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1、 2023 Boston Consulting Group1Capital allocation may be the most critical means of translating corporate strategy into action.It hasrecently gained even more attention by corporate boards as most companies face substantialinvestments and reallocation of capital for their digital and sustainability t
2、ransformations.Yet,surprisingly,an analysis of BCGs capital allocation database,which includes over 10,000 listed firms,found that capex levels relative to revenues have fallen by 10%in the last ten years.Over the sameperiod,payouts to shareholders(dividends and share buybacks)as well as cash levels
3、 relative torevenue have risen by over one third.It seems that company leaders are becoming more reluctant toThe Art of Capital AllocationCFO Excellence SeriesNOVEMBER 02,2023 By Sebastian Stange,Ulrich Pidun,Alexander Roos,and Martin LinkREADING TIME:12 MIN 2023 Boston Consulting Group2actually rei
4、nvest cash flow in light of increasing uncertainty,macro-economic volatility,and growinginterest rates.They risk conflicts with investors who grow impatient and want firms to invest in value-creating growth,as repeatedly confirmed in BCGs investors surveys.The reason for this reluctance is not a lac
5、k of opportunity.Successful companies are making smartinvestments.For example,our analysis of historical capital allocation performance has demonstratedthat outperformerscompanies in the top-third of stock market valuation relative to their peersinvested approximately 50%more in capex than their pee
6、rs and achieved approximately 55%higherreturns on assets and approximately 65%higher sales growth.(See Exhibit 1.)So how can management ensure better capital allocation performance?Our research and caseexperience reveal a number of best practices that top-performing companies consistently follow.The
7、ycan be grouped into three disciplines:Strategic capital budgeting.Smart companies rigorously translate their strategic priorities intoresource budgeting guidelines,which they use to balance their investment portfolios.Investment project selection.Top performers are equally tough-minded in their fun
8、dingdecisions with respect to individual project investments.Their CFOs perform investmentevaluations that provide a relevant understanding of the projects under consideration.2023 Boston Consulting Group3Strategic Capital BudgetingCompanies that exercise superior capital budgeting discipline do thr
9、ee things well:they invest inbusinesses rather than projects,they translate portfolio roles into capital allocation guidelines,andthey strive for balanced investment portfolios.Invest in businesses rather than projects.Capital allocation is about looking at the forest and the trees,and top performer
10、s look at the forest first.The outperformers in BCGs capital allocation databaseinvest systematically in businesses that create value from a strategic as well as a financial point of view,whereas underperformers invest too much in value-destroying growth.(See Exhibit 2.)While high-performing compani
11、es certainly focus on the financial return of individual investments,theyalso assess the strategic attractiveness of a business and the extent to which an investment issupported by favorable tailwinds from the market and strengthens the firms competitive advantage,which is key to producing sustainab
12、le high returns.Assessing strategic potential helps avoid commoncapital allocation pitfalls,such as the maturing-business trap(not reducing capex even though theInvestment governance.Superior capital allocators establish consistent governancemechanisms that they use to choose,support,and track inves
13、tments at the corporate level.2023 Boston Consulting Group4business is maturing)and the egalitarian trap(every business unit gets its“fair capex share,”irrespective of potential).A business potential-based approach to capital budgeting helped IBM,for example,reorient itsportfolio from hardware to cl
14、oud-based services.Similarly,Tata Consultancy Services divested its callcenter operations,even though the business was still booming,to free up management capacity andresources for a push into value-added services,which the company believed to be much morepromising going forward.Today,many companies
15、 in the energy and automotive industries are shiingtheir investments away from their past cash cows and towards renewables and green technology.Naturally,the magnitude and speed of the shi depends on the perceived size of the concrete greenbusiness potential.Translate portfolio roles into capital al
16、location guidelines.Assigning clear roles to the individualbusinesses in the portfolio and setting corresponding capital allocation guidelines is a good way to linkstrategic potential to resource allocation.(See“Corporate Portfolio Management:Theory andPractice,”BCG article,April 2011.)Take the exam
17、ple of one of our clients,an international energy company,which classifies businessunits as development,growth,anchor,or harvesting businesses,depending on their position in themarket life cycle.Each portfolio role has its own performance requirements,and businesses aremanaged based on specific sets
18、 of financial indicators.More important,the role of each businessdetermines its guidelines for capital allocation.For example,coal power generation is classified as amature harvesting business and capex is limited to mandatory investments,effectively shrinking itsasset base.This frees up money for i
19、nvestments in the renewables segment,which is considered agrowth business and as such is allowed to invest up to three times its own cash flow from operations.Balance the investment portfolio.Another way to link corporate strategy to capital allocation is toanalyze a companys investment program from
20、 a portfolio perspective.Is the investment portfolioconsistent with the companys strategic priorities,and is it balanced according to key strategic criteria?The energy company mentioned above regularly analyzes the risk-return balance of its investmentportfolio.Doing so enabled the company to see th
