SMI 01 | Cover Story

Lost in the Bermuda Triangle

Companies often miss budget and specification deadlines when procuring capital goods. Integrating procurement in planning and organization early on can make it possible to meet these goals, and also, to beat them.

On December 5, 1945, shortly after the end of the war, five fully-fueled US Air Force torpedo bombers set off from South Florida on a training flight. Not one of the aircraft returned to the Fort Lauderdale base. The subsequent search by air and sea was in vain. Flight 19 is now considered to be the beginning of the so-called Bermuda Triangle, and numerous myths surround other similar mysterious disappearances of ships and airplanes in the region.

Today, we sometimes get the impression that a new Bermuda Triangle has emerged in business. Generally, though, it is not ships or airplanes that disappear, but cash, capital and other assets. Notable examples are the Berlin-Brandenburg Airport, Stuttgart 21, and the Elbe Philharmonic Hall. It is not only major public projects that are affected by the phenomenon of such a remarkable waste of money, time and again, private business has problems with investment projects. This is because, in many companies, particularly mid-sized companies, CAPEX, as opposed to OPEX, is not professionally managed, to the considerable detriment of anticipated profit and operating results.

What is the difference between CAPEX, OPEX, and TOTEX?

CAPEX includes all capital expenditure within the company. In accounting terms, it is treated as fixed assets and is subject to tax depreciation allowances over a period of time. OPEX refers to business operating expenses. The term TOTEX represents the total expenditure of a business.

TOTEX = CAPEX + OPEX.

CAPEX Expenditure Rising Steadily

CAPEX expenditure is many times greater than expected, and is continuing to grow. CAPEX requirements of the 11,000 largest companies in the world rose from USD 1 trillion to 3 trillion from 2002 to 2015. That represents an average increase of 8.7 percent per annum.

Capital-intensive industries, however, are way ahead of these CAPEX investment figures. Electricity suppliers come top of the CAPEX board, with an average of 13 percent of their turnover, closely followed by oil and gas companies, metal production, and mechanical engineering, with an average of 6.3 percent. But CAPEX also represents a significant share in all other industries, and can be essential for success.

Since CAPEX requirements occur in many product groups, their characteristics and complexities are very different. CAPEX expenditure is divided into three categories:

Day-to-Day CAPEX

Ongoing, day-to-day CAPEX for business operating expenses. Examples include IT (e.g. a server or high-cost software system), logistics and marketing
Large, recurring CAPEX

This includes investment in machinery in industry, or store fittings in retail
CAPEX projects

One-off CAPEX investment in buildings or plant construction

The CAPEX Phenomenon

It is striking that OPEX procurement has achieved a high degree of maturity in recent years and is often structured in a very professional way. Expenditure on CAPEX requirements, though, is often only managed superficially in terms of procurement. This may result in companies negotiating intensively for OPEX requirements, while sometimes giving away millions on CAPEX. You could even dare say that the price of every paper clip is haggled over, while the responsibilities of procurement e.g. when determining complex requirements such as buildings, machinery, or IT systems, rarely extend to using total cost of ownership (TCO).

We are frequently seeing that the more complex the CAPEX requirement is, the less procurement is involved. However, even with demanding investment projects, price and performance transparency is just as indispensable as scrutinizing specifications.

While OPEX buyers frequently control the whole process, procurement is often called in at a late stage in large, recurring CAPEX requirements and projects – sometimes only for the final negotiations. Procurement cannot pursue its strategy because it is involved so late, meaning huge opportunities are lost. Moreover, while requirements and expenditure risks rise with complexity, procurement could cushion against this by taking effective measures.

Provocatively said, the price of every paper clip is haggled over, while the skills of the procurement department are rarely used for complex requirements.

Significant risk overhang in the recurring and project CAPEX areas

Common KPIs show that, in general, CAPEX procurement maturity decreases as spend and complexity increases

CAPEX Procurement Challenges

CAPEX requirements are often not as standard as OPEX requirements due to their complexity and rarity. Even recurring investments and projects are only procured irregularly, so there are no standardized procedures. Depending on the project structure, the roles of the project partners also vary.

Company interfaces, complex technical specifications, and interdependencies require close, early cooperation with engineering, key project partners, and core suppliers.

Due to the high level of investment, decisions on CAPEX requirements in mid-sized companies are often initiated by senior management. Because of its “exceptional character”, otherwise customary forms of involving departments and procurement are not sufficient, or specialist expertise is not called upon until it is already too late to make key changes to the requirements. Moreover, in investment procurement, companies often do not think in overarching terms of projects and locations, so they do not benefit from the considerable potential of standardization and bundling.

