Large-scale capital expenditures (capex) all face a crucial challenge: finding the right trade-off between capex cost and financing options to optimize return on investment (ROI). They also share many characteristics, including, for example, complexity, multiple stakeholders, and bankruptcy risks.

Generating the best possible ROI is arguably the main objective of a large capex project. One of the toughest challenges in reaching that objective is meeting the expectations of stakeholders—financial and commercial stakeholders, procurement experts, engineers, project managers, lawyers—who have their own concerns and expertise. Some of their expectations are in direct conflict with others. Every expectation has the potential for conflicts and contradictions.

Managing total capex is the key to carrying out a successful project. After all, the most important criterion for potential owners to evaluate a project is its ROI, and a good ROI depends on the project’s commercial attractiveness, which depends on financing costs, which influence capital structure and capex, which must meet all stakeholders’ quality and time requirements. Furthermore, different financing options assert different influences on large capex projects, primarily because large projects require multisource funding. These options include stakeholder equity, ECA-guaranteed debt, International Financial Institutions (IFI) guaranteed debt, and commercial debt. The larger the project, the likelier it is to depend on ECA and IFI financing, especially if the project lacks a major shareholder.

Our approach to successfully managing large capex projects is executed in four phases:

Phase 1: Define data and constraints.
Phase 2: Develop different scenarios.
Phase 3: Discuss output and adapt scenarios accordingly.
Phase 4: Evaluate and select final procurement scenarios.

Collaborative optimization is an excellent tool for navigating the process of finding the best procurement strategy. It is an innovative sourcing technique that creates value through bidding and business-award optimization, and helps identify the best combination of lots and suppliers to meet buyer requirements and supplier strengths.

Collaborative optimization allocates bidders according to the constraints detailed in Phase 2. For each scenario the goal is to minimize the following: adjusted payment to bidders, including optional discounts and penalties; penalties for violating rules related to constraints; and prices of lots that don’t get allocated. We add constraints such as minimum contract value and national content requirements to create further scenarios to help find a solution.

In most cases there are many possible procurement scenarios to analyze, and A.T. Kearney has developed a three-pronged “filter” approach to paring down the number of scenarios until the best one is left standing.

The first filter aims to eliminate scenarios that offer a poor supply-market situation—the goal here is to identify scenarios that don’t involve materials, products, or components that might become bottlenecks in times of high demand.

Filter two is crucial, since it focuses on ROI—here, scenarios are filtered according to the impact of their financing costs and capex on the project’s ROI.

Finally, filter three is a basic risk assessment to determine operational risks, contracting risks, and the risk of limited level of competition among potential bidders during the tendering process.

When volatility hits the financial markets, investors shudder. When volatility hits the commodities markets, corporations shudder. The recent U.S. drought reinforced this message as it affected the price of corn, soybeans, animal feed, and other inputs to the food supply. The drought and its impact on future commodity prices are expected to have serious repercussions on all food prices.

We recently surveyed 21 chief procurement officers (CPOs) and heads of the commodity risk management functions of major food and beverage companies. This is the first in a series of studies to assess the impact of rising commodity prices and gauge corporate approaches to commodity risk management. Study participants were asked a range of questions, including: What impact is the rise in commodity prices having on your company? What are your expectations for the future? How do you approach and manage risk? How is your company positioned for the future if commodity prices remain volatile for the next several years?

Overall, our participants know that increased volatility in commodity pricing is not a short-term phenomenon. In a global marketplace, weather shocks—hurricanes, tsunamis, floods, or drought—are recurring events that will increase price volatility. Other factors such as increased global demand, geopolitical conflicts, and biofuels are causing a host of new headaches.

They have largely relied on hedging to manage their risk, maintain costs, and ensure a more predictable source of supply. Now, however, given the size and scope of the influencing factors and recognizing that commodity volatility cannot always be controlled, they say hedging alone is no longer a sufficient risk management approach.

Most CPOs believe volatile commodity prices will affect consumer pricing, and 43 percent believe the volatility will also impact company profitability (see figure 2). Most believe that the impact will not go away anytime soon—80 percent think the price hit will last more than a year, and 60 percent say they should increase their buying coverage. Tight supplies at the end of 2011 and lower than expected yields mean that stock will be depleted going into the 2012-2013 marketing year.

No good risk management strategy begins without discussions with senior executives about expectations and appetite for risk. Is the company inclined to ride out the market or more interested in predictable costs? Is the objective to beat the competition or to dominate the market? In our work with clients, we often recommend the following:

• Understand market dynamics and what “value” is at risk. Know your markets, your position in them, and your value drivers. 
• Have a mitigation strategy in place. Have a plan in place that outlines the potential risk mitigation strategies—deflect, transfer, hedge, or operate—for all commodities. 
• Reach market-driven decisions. Make decisions about risk factors and mitigation tactics with your markets in mind. 
• Manage execution and governance. Manage major risks cost-effectively while also considering the residual risks, such as foreign exchange.