 118
5.6.2 Basechemicalscaseexample 119
5.7 Summary 120
Reference 121
6 RightLocation:GettingtheMostfromGovernmentIncentives 123
6.1 Governmentincentives:Anoverview 124
6.1.1 Creatingpublic-private,win-winsituations 125
6.2 Commontypesofincentiveinstruments 127
6.2.1 Subsidies 131
6.2.2 Financingsupport 131
6.2.3 Taxrelief 133
6.2.4 Othertypesofgovernmentincentives 134
6.3 Thefinancialimpactofincentives:Amodelingapproach 136
6.3.1 Generalimpactofsubsidies 137
6.3.2 Generalimpactoffinancingsupport 138
6.3.3 Generalimpactoftaxrelief 138
6.3.4 Specificimpactofincentivesondifferentindustries 139
6.4 Geographicaldifferencesinincentivestructures 140
6.5 Managinggovernmentincentives 141
6.6 Summary 142
References 142
7 RightDesign:HowtoMakeInvestmentsLeanandFlexible 143
7.1 Leandesignasacompetitiveadvantage 143
7.1.1 Theleanway:Movingfromcapitalinvestmentprojectstoalean
designsystem 143
7.2 Thethreedimensionsofaleancapitalinvestmentsystem 146
7.3 Dimension1:Thetechnicalsystem 147
7.3.1 Startwithprojectobjectives,designprincisples,andtargetsetting 147
7.3.2 Valueengineeringandleantools 149
7.3.3 Designoptimization 152
7.3.4 Fromthebasicdesigntostartofproduction 153
7.3.5 Anchoringtoolsandpracticestoformalstandards 155
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7.4 Dimensions2&3:Managementinfrastructure,mindsetandbehavior 155
7.4.1 Projectorganizationandperformancemanagement 155
7.4.2 Institutionalizationandlearning 156
7.4.3 Adaptingthesystemtolocalspecifics:Projectdesigncannotbe
“onesizefitsall” 156
7.4.4 Gettingstarted 157
7.5 Flexibility:Justwhatcustomersandthecompanyneedandnomore 158
7.5.1 Macro-levelflexibility:modularityinplantdesigntoensure
flexible,cost-efficientassets 158
7.5.2 Midi-levelflexibilityinplantdesign:caterforproduct
portfoliodiversity 159
7.5.3 Micro-levelflexibilityinplantdesign:designforiso-productivity 160
7.6 Howtoavoidcreatingafront-pagedisaster:Anticipatingwhatcan
go wrong 162
7.6.1 Performancemanagementanddecisionmaking 163
7.6.2 Toolswhicheverycompanyandprojectteamneedtomaster 164
7.6.3 Cross-functionalcoordination 165
7.7 Summary 166
References 166
8 RightFinancing:ShapingtheOptimalFinancePortfolio 167
8.1 WhyFinancingMatters 167
8.2 Three-StepFinancingApproach 170
8.2.1 Step1:Evaluatingtheinvestment’scashflowparameters 170
8.2.2 Step2:Assessinginvestmentrisks 172
8.2.3 Step3:Composingthefinancingportfolio 180
8.3 Summary 183
References 183
PARTIII 185
9 RightAllocation:HowtoAllocateMoneyWithintheCompany 187
9.1 Keyrequirementsforcapitalallocation 188
9.2 Fourmodelsofthecorporatecenterroleinshapingtheinvestmentportfolio 192
9.3 Capitalallocationapproachforoperatorsandstrategiccontrollers 195
9.3.1 Step1:Treatspecialprojectsashighpriority 196
9.3.2 Step2:Allocateremainingcapitaltobusinessunits 197
9.3.3 Step3:Businessunitsdistributecapitaltoindividualinvestments 199
9.3.4 Step4:Implementacapitalassuranceprocess 201
9.3.5 Improvingthe“capitalallocationkey” 203
9.3.6 Capitalallocationbackbone 204
9.4 Capitalallocationapproachforstrategicarchitectsandfinancialholding
structures 210
9.5 Summary 213
References 213
Index 215
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About the Authors
Hauke Hansen works as a production manager for ASML in Veldhoven (NL). Prior to his
currentjobhewasanAssociatePrincipalinMcKinsey’sDu¨sseldorfoffice.Heservedhigh-
tech, logistics and telecom companies and supported several multi-billion dollar investment
projects. He holds a PhD in physics from the University of Konstanz and was a Fulbright
ScholarattheCaliforniaInstituteofTechnology.
