Building industry discovers the importance of business cases

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Following the collapse of Mainzeal, Construction Industry Council chairman Pieter Burghout said the shock news showed the fickleness of the industry.
“When you’ve got the third largest construction company in New Zealand with an order book worth billions…and it can collapse, that’s a reminder to the whole industry that you have to run your company in an absolutely bulletproof way.”

Actually, for at least six straight years, Mainzeal annual reports showed an average profit margin of just 1.2% — leaving scant funds to absorb cost overruns such as the $22.2 million incurred on the Vector Arena roof, and for fixing various leaking buildings.
In the wake of Mainzeal, the Solid Energy debacle and a litany of project failures, companies have discovered the importance of business cases.
These days, construction costings and QS assessments simply must be accurate, and a “business case” approach to bidding is imperative.

Risk appraisal methods
Alternative development options must be considered, client due diligence undertaken, and assumptions must be rigorously tested.
Risk appraisal methods such as Monte Carlo simulations are now commonplace, and company capital expenditure (capex) programmes must be subjected to the same disciplines.
Perhaps the reason that companies used to take a casual approach to preparing business cases was due to inflated confidence levels by senior management.
When preparing business cases, incorporating input from others can enhance decision quality, yet often senior managers do not effectively utilise advice, according to US research in 2010.

A study into organisational behaviour prepared by See, Morrison, Rothman and Soll explored the detrimental effects of power on confidence, advice taking and accuracy. Results from a series of experiments found that although higher power participants had greater confidence in their final judgements, they had significantly less accurate final judgements and took less advice.

Aware of this phenomenon, the New Zealand Treasury has prepared a series of guidelines for preparing business cases, with the aim of improving the quality of analysis and decision making around capex.

Key aims
Key aims of business cases are to promote informed decision making, innovative thinking, and facilitate benefits trajectory monitoring. They provide the essential link between strategic plans and the company’s operating budgets and targets.
Business case processes form an important sub-set of an organisation’s capital management infrastructure which, among other objectives, will identify the entity’s cost of capital.

In his book titled Corporate Governance & Wealth Creation in NZ, former Regional Investment banking head Joseph Healy pinpoints poorly specified or non-existent return on capital objectives.
American quality control champion Edward Deming (1990) believed that poor capital allocation occurs when a business lacks a well-designed capital allocation system disciplining management to optimise shareholder value.
Some astute New Zealand companies have, for many years, embraced such systems.

For example, Winstone Aggregates is a large quarry operator within the Fletcher Building Group. Since 2001, this entity has systemised the compilation of their business cases so that health and safety, environmental considerations and the like form an integral part of the process.
Port of Tauranga (POT), on the other hand, has achieved a stunning 24% compounding return for shareholders over the past decade, compared to the 5.6% NZX Index average.
POT is the best performing share on the NZX over the past 15 years. Judged the most efficient port in Australasia, POT’s key has been to back innovation-driven capital investment with rigorous economic and financial analysis.

Fourteen years ago, POT implemented capex software to assist in business case compilation and priority setting. Their CFO manages capex as a limited resource and rejects ad-hoc spreadsheet building as inconsistent, time-wasting and error prone.
Even plant replacements undergo rigorous financial analysis. POT refuses to spend hard-earned capital resources on “gut feel” or doubtful “strategic” projects.

Robust capex infrastructure
As a specialist consultant in the field, I applaud both companies’ innovative approach to capital spending.
The need to rigorously evaluate alternatives, test assumptions, systematically assess risk and carefully analyse (and then monitor) true value are essential elements to a robust capex infrastructure.

It is very concerning that such a disciplined approach so often falls through a crack in the floor.
Sadly, a 2010 KPMG study of 100 New Zealand companies and their project planning practices raises serious concerns. It found that many companies begin projects with only a vague hope of achieving a return.

Major project failure
Seventy per cent of companies experienced at least one major project failure in the past year, and only one third of companies always prepared a business case.
Sixty per cent do not measure project benefits, so cannot determine whether their investments prove worthwhile.
KPMG’s conclusion: Many firms are unable to translate project investments into valuable returns.

Today, more than ever, the Board should ensure appropriate financial management information systems are used to monitor profit margins from development projects and assess returns on invested capital.

It must insist that management use a robust capital management and business case infrastructure based on current best practice.
And it’s also about improving productivity. For example, the capex workflow, collaboration and reporting process in many organisations can be streamlined, saving considerable management time.

• Tony Street is a consultant with Capex Systems Ltd, a Hamilton-based consultancy formed in 1999. Capex Systems Ltd (CSL) provides strategic advice to corporate clients in the areas of capital expenditure, investment, procurement and business cases.
CSL coaches team members in preparing Better Business Cases (BBC), provides help with developing business cases, and supplies capex and business case software solutions.