21、at it was focusing too much on low-risk,low-returnprojects and making only a few big and risky bets with a high potential return.As a result,management changed the investment strategy and encouraged managers to take on more small,buthigh-risk,endeavors in order to improve the companys overall risk-r
22、eturn profile.A medical devices company that undertook a similar analysis realized that it was spending too muchon product life cycle management and“me too”products and was not investing sufficiently in the nextgeneration of blockbuster devices.The company had fallen into a typical trap.It was favor
23、inginvestments with short payback times because of financial attractiveness and low perceived risk,and 2023 Boston Consulting Group5these opportunities were crowding out higher-risk investments with longer payback timestheinvestments necessary to generate future growth.Investment Project SelectionFu
24、nding individual capital projects is a financial exercise,but outperformers also make sure that theyfully understand the financial profile of the projects in questionthe quality of the estimates,thevariability of cash flows,and the payback profile over time.Go beyond internal rate of return.In theor
25、y,there is a simple rule for choosing among competinginvestment projects:sort the list of projects based on their expected internal rate of return and selectthose with the highest IRRs until the budget is fully committed.In practice,however,the effectivenessof this approach is constrained by the qua
26、lity of the assumptions that go into the valuations and by theinfluence of additional criteria that are not transparent or not explicit in selection decisions.A good way to improve the quality of assumptions is to require all business cases for major investmentprojects to include a model that shows
27、the important business drivers.This makes critical assumptionsexplicit and allows decision-makers to understand the impact of the key drivers.Moreover,it facilitatessimple sensitivity and scenario analyses.Managers can calculate the break-even values of criticalvariables that must be achieved for th
28、e project to generate value.This approach will help avoidfocusing only on the expected rate of return in a hypothetical base case.At many companies,criteria beyond financial returns also come into play in making investmentdecisions.But if such factors are not made explicit and predefined upfront,the
29、y can distort thedecision-making process and encourage political behavior.One European industrial conglomerateaddresses this challenge by evaluating investment projects based on four explicit criteria that aresummarized in a simple scoring model:strategic profile(growth potential and fit with the st
30、rategy ofthe underlying business),financial profile(expected project return and short-term impact on EBIT),riskprofile(payback time and assessment of market risks),and resource profile(fit with existingcapabilities and required management attention).Management still makes the final investment decisi
31、on,but the decision-making model ensures that allrelevant aspects of the decision are explicit and taken into account.Sustainability considerations andmetrics can also be factored into the decision in this way.Apply relevant criteria.Depending on the structure of a companys investment portfolio,deci
32、sion-makers may need to apply different sets of criteria for the different types of investment.For example,astrict focus on internal rate of return and payback time may systematically favor incrementalimprovement investments at the expense of larger breakthrough or growth investments that tend tohav
33、e longer-term and uncertain payoffs.2023 Boston Consulting Group6The process followed at a large mining client illustrates best practice.The company applies relevant,but different,evaluation criteria for each investment type.Efficiency improvement investments,such asequipment upgrades,are assessed b
34、ased on their direct financial impact.Capacity extensions,on theother hand,are evaluated in the context of market assumptions,such as competitor capacity and theoutlook for commodity prices.And long-term investments,such as R&D in digital technology,areweighed on the basis of strategic attractivenes
35、s and prospective longer-term options;financial returnsare not part of the analysis.Such an approach ensures that the company chooses the best projectswithin each investment type without discriminating against individual categories.Embrace riskbased on true understanding.Understanding the underlying
36、 risks should be aparticular focus in project selection.Research has shown time and again that human beings are weakat risk assessment,but some techniques can help.A good starting point can be to frame the discussionin terms of a base question:What do we need to believe in to make this an attractive
37、 investment?Thisframing can help uncover the implicit business assumptions behind a proposal and the key riskshidden in the business plan.For very uncertain investments,the critical assumptions of an investmentmay even be tested in systematic validation experiments through a“discovery-driven plannin
38、g”approach.Some companies use advanced modeling techniques,such as Monte Carlo simulations,to get theirarms around the risks inherent in an investment proposal.While these techniques have their merits,few decision-makers want to rely on such complicated“black box”models,especially when large,importa
39、nt,and complex investment opportunities are at stake.In our experience,it is more importantto get the relevant risks out on the table than to quantify their exact impact.A method that oen helpsis a“premortem analysis”imagining that the planned investment has failed terribly,then askingeveryone to fi
40、nd reasons for what went wrong.The focus quickly shis from confirming that theinvestment has great potential to uncovering its hidden risks.The required funds should only becommitted when these risks seem manageable.Investment GovernanceHigh performers apply the right governance mechanisms to choose
41、,support,and track majorinvestments.They seek to address cognitive biases,establish accountability,and institute effectivefeedback loops.Address cognitive biases.Research and experience have shown that capital allocation decisions areprone to several cognitive biases,such as framing decisions too na