Transparency: the Key to Success

By way of example, a vending machine service company outsourced its equipment procurement to local management teams. This meant there were considerable differences across locations in terms of the number and type of vending machines. By analyzing which functionalities were actually needed and which machines were used the most, procurement first gained a overview of all sites. Considerable savings could then be achieved through standardization and bundled procurement.

CAPEX investments often involve large budgets, a long-term timescale, tight timings for the individual phases, and the commitment of different resources. There is a conflicting relationship here between time, costs, quality, and project scope. Within this relationship, the major challenge is keeping within budget and time constraints. Optimal solutions call for intensive and efficient coordination and cross-functional teamwork. Closely involving procurement at all stages of CAPEX projects is indispensable.

Procurement can support the specification of requirements by providing information on hidden costs, qualifying suppliers in advance, and identifying possible problems.

Procurement: More Than Commercial Knowledge

The role of procurement has changed significantly in recent decades – away from the purchasing clerk, toward the strategic entity. Successful procurement involves not only obtaining an overview of the procurement processes themselves, but also the upstream and downstream processes. Buyers are used to thinking across departments and processes, identifying potential risks and countering them in good time. Using methods such as cost breakdowns and TCO considerations, buyers ensure transparency and in-depth analyses, providing the necessary background knowledge to plan budgets, processes, and timeframes.

Practical examples:

A company was planning underground transport facilities as part of a large construction project. After installing the rail tracks, bridges and tunnels, it became apparent that only one provider’s trains could be considered because the clearance heights and widths had already been fixed. Involving procurement in the planning process early on could have avoided this.

Another typical example is store layout in retail, initially often a design-driven process whereby procurement can check whether the design department’s drafts can actually be implemented in the budget from the outset. In addition, procurement can point out the bundling and standardization opportunities from the beginning, allowing the design department to plan ahead.

Specifications prepared across departments, coupled with detailed process planning and scheduling, are prerequisites for a successful procurement process. In this way, procurement can determine the optimal purchasing levers for the requirements of the tendering process, the negotiations and, ultimately, the supplier contracts.

Avoiding Budget and Time Overruns

Active risk control by procurement is crucial for completing CAPEX projects successfully within cost and on time, while maintaining optimal quality. Only if it succeeds in anticipating existing risks, balancing them, and counteracting the threat of undesirable developments does the project remain within the planned framework. CAPEX projects in particular that span a long period of time, such as in plant construction or the building industry, are exposed to constant risk, whether because of political or regulatory constraints, natural phenomena, or supplier circumstances. However, uncertainties must be taken into account in the planning. In risk management, procurement acts as a navigator and shows ways to avoid, or at least reduce, these risks.

In addition, involving procurement has another advantage in that it oversees the whole process. Furthermore, it can directly negotiate services linked to capital goods. Additional savings can often be achieved by tendering out service packages.

The following practical example illustrates the consequences when this does not happen:

As part of an extensive construction project, sliding doors were procured and installed as a CAPEX requirement, with the construction department taking responsibility for this. However, they did not take into consideration that these doors would need regular maintenance after installation. Procurement was responsible for securing the maintenance contracts, but was now severely restricted because it was only possible to negotiate with the appointed supplier (lock-in effect). Considerably better terms could have been obtained if the purchase of the sliding doors and the maintenance work had been negotiated immediately as an entire order.

CONCLUSION: Escaping the Bermuda Triangle

A company’s procurement department ensures transparency through TCO considerations and provides the necessary details for planning the budget, processes, and timeframe. In so doing, it complements the departments that do not always prioritize cost-performance optimisation in procurement, and do not always recognise the consequential costs. While procurement is, of course, responsible for meeting OPEX requirements in practice, CAPEX decisions often lack a balanced distribution of tasks between procurement, departments, and senior management.

This leads to a considerable loss of synergy and untapped optimization potential when budgeting and scheduling the projects. While monitoring and analyzing the reasons for budget overruns in CAPEX projects, it is striking that these could be avoided by involving procurement and professional project management early on.

Selected CAPEX Use Cases

Different types of CAPEX vary widely in their characteristics and specifications and, as such, need to be treated very differently. The following projects exemplify procurement success, without taking into account other levers such as demand management.