WolfgangHuhnisaDirectorinMcKinsey’sFrankfurtoffice.Heprimarilyservesclientsin
thehigh-techindustryaswellasinenergy.WolfgangisamemberoftheBusinessTechnology
OfficewhereheleadstheindustrialsectorinEuropeandhealsoleadstheEuropeanProduct
DevelopmentPractice.PriortojoiningMcKinsey,Wolfgangstudiedelectricalengineeringand
physicsatAachenandintheUKandobtainedhisPhDinPhysicsfromtheRWTHAachen.
From1998to2000,WolfgangwastheCEOofaVC-backedcompany.
OlivierLegrandisaPrincipalinMcKinsey’sParisoffice.Heservesclientsinthetranspor-
tation,steelandaluminumindustriesaswellasinconsumergoodsandenergy.Olivierco-leads
McKinsey’sglobalcapitalproductivitygroup.OlivierholdsanMBAfromStanfordBusiness
School.
DanielSteinersisanAssociatePrincipalinMcKinsey’sDu¨sseldorfoffice.Heservesclientsin
electricpowerandchemicalsandisaco-leaderofMcKinsey’sEuropeancapitalproductivity
group. Daniel received adiploma inbusinessadministrationfromMu¨nster Universityanda
PhDinmanagementaccountingfromtheEuropeanBusinessSchoolinOestrich-Winkel.
ThomasVahlenkampisaDirectorinMcKinsey’sDu¨sseldorfoffice.Heservesclientsinthe
coal,oil,gas,power,andchemicalsaswellastransportationindustries.Thomasisthesector
leaderoftheEnergyandMaterialsPracticeinGermanyandamemberoftheleadershipgroup
of the European Electric Power and Natural Gas Practice. His educational background is in
polymerchemistry.HeholdsadegreefromtheTechnicalUniversityofAachen(RWTH)and
adoctoratefromtheMaxPlanckInstituteforPolymerResearch.
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Part I
Why Investments Matter
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1
Introduction
1.1 INVESTMENTS:THEFORGOTTEN VALUELEVER
Muchofthecurrentmanagementliteraturefocusesonalimitedsetof“classical”valuelevers,
suchascostreduction,salesoptimizationormergers&acquisitions,thusneglectinganother
corevaluelever:capitalinvestments(Capex).
Thatcapitalinvestmentsreceivesuchlimitedattentionisallthemoresurprisingwhenone
considers just how vitally important they are to the economy as a whole and to business in
particular.In2007,morethan$11.8trillionwasspentoncapitalinvestmentsglobally–more
thanthecombinedGDPofJapan,China,India,SouthKorea,andTaiwan(orGermany,France,
Italy,SpainandtheUK).Notonlyisthesuminvestedenormous,butitsinfluenceonlong-term
company performance is critical. Since the early 1990s, asset-heavy companies in the S&P
500 have increased their average return on invested capital by 3.8%. Our analysis indicates
thatabouthalfofthisincrease(48%)isrelatedtoinvestmentactivities(Figure1.1).
Investments are important not only in optimizing the asset structure of a venture but also
forenablingtheintroductionofnewproductsorforintroducingstructuralcostreductions.
Managersknowthatthevalueofaninvestmentisnota“given”thatresultsinaninevitable
rateofreturn.Awiderangeofvariablesinfluencestheoutcomebothpositivelyandnegatively.
Understanding these variables is therefore critical in assessing the likely performance of an
investment.
Theexperiencesfromarangeofcapitalinvestmentoptimizationprojectsshowthatthereis
significantvaluecreationpotentialinoptimizingcapitalinvestments.Resultsachievedacross
awiderangeofoptimizationprojectsdemonstratethispotentialtobeoftheorderof15–40%
ofthereturnonaninvestment.Thisvaluepotentialarisesfromthreecoreimprovementlevers
for investments: reductions in theamount of capital invested, acceleration of the production
ramp-up,andincreasesintheoperatingcashflowduringtheproductivelifeofaninvestment
(Figure1.2).
