How board oversight of capital allocation can drive strategy

Capital allocation is essential to advancing a company’s strategy; its oversight is one of the board’s most important and fundamental roles.

In brief

• Ongoing economic uncertainty and an unyielding commitment to transformation are causing boards to deepen their focus on capital allocation.
• Boards can take five practical steps to enable management to maximize profitability and position for business transformation despite current headwinds.
• By revisiting the fundamentals of capital allocation oversight, boards can assess and optimize their governance practices in this important area.

The board’s role in capital allocation has become more challenging and more scrutinized. Current economic conditions – including lower growth prospects, increased geopolitical risks, sticky inflation and “higher-for-longer” interest rates – mean capital allocation decisions are now essential to achieving strategic goals. Despite current headwinds, for many companies those strategic goals include business transformation. An EY survey of 1,200 CEOs globally in December 2023 found that 95% are planning to maintain or accelerate their transformational change in 2024, with those looking to accelerate plans (58%) nearly tripling from July 2023.

Achieving such transformational goals in today’s market reality demands a more disciplined and efficient use of capital, as well as robust governance of investment decisions and related performance. Capital expenditures are strategic decisions that should maximize efficiency, profitability, and long-term value, all while mitigating as much risk as possible. Directors are attuned to these demands and have ranked capital strategy the second highest board priority for 2024, according to an EY survey of more than 350 corporate board members across the Americas.

To support boards as they deepen their capital strategy engagement we offer five actions boards can take to guide capital allocation in the current environment. It also provides a back-to-basics refresher on the fundamentals of capital allocation oversight that can help boards assess and enhance their approach to this core responsibility.

Five ways boards can guide optimal capital strategy now

Getting back to basics: capital allocation fundamentals for boards

While the current economic environment is generating unique challenges for capital allocation decisions, boards can continue to rely on fundamental oversight practices for capital strategy that will serve them in any environment.

Adopt a dynamic approach to overseeing how the investment roadmap drives strategy

Capital allocation strategy should support and drive overall corporate strategy, working hand in glove. To ensure this alignment, boards need to adopt a more dynamic approach to reviewing capital budgeting and management. The one-off, board strategy session has evolved. Leading boards are now working with management to frequently revisit the strategic plan and its key elements and assumptions to enable more agility and strategic pivots. This same approach should apply to the capital budget, which should be revisited regularly alongside the strategic plan.

When those are in place, the focus should turn to capital management. For the board, this should mean ongoing monitoring of performance to allow for adjustments that reinforce the strategy and optimize capital efficiency. This oversight should include asking management about how they are leveraging in-flight reviews of larger projects to allow for course corrections and leveraging post-mortems to learn from more- or less-successful projects along the way.

Focus on the right metrics

Capital allocation strategy should support medium- and longer-term value creation goals in addition to short term key performance indicators (KPIs), which makes focusing on the right metrics essential. Best practice is to use a balanced scorecard approach that leverages a small set of financial (investment timing, ROI assumptions/timing) non-financial (e.g. product mix, customer retention) and qualitative (e.g., community engagement, social media sentiment) KPIs in the investment decision making process that all align to the overall corporate strategy.

When it comes to financial KPIs, return on invested capital (ROIC) is a multifaceted KPI that can be deconstructed to align different business units to the most appropriate value-creating level, given their situation. For example, a company can have a goal of increasing ROIC from 20% to 25%, and each business unit in the company can have its own goal (e.g., a very profitable business unit can focus on revenue expansion; a market leading unit can focus on margin improvement; a capital-intensive unit can focus on improving capital efficiency by pursuing asset-light strategies). It is the same ROIC KPI, but every business unit can play a different role, allowing for more customization for individual management teams. Anchoring on ROIC as the benchmark for capital allocation decision-making helps management assess risk and make fully informed, unbiased decisions.

Know the value of each component of the business and enable business agility

To enhance their own value to management, boards should understand the value of each business or asset and how it is supporting the corporate strategy. Each business unit or asset plays a role in the portfolio, e.g. driving revenue or profitability, and can be more or less capital intensive. By understanding the value of each business and asset to the company, and to potential buyers, the board is positioned to provide effective challenge to the status quo and accelerate transformational change when needed.

Boards and management teams should take a page from the private equity playbook and be ready to sell a component of the business that is worth more to someone else. Know the market potential and ease of divesting so the company can prioritize business divestitures if it needs to raise capital internally. While their role is one of oversight, boards should feel empowered to suggest transformational deals to achieve strategic goals, leveraging the experience and acumen that make them a strategic resource for management.

Going forward: enable agility and capital strength

As companies navigate challenges and opportunities related to capital availability and deployment, the board will play a critical role in providing both robust oversight and strategic advice, guiding management in balancing risk management and long-term value creation. Ultimately the current environment requires continued progress along business transformation – and investment in innovation takes capital. By educating themselves and leaning into their governance of capital allocation, boards can enable agility and capital strength, refocus management on the long-term, and oversee communications that tell a compelling capital strategy narrative to stakeholders.