42、rrowly,relying too heavily on readilyavailable information,anchoring(that is,being reluctant to adapt to new information),and falling into“groupthink”(making decisions as a group in a way that discourages individual dissent).2023 Boston Consulting Group7To sidestep such biases,we recommend applying
43、the following practices to the design andmanagement of the project selection process:Establish accountability.In most firms,incentives are tied to company or business unit performance.The consequences of large investment decisions typically take too long to materialize to have animpact on an executi
44、ves bonus or promotion.This can lead to moral hazard,especially whenmanagers expect to move on aer a couple of years in a position.We recommend tying personal targets and incentives to the success of major investment projectsthrough the establishment of long-term compensation components and accounta
45、bility.A globalchemicals company,for example,has established a manager evaluation system and a long-termbonus pool that assigns a big part of the responsibility for success(and rewards)to the initiator of aninvestment proposal.External factors are not accepted as excuses for failure;teams are expect
46、ed toaccount for them when a project is proposed in the first place.Executives are incentivized to applyscrutiny when they propose a major investmentand also to ensure its ongoing success even aerthey have moved on.Institute feedback loops.In the end,successful capital allocation is the result of st
47、rong judgment skills,which are built through learning and adaptation.Effective feedback loops are essential.In M&A,whichoen requires a very large allocation of capital,this type of rigor and commitment to continuedlearning is one of the reasons that frequent dealmakers consistently outperform less e
48、xperiencedcompanies.(See BCGs M&A report series.)While post-completion audits for large projects are common in many companies,the feedback intodecision-making typically happens only sporadically.Advanced companies review not only projects butEstablish a central investment committee that can act as a
49、n independent warden of return-on-capital performance and a“final safeguard,”as former Rio Tinto CEO,Sam Walsh,called it.Bundle project investment decisions in monthly or quarterly investment committee meetings,rather than making decisions on a continuing basis.In this way,potential tradeoffs betwee
50、nprojectsincluding projects in the pipelinebecome more apparent.Push each business to propose enough projects to allow for tradeoffs and selectionfor example,by applying systematic investment-search and idea-generation approaches.Ensure that each investment proposal contains a next-best alternative.
51、Too many proposals arepresented in such a way that management can make only a go or no-go decision.This particularlyapplies to projects that are“legally required.”Foster a culture of“constructive disagreement”by assigning proponent and skeptic roles in cross-functional teams to help prevent confirma
52、tion bias.2023 Boston Consulting Group8also past decisions.The head of corporate strategy at a large industrial conglomerate puts it this way:“We made our biggest losses from moves not made.So,we also explicitly review opportunity costmistakes.”The systematic review process at Bridgewater,a large in
53、vestment management firm,includes a rootcause analysis of the specific data,decision criteria,and steps involved in the original investmentdecision.The investment committee also explores the thoughts of everyone involved at the time of thedecision to enable personal growth and skill building.Capital
54、 is only one scarce corporate resource requiring careful allocation.Executive time andmanagement talent,IT capacity,and operating budgets are others.But capital oen has the biggestimpact,which is easy to measure.The three basic disciplines of capital allocationstrategicbudgeting,project selection,an
55、d investment governanceprovide a powerful framework,and the bestpractices within each discipline give any company a good set of guidelines to follow.(See Exhibit 3.)These days,investors are quick to punish what they regard as wastefulness.They are equally eager toreward smart capital allocation deci
56、sions and strong execution.2023 Boston Consulting Group9“The Art of Capital Allocation,”which describes what distinguishes outperformers in the field of capitalallocation,is part of a publication series on CFO excellence.Please find more information and insights at BCGsCenter for CFO Excellence.This
57、 article was first released in March 2017 and has been updated.2023 Boston Consulting Group10AuthorsSebastian StangePARTNER&ASSOCIATE DIRECTORMunichUlrich PidunPARTNER&DIRECTOR,BCG HENDERSON INSTITUTE FELLOWFrankfurtAlexander RoosMANAGING DIRECTOR&SENIOR PARTNER;GLOBAL CO-LEADER,CENTER FOR CFOEXCELL
58、ENCEBerlinMartin LinkKNOWLEDGE EXPERT,TEAM MANAGERMunichABOUT BOSTON CONSULTING GROUPBoston Consulting Group partners with leaders in business and society to tackle their most importantchallenges and capture their greatest opportunities.BCG was the pioneer in business strategy when it wasfounded in
59、1963.Today,we work closely with clients to embrace a transformational approach aimed atbenefiting all stakeholdersempowering organizations to grow,build sustainable competitive advantage,and drive positive societal impact.Our diverse,global teams bring deep industry and functional expertise and a ra
60、nge of perspectives thatquestion the status quo and spark change.BCG delivers solutions through leading-edge managementconsulting,technology and design,and corporate and digital ventures.We work in a uniquely collaborativemodel across the firm and throughout all levels of the client organization,fue
61、led by the goal of helping ourclients thrive and enabling them to make the world a better place.Boston Consulting Group 2023.All rights reserved.For information or permission to reprint,please contact BCG at .To find the latestBCG content and register to receive e-alerts on this topic or others,please visit .Follow Boston 2023 Boston Consulting Group11Consulting Group on Facebook and X(formerly Twitter).