Investment-related ROIC
changes (48%)
ROIC change* in focus
1.8 3.8 Investment related ROIC drivers
industries 1992−2007
Sales increase effect 0.5 1.5 (cid:127) New product investments
(cid:127) Investments to achieve
Cost reduction effect 0.4 1.4
structural cost reductions
(cid:127) Capital efficiency increases and
Invested capital effect 0.9
investment activity reductions
*Difference between 10-year moving average of revenue-weighted ROIC in 1992 and 2007
Source:MCPAT, McKinsey analysis
Figure 1.1 DriversoftheincreaseinROIC,1992–2007
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4 CAPEXExcellence
Core Investment Phases ROIC impact*
Decision and design Execution and ramp-up Life cycle management
Core focus
of this book Optimized
Core value levers
available in decision 0 –15%
& design phase only
(cid:127) Invest strategy Base case
–Why, where, how 5 –10%
to invest?
Time
(cid:127) Invest design
–Right positioning to 10–15% Accelerate ramp-up Increase operating cash
risk & competition (cid:127) Aggressive ramp-up flow
–Right technology planning (cid:127) Reduced operating costs
–Right time (cid:127) Effective critical path (cid:127) Increased yield
––RRiigghhtt lsoizceation R(cid:127) eImduprcoev ecda pceaxpital goods (cid:127) &C opnrtorjaecctto mr mgmgmt.t. (cid:127)(cid:127) SSuaplvpalgy/ed evamluaen do pmtiamtcizhaintigon
procurement
–Right design (cid:127) Capexspend control
–Right financing
15−30%
Value contribution (not additive)
*Estimated typical impact on a capital investment based on team analyses, expert interviews, and project experience
Source:CI team
Figure 1.2 Corevalueleversforoptimizingcapitalinvestments
1.1.1 Theearlybirdcatchestheworm
Once a project progresses from the design phase to the execution and ramp-up phase the
potentialforoptimizingtheinvestmentnarrows,asmuchofthecashhasalreadybeenspentor
committed.Thedecisionanddesignphase,therefore,isofcriticalimportancetotheperform-
ance of any capital investment. This phase provides the largest value creation opportunity
forinvestingcompanies.Thecrucialquestionsmanagersarefacedwithinthisphaseare,of
course,“Where,whenandhowtoinvest?”,“Howdowedesigntheinvestmentsoastoensure
anoptimumreturn?”and“Whatisthebestwaytofinancetheinvestment?”
Thedecisionsmadeinthisphasedeterminetheboundaryconditionsforthebusinessassets–
andasignificantpartofitsROIC–formanyyearstocome.Despitetheimportanceofthese
decisions, it is rare to find them managed well from the outset. One of the reasons why
companies continue to struggle with the design and execution of large capital investments
is that their often discrete nature makes it difficult for companies to build up and maintain
investmentmanagementcompetencyin-house.Asecondreasonisthat,despitethewealthand
depth of material on financial investment valuation and assessment, there is currently little
ornohands-on,practicaladviceforcapitalmanagementandoptimizationwrittenfromatop
managementperspective.Toalargeextent,managersareleftleaningontheirownexperience,
pullingtogetherthebestteamtheycanfindwithintheirorganization.
This surprising lack of practical management advice has been one of the main reasons
promptingustowritethisbook:decision-makersneedthebestpossibleadvicetoaidthemin
makingdecisionsonlargeinvestments.Weintendthisbooktofillthisgapandtoprovidea
strategicmanualonlargefixedcapitalinvestments.Ithasaholisticapproachtothetopic,one
thatisbothstrategicandpracticalinitsperspective.
In researching this book, we have invested a significant amount of time and effort in
collectingandanalyzingtheinformationthatformsthebasisoftheideasthatshapeit.Inthe
courseofthisworkwehavemadeextensiveuseofthewealthofknowledgeandexperience