Procedure

Success Factors

Achievements

STORE LAYOUT IN FOOD RETAILING - converting the entire store network

Involve all areas of responsibility
Carry out test phase
Increase competition through a broad market approach

Specifications
Standardization + volume bundling
Structured tendering and negotiating

7-month timeframe met
18% under budget
Framework contracts signed for entire renovation phase
Optimized + expanded supplier pool

INDUSTRY - New plant / assembly line

Plan process steps in accordance with technical specifications and risk factors
Specify calls for tender for the individual construction phases
Negotiate with suppliers, including technicians

Interdisciplinary teamwork
Comparison with reference projects
Process optimization
Active risk management and TCO considerations

Came within budget, even under budget in some phases
Kept to schedule
Avoided risk of default

CONSTRUCTION OF NEW Shopping Center

Break down the overall plan into individual phases
Demonstrate saving and bundling potential according to construction phase
Create a supplier pool for short-term contracts

Coordinating the entire team and the planning offices
Defining procurement processes and guidelines
Standardizing construction phases
Detailed description in the catalog of services

Identified appropriate suppliers for all phases
Reduced complexity through standardization
Complied with budget and timeframes

IT - Server Procurement

Plan requirements
Standardize specifications and requirement profiles
Include relevant maintenance services
Issue call for tender + negotiate the annual requirement

Defining procurement strategy and processes for servers
Total support contract for services with one supplier

12% under budget
Best possible cost control
Reduced the risk of default
Data security ensured

Experts on CAPEX

CAPEX in Machine and Plant Construction

CAPEX in Retail

CAPEX in the Energy Sector

CAPEX in IT

How important is CAPEX in industry?

CAPEX projects are only important in a few industrial sectors, such as energy and construction. Large and, in particular, recurring CAPEX investments play an important role in industry. However, the maturity of CAPEX procurement in companies can be very different.

You would think that dealing with CAPEX projects would be routine in industry.

That is unreservedly true for the big players. However, there is a significant difference between big corporations and mid-sized companies. While corporations are very mature and professional when it comes to CAPEX, and in some cases have their own organizations for it, mid-sized companies have major shortcomings.

What is the main difference between the big players and mid-sized companies?

In industry, it is usually about investing in replacement machinery. This is quite normal for major players such as the automotive industry because, in a factory, machine parts have to be constantly replaced with new ones. To avoid downtime as much as possible, these companies have well-established structures for CAPEX procurement. Although new plants are being built much less frequently, this is still more common in large companies than in mid-sized companies. Since these requirements are rarely relevant in mid-sized companies, strategically-aligned CAPEX procurement just does not happen.

How do mid-sized companies get around this problem?

Often, not at all! Our experience shows that CAPEX has neither a culture of controversy nor an open discussion around it. Mid-sized industries do not realize how much money they are wasting through their current shortcomings in CAPEX procurement.

Who takes care of the resulting CAPEX requirements?

Planning and decisions are simply left to the departments and planners, so functionally-driven commercial expertise is ignored.

And what is the intention behind this?

None, to be perfectly clear. It is more the result – whether consciously or unconsciously – of a lack of imagination, and sometimes there is just no desire to leave their comfort zone. Establishing or optimizing viable procurement structures is a complex process that requires cross-functional teamwork, and many mid-sized companies shy away from making this effort.

How would you advise mid-sized companies?

The first step is to create transparency about CAPEX expenditure and reveal the potential. Then, that can serve as a basis to plan the next process. Since many companies only rarely have CAPEX projects, it does not always make sense to create a separate organization for this, which is what big corporations are able to do. But there should be a defined process for CAPEX procurement in every company, where the individual process steps, roles, and responsibilities are clearly defined for all parties involved. Only then can the identified potential be achieved.

What basic recommendations would you make to companies when it comes to procurement of store layout requirements?

I would generally advise retail companies to make the procurement process for store layout and visual merchandising as efficient as possible, using all the necessary freedom of creativity and design they have. Above all, that means reducing complexity and increasing standardization.

Is store layout particularly complex?

Yes, because in this sector, there is usually a lot of stakeholders with specific requirements and interests: designers, the store building department, and also often corporate management, because store layout is a senior management issue. Procurement is then frequently the last link in the process chain.

And how could this predicament be resolved?

The real challenge is to coordinate CAPEX requirements. This means creating a central coordination point, requiring interdisciplinary teamwork in all the relevant business units.

Does that not usually happen anyway?

