Small equals big: Unlocking savings in small to midsize
capital-project portfolios in chemicals
Increased rigor in
managing smaller chemical projects can help capture significant untapped value.
Capital projects are an
essential contributor to chemical-company growth: witness the half dozen new
ethylene crackers currently being built on the US Gulf Coast. Such large-scale
projects get a lot of top-management attention. But they account for only just
over half of the chemical industry’s $400 billion in annual capital spending.
There is another category of capital expenditure that many chemical companies
have struggled to manage: modest outlays for sustaining and maintaining
existing assets as well as for small to midsize growth projects. Chemical
companies have an opportunity to capture significant additional value—and
promote increased asset reliability and safety—by better managing their
portfolios of small to midsize projects.
Projects with a value of $50 million or less
(and commonly less than $10 million) add up to a major portion of
chemical-company spending. These typically account for 80 percent of all
capital projects by number, and up to 50 percent of capital-spending value. In
our experience, improving the way these projects are selected and managed can
deliver savings of 15 to 30 percent, and these savings can be redirected to
more value-creating projects. Such projects can have return-on-investment rates
significantly higher than many larger ones: debottlenecking exercises, for
example, can earn high returns because they sell into familiar markets and to
customers already known to want more product. Done right, this kind of action
can also boost overall return on invested capital (ROIC) by as much as four percentage
points—an important consideration, given that ROIC performance has historically
been the primary driver of chemical-company valuations.
When speaking of their approach to
managing smaller capital projects, most chemical-company executives we talk with
describe a well-defined and effective process: projects are selected based on
business logic, designed with optimal scope, and executed under stringent time
lines with sufficient supplier engagement. Indeed, we observe that in many
cases, these companies do have robust stage-gate governance frameworks with
clear requirements in place that would, if followed, lead to capital projects
that are well designed and executed.
The reality, however, is often vastly
different. Time and again, we see business cases that overestimate returns
while underplaying risks, and we see projects advance through stage-gate
processes that are not followed or are applied with significant gaps. Despite
having a robust paper process, project sponsors are usually overburdened by the
large number of projects and have insufficient time and, in some cases,
technical capabilities needed for truly stress-testing a proposed small to
midsize capital project.
As a result, many of these projects are
poorly formed in the front end. They end up being relegated when up for final
approval and funding, where the added scrutiny typically sends teams back to
the drawing board. Not only does this approach waste time and money, it also
increases the risk of approving a flawed solution. Best-in-class chemical
companies are overcoming these problems by developing small to midsize
capital-management programs and teams, based upon six building blocks: align
capital strategy and allocation with corporate strategy, optimize portfolios,
streamline project concept and design, implement lean project governance, use
effective procurement and contractor-management processes, and institute
sustainable organizational enablers.
Align capital
strategy and allocation with corporate strategy
Companies that manage capital projects
well translate overall corporate strategy into individual business-unit or
regional capital strategies. If the overall strategy cannot clearly translate
to allocation to component businesses, it is unlikely the strategy will lead to
the desired outcomes. To get capital allocations right, companies must closely
consider the risk-return profile of each business unit or region.
Some best-practice chemical companies make
sure projects are properly aligned with overall strategy and are appropriately
prioritized. Because many of the projects are small, the allocation is often
done at the business-unit or product-line level, which makes it necessary for
companies to adopt disciplined processes to ensure expenditures are aligned
with overall strategy. For example, to ensure a tight link between high-level
strategy and small-project execution, one diversified chemical company added a
gate to evaluate how any project’s goal linked to strategy. At the same time,
the company prioritized the assets that it judged most critical to executing
its overall strategy.
Leading companies also make sure to
examine projects in terms of the value they create for the company overall.
This approach often leads to a conclusion that a project should not go ahead
and that the value-creation goal can be achieved in other ways. This process
constitutes an important release mechanism enabling chemical companies to
escape from the “engineer’s mind-set” seen at some companies—a focus on
implementing the best engineered project possible regardless of value created.
