Capital Budgeting -- The Process

In addition to understanding advanced methods of capital budgeting (i.e. real options), we have to discuss the process by which capital budgeting decisions are made. This is very important because no matter which method of capital budgeting being used, the answer is only as good as the underlying assumptions. It is unlikely that the financial manager who makes the decision or who sets up the methodology knows as much about the technical details and assumptions of a project as the engineers and line supervisors involved with the project. The process of capital budgeting has to align the incentives and interests of these employees with those of shareholders.

Thus, a large part of the process revolves around contracts with these employees. In fact, Tom Copeland told me in 1993 that he believes that designing such contracts would be the most important problem facing major corporations in the 21st century (and would hence be a major concern of the top consulting firms such as McKinsey).

Finance has long recognized the importance of designing employment and compensation contracts with an eye toward mitigating agency problems. Many CEOs now have performance-based bonuses and receive a large percentage of total compensation in the form of executive stock options. However, a plant supervisor may (correctly) feel that her actions are unlikely to affect the stock price. As the three articles from the McKinsey Quarterly suggest, these employees' major concern is that negative attention is not focused on them. Thus a plant supervisor may have an incentive to spend far too much capital on preventing down-time. Such a supervisor may feel that a plant shutdown would cost his job, for example.

Many companies separate the budgeting process into an operational budget and the capital budget. In these companies most of the political energy is focused on the operational budget. Head Office spells out revenue and expense expectations for the year, and supervisor bonuses depend entirely on performance relative to the operating budget. The capital budget is almost an afterthought, and often involves an arbitrary rationing across operating divisions, and so on down the line. Copeland and Ostrowski note that it is not uncommon for 60% of the corporation's capital budget to be invested below the level of Head Office.

Of course in this setting, a supervisor's incentive is to spend his entire capital budget, and exert effort to get a bigger ration. In this setup, spending capital has only positive benefits to the supervisor: she has a bigger empire, hence gaining political power within the organization; plus she is more likely to meet or beat the operating targets. In this setting everyone feels that the manner by which capital is rationed within the company is unfair (and that they are not getting their ``fair share''). Such feelings can disrupt morale and negatively impact operating performance.

Managerial accounting tools such as Economic Value Added or EVA represent an attempt to tie the capital budgeting process to the operating budget process. Supervisors are not evaluated on operating performance, but on return on invested capital. If this is implemented successfully, it would make a dramatic difference on incentives and notions of fairness within the organization.

Successful implementation is complex, however. Consider the staff function. These folks do not typically generate revenue, and invest large amounts of capital on IT. We will explore the methods of analyzing such investments -- assuming that the CEO (or a representative shareholder) will make the decision -- but developing a process to achieve this result requires a major effort in managerial (or cost) accounting.

by Chris Lamoureux, January 18, 2000.