No, it is more the exception rather than the rule. Individual departments often cooperate very little, or even not at all. This must be reconciled in order to effectively leverage the opportunities for synergy.

Can you explain this using a real-life example?

Yes, there was a large food company with several independent subsidiaries setting out to equip its stores with 36 different shopping carts, because each subsidiary buys them independently. Significant savings were made by standardizing three different types and creating bundled procurement for all stores. This applied across the whole group, but everything was coordinated through a purchasing unit such as central procurement. Of course, every subsidiary still has control over its own designs and can add its own branding to its shopping carts.

How skilled would procurement be in terms of design?

Procurement does not, of course, deal with technical questions autonomously, because ultimately it is, and remains, merely an executive body of consumers, equipped with commercial expertise. It should, however, be closely involved in the design process to ensure that designs are realistic and achievable, and that the budget is not exceeded. The keywords here are “commercial knowledge”. Procurement can pre-qualify suppliers in the early design phases and perform practical design tests.

Will CAPEX not lose importance in the wake of continued growth in online trade?

No, quite the opposite. In relative terms, this shift will even cause CAPEX to rise in the future, although traditional bricks-and-mortar retailers will tend to stagnate or decline. But, when it comes to the shopping experience itself, customer expectations of those retailers are increasing. To meet this demand, retailers need to become more innovative in equipping their stores, meaning the costs will rise.

What are the biggest challenges facing the energy sector?

Planning cycles for these investments are very long-term. Life cycle planning often stretches over decades. Reasonably realistic planning therefore requires key risk factors to be identified early. An adequate timeframe for critical procurement decisions, the most specific requirement planning possible, detailed construction phases, and sub-projects to complete the design stage are all crucial from a procurement point of view.

To meet the planned requirements on time and in line with specifications, the timeframes for strategic procurement processes and critical delivery must be taken into consideration from the outset as part of project planning. Despite a relatively high degree of maturity in project management and capital goods procurement in energy companies, there is often still work to be done in timely, cross-functional cooperation.

What other factors play an important role?

In spite of high volumes of regular investment, gaining optimal benefit from the experience of previous projects is often neglected, something that is due mainly to low staff continuity. In addition, project processes, including involvement in procurement, are insufficiently standardized. This begins with determining the optimal project structure for construction phases and signing appropriate agreements to incentivize partners in terms of crucial objectives, such as the date of commissioning. Procurement, as part of the project team, should help shape relationships with key partners from the outset, ideally using project-related managers. This includes actively monitoring the change process in projects in order to minimize any additional demands by using effective follow-up management.

How can procurement ensure compliance with planning values?

Strategic risk management is essential for this. To estimate the impact, a model-based evaluation of the effects of strategic procurement on project efficiency, complexity, and scheduling is crucial. The risk of delay can then be evaluated financially, and any possible additional costs, for example from changing suppliers, can be calculated, in order to make the right decisions.

Why do you argue that OPEX and CAPEX should not be considered separately?

Whether a requirement is OPEX or CAPEX is initially completely irrelevant from the buyer’s point of view and only has consequences for the subsequent financial posting. The practice of separating OPEX and CAPEX requirements is counterproductive, as this lacks the necessary transparency in mixed product groups. I would therefore argue that purchasing should first only be differentiated according to functional IT product groups, which then contain all the requirements of this category, whether OPEX or CAPEX.

What does this mean in concrete terms in IT procurement?

The procurement of a server, for example, is CAPEX or OPEX, depending on whether it is purchased, leased or procured as-a-service. For the demand planners, however, it is not relevant how the server is procured, because the demand is always the same. Only the procurement channels are different. Consequently, the anticipated separation of OPEX and CAPEX is premature from a purchasing point of view. The merger, on the other hand, ensures transparency and enables more efficient viewing and support together with the procurement department.

In your opinion, where else are the IT requirements affected?

In IT, there is sometimes an excessive need for security and a latent aversion to risk. This often leads to a considerable over-specification of actual requirements. Take the example of a new data line. This is where IT decides in favour of the feature with the highest availability. However, this decision is neither future-oriented nor appropriate. This would be the case if the capacity of the data line could be flexibly adapted to the respective future requirements and already available models of the market could be used.

How can such situations be solved?

Through trustful cooperation between the specialist department and procurement – throughout the entire purchasing process. Always on the basis of IT requirements, Purchasing can already support the vendor-independent specification, methodically accompany the joint market development, help evaluate alternatives from a business point of view and point out potentials.