Best practice also calls for establishing
systems to monitor capital spending regularly. One multibusiness-unit chemical
conglomerate holds an annual cross-unit reporting session where the heads of
engineering and operations outline total spending, return on capital deployed,
project-status snapshots, and each unit’s capital-spending priorities and
project pipelines. This ensures discipline in annual capital-spending cycles.
Optimize portfolios
Management teams often lack the data or
process to debate the merits of one portfolio of projects over another.
Instead, they may pursue a default basket of projects year after year or make
blunt, across-the-board spending cuts without actively shaping the portfolio so
that it is optimized not only to maintain operations but also to enable growth.
In contrast, the most successful companies identify an optimal portfolio of
projects, basing their assessment on three factors:
·
Prioritization. Best-practice companies require a
business-case evaluation for each project. This helps bring transparency about
the business problem the project aims to solve, and it helps determine which
projects can be delayed or canceled. This in turn frees up funds to spend on
the projects with the most attractive returns. These companies also classify
their projects and make sure that the mix aligns with their strategic aims.
Typical classifications include “must do” investments to comply with
regulations, “sustaining” projects to improve the production process and reduce
the likelihood of outages, “strategic” projects to open up future growth
directions, and “growth” projects to increase margins or revenues (Exhibit 2).
Here again, having a clear business case that shows return on investment helps
prevent projects being advanced simply based on their classification. Across
all these categories, committed and work-in-progress capital expenditures
generally are prioritized to minimize cost escalations.
·
Financial- and nonfinancial-indicator trade-offs. Trade-offs are
based on financial measures such as net present value (NPV), internal rate of
return, and profitability index, as well as nonfinancial indicators such as
carbon-dioxide emissions. Best-in-class companies apply NPV calculations to all
projects, including those that have no revenue component and those that can
reduce the risk of significant hits to the company’s profitability resulting
from production outages. Applying a range of measures enables the company to
make refined trade-offs in choices of projects.
·
Scenario modeling. Evaluating the outcome of a
portfolio under various hypothetical strategic objectives or constraints can be
a powerful way to show management the risks and other factors it should
consider. For example, one chemical company models the net cash flows to the
business under different end-product and feedstock-price scenarios and compares
returns of different portfolios; in bear markets, some maintenance-biased
portfolios actually come out ahead of purely growth-focused portfolios.
How two companies found major savings in their small-project
capital spending
Streamline project
concept and design
Streamlining project concept and design
requires two steps. First, managers need to scrub the business cases for each
project to ensure they are realistic, robust, and comparable with each other.
Second, projects should be optimized for cost and value over their life span
(see sidebar, “How two companies found major savings in their small-project
capital spending”).
When scrubbing business cases, companies
must ensure projects meet key objectives. Does the proposed project fix a real
problem, or can noncapital solutions be employed to address the root issue (for
example, using contract manufacturing or rebalancing supply across plants to
meet demand)? Is it based on complete, error-free data? Are the underlying
assumptions reasonable? Have all dependencies been identified? In addition,
managers should look for common pitfalls or problems that can occur. Examples
include teams tacking on nice-to-have but costly features or capabilities,
exaggerating the impact of not doing the project, proposing major modifications
when easy workarounds to solve the problem are possible, and proposing
expansions for plants that are neither sold out nor expected to sell out any
time soon.
When optimizing projects, managers should
analyze key cost drivers. Can the project be done with less capital by
optimizing the project scope, simplifying technical specifications, or buying from
lower-cost sources? Can the project be made to generate revenue faster—for
example by reducing construction or ramp-up time or by introducing a phased
implementation process? Can cash flows during the operation be enhanced by
improving yields or reducing running costs? Careful evaluation and
brainstorming with technical or commercial experts can often lead to solutions
that offer the same benefits at greatly reduced cost. Best-in-class companies
conduct design-optimization reviews as a project progresses, starting with
project design and continuing through equipment selection once basic
engineering is completed.
Following this approach, one petrochemical
company avoided replacing expensive process vessels, saving more than 50
percent of the originally budgeted capital cost. By applying this process to
more than 100 projects ranging in value from $8 million to $150 million, the
company cut 30 percent from the projected capital-spending requirements,
netting total savings of more than $1 billion to date, and increasing overall
NPV by more than 70 percent. More significantly, the training and experience
its staff received during this yearlong effort built permanent analytical and
technical skills that the company is now applying to scrub and optimize both small
and large projects.
