Capital allocation, i.e., deciding on investments, is probably the most important responsibility of the top management of any organization. This is no easy matter. Warren Buffett, chairman and CEO of Berkshire Hathaway and probably the most successful investor of the 20th century, described this in his 1987 letter to shareholders:
This point can be important because the heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.
Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it’s as if the final step for a highly-talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve.
As we highlighted in a previous blog, Enterprise Portfolio Management (EPM) is the discipline that supports this allocation of investments to various asset categories of the organization, such as capabilities, applications, or infrastructure, EPM helps to create a healthy set of projects and programs that realizes strategic goals.
EPM supports you to make informed and coherent investment decisions, improve alignment with strategic goals, decrease waste, prevent scope creep, and monitor the planned versus realized progress of changes. This ensures a coordinated execution of business transformations and improvements.
Overview of run costs of applications in a portfolio
There should be a balanced investment in the types of projects (e.g. long-term vs. short-term, high-risk/high-gain vs. low-risk/low-gain) or the categories of assets (e.g. stable back-office vs. innovative front-office applications). Investment allocation is facilitated by grouping assets or projects in portfolios according to these characteristics, e.g. ‘innovation’, ‘new product introduction’, ‘going concern’, or ‘retirement’. For example, this helps to avoid the ‘innovation squeeze’: an ever-growing maintenance budget that eats up other investments.
This way, senior management can decide on investment allocation across whole portfolios instead of looking at each individual investment. Authority for decision-making on priorities within each portfolio can then be delegated to a lower level in the organization.
We recommend scoring each investment on the following criteria:
- Architectural fit
- Development risk
- Strategic importance
Cost is often the least complicated to calculate. Elaborate cost models are used by many financial departments to ensure all costs are accounted for. Our example shows how you can calculate and distribute costs using your architecture model.
Benefits can be more difficult to determine: there is a lot of uncertainty assessing future benefits. Revenue contributions may include:
- New business: potentially brings new customers or markets
- Up-sell: potentially brings more money from existing customers
- Retention: avoids losing customers
- Efficiency: saves money in current operation
In public sector organizations, societal benefits may be more important than financial revenues.
Architectural fit addresses whether an asset or a project fits with the envisaged architecture of the organization. Initiatives that do not fit should not be approved, or only if they commit to solving this problem later on (within their own budget!). The extra costs to make it fit afterwards may be a useful quantitative measure of architectural (mis)fit.
You also need to take risk into account. In evaluating a portfolio of projects and programs, the development risk, i.e., the risk that a project fails, is the most important criterion. You can quantify this as probability of failure times expected loss. There are other risks, e.g. financial, safety, quality, or legal risks; those should be dealt with within the projects and programs themselves. Do not try and avoid all risk; rather, aim for a balanced portfolio of safe, incremental and more risky, innovative initiatives that have the potential to add significant value.
Finally, you need to factor in the strategic importance of an initiative. For example, replacing a monolithic legacy system with a new, flexible business process management suite may enable various valuable future options, such as introducing new products as a ‘first mover’ or outsourcing business processes.
With a fixed investment budget, ranking investments relative to each other may be good enough; you do not need the exact numbers. A first step with simple, qualitative metrics (e.g. “t-shirt sizing” in XS, S, M, L, XL) is a good starting point.
Such a qualitative scale is also common in questionnaires, which often use a five-point Likert scale. When you assess for example the business value of a service or the quality of an application, you will often use such a qualitative scale. Similarly, in evaluating the strategic importance of initiatives, long-term quantitative data may be hard to come by, and a qualitative assessment is required.
In larger companies, a financial department will already apply standard metrics and business case analyses to investments. Don’t reinvent the wheel. It is important that you use the same metrics to compare investment choices. A common financial metric for calculating the expected return of an investment is net present value (NPV). This is the sum of the cash flows in the years to come, discounted back to their present value at a given discount rate. If the net present value is positive, the investment yields a positive return, so the investment may be accepted. If the net present value is negative, it should be rejected.
The difficulty in using NPV and similar measures lies in estimating future cash flows, since the future is uncertain. To deal with this uncertainty, you can use different scenarios, e.g. to account for different market developments, and calculate a weighted average of the resulting NPVs multiplied by the probability of each scenario.
If some aspects of the future are very uncertain, your business model, operating model and architecture need to be flexible enough to accommodate that uncertainty. The strategic value of projects or assets that promote this flexibility will then be high.
Such future options can be valued in financial terms as well, using Real Options theory (which applies financial option techniques to capital budgeting decisions). This is only for very advanced portfolio management.
The outcomes of these value calculations are just estimates, since nobody can predict the future. You should always combine such a calculation with an estimate of its uncertainty. To quote Warren Buffett again:
If a business is complex or subject to constant change, we’re not smart enough to predict future cash flows. Incidentally, that shortcoming doesn’t bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know. An investor needs to do very few things right as long as he or she avoids big mistakes.
Next in this series: Enterprise Portfolio Management: User Perspectives