“The root of my success is acting rationally about capital allocation” – Warren Buffett
As the weather here starts to turn and we enter the fourth quarter of the calendar year, two separate cycles combined in my mind. The cool weather creates perfect opportunities to be outside grilling and cooking, and businesses are polishing their budgets for 2018.
Your favorite chef knows that leaving the fat on a piece of meat will result in a more flavorful and tender result, the best managers apply the same practice to capital budgeting.
Estimating is the heart of the capital budget. What will we have to invest to get our targeted return? The size of that investment, especially for industrial projects, is an estimate – space, land, materials, time, purchased items, etc – that is weighed against the estimated future benefits created by the investment. When making the estimate, and pitching for approval, the pressure is often to reduce, to estimate cheaper. Resist this temptation at the outset; leave the fat in. Use your highest vendor quote. Use the highest labor estimate. Justify better quality. Assume higher growth in that division.
When the project starts implementation, several months or years in the future, circumstances will have changed – some for the better, some for the worse. Leaving the fat in will allow you to make the right decision at that time, to get the right trade off or pursue a new idea. There will always be prudent opportunities to save money in the moment, there will not always be additional capital left to allocate.