Implement lean
project governance and stage-gate processes
Many companies have effective stage-gate
processes for managing large projects. However, we observe that this is rarely
the case for smaller projects. A common challenge is the application of a
one-size-fits-all approach to managing projects, which leads to frustration and
to process or bureaucratic overload.
Companies with effective portfolio
management tailor their approach by size and complexity of a project. They
apply levels of rigor according to the scale and degree of complexity: for
example, for smaller, simpler projects, they streamline the number of stage
gates and stakeholders involved. By redeploying engineering and
project-management staff to the most complex or costly projects, they maximize
value.
We have also found that companies often
miss a crucial step in governance when it comes to smaller projects:
stress-testing or challenging of objectives of project proposals and the
assumptions behind calculations. Examples include using benchmarks for cost
estimates instead of precise project-specific calculations, or failing to
consider multiple design solutions. Stress-testing provides another opportunity
to verify that the project will truly meet a business’s objective. This work is
best done by experts who are independent of the project teams. In our
experience, formally introducing and ensuring external and independent
challenges at each stage gate is fundamental to delivering the required
optimization and execution outcomes.
Use effective
procurement and contractor-management processes
Many companies describe excellent
capabilities in managing their capital procurement. In reality, many fail to
integrate procurement professionals into the front end of the project life
cycle. As a result, they miss opportunities to incorporate the latest
supply-market insights or technology advancements.
In the procurement of products and
materials, the best-performing companies create clear product road maps,
allowing them to bundle like commodities across different projects and sites.
They employ advanced analytic tools such as clean-sheet cost modeling to
facilitate supplier discussions. Finally, these companies look to expand their
supply markets to include global suppliers to take advantage of the best
technology or labor markets.
Best-practice companies also effectively
manage the contractors that fabricate, install, or replace capital equipment.
They find the most appropriate contracting models (for example, switching
between cost-plus and lump-sum approaches) rather than always sticking to the
same contracting approach. They base decisions upon the clarity of the project
scope and an understanding of the execution risk of the project, as well as the
natural ownership of that risk. They carefully assess contractor capabilities
and select contractors that can deploy the most efficient and effective crews.
Finally, they recognize that regardless of the contracting model, effective
owner oversight is critical. Not only does it mitigate the typical information
asymmetry between owners and contractors, it also creates room for additional
contractor margins.
Institute
sustainable organizational enablers
One of the most important success factors
in effective small to midsize capital-project management is that senior
management treats it as a priority. Leading companies actively manage their
process with regular performance dialogues between project teams and senior
management.
In addition, these companies do not treat
small to midsize capital-project optimization as a one-off event.
High-performing companies invest in team capabilities that promote project
optimization and higher standards of execution throughout the company. They
invest in training a cadre of project- and portfolio-management experts. They
also create centers of excellence, which they use to train small-project teams
from different production sites to be more effective and efficient in
leveraging resources at their disposal. Over time, the training program can be
rolled out across the whole company. This approach spreads expertise across all
sites, which is essential for small-scale projects that are typically driven at
the site level, in contrast to megaprojects that get lots of attention from
headquarters. Using this “Capex Academy” approach, one company put every
project team through thorough training and coaching on the prefeasibility and
feasibility phases. This effort resulted in substantial increases in project
quality.
While
many companies manage large-scale projects effectively, few apply the same
discipline to small to midsize projects. By applying appropriate rigor in their
evaluation, prioritization, and optimization of this small to midsize
portfolio, companies can unearth significant savings and develop a strong
organization rooted in capability building. The impact of adopting these
approaches is significant, not only in capital-spending savings but also in NPV
gains.
By Matt Banholzer, Ashish Chandarana, Matthew Parsons, and Owen
Stockdale
http://www.mckinsey.com/industries/chemicals/our-insights/Small-equals-big-Unlocking-savings-in-small-to-midsize-capital-project-portfolios-in-chemicals?cid=other-eml-alt-mip-mck-oth-1604
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