After studying this chapter, you should be able to:
1. Explain capital budgeting and define the capital budgeting methodology and list its stages.
2. Describe how planning for capital projects should be conducted.
3. Discuss why and how feasibility, benefits, and cash flows are estimated.
A capital project is an asset or undertaking that is used to generate revenues or cost savings by providing benefits for more than one year. Capital budgeting allocates or rations funds for one or a mix of capital projects. The amount of these funds is usually sizable. This chapter suggests a capital budgeting methodology that systematizes capital budgeting decision making.
Because the long-term profitability of most enterprises depends on the nature and quality of their capital project investments, appropriate planning, evaluation, and implementation of high-return capital projects are imperative. Capital budgeting helps managers plan for the acquisition of capital projects that promise high returns.
Types Of Capital Budgeting Decisions
The impetus for capital budgeting decisions comes from many diverse sources. Sometimes these decisions are necessary to meet present needs of the enterprise such as the replacement of equipment. Or they may be the result of an organization's new vision and strategy. In some cases, they may be the result of expansion into a new market. Most capital budgeting decisions can be classified into one of the following capital project categories:
Legal and social responsibility. Capital projects in this group are implemented due to legal requirements; examples include pollution control devices and worker safety facilities. Also, various capital projects are implemented for social responsibility (e.g., homeless shelters) and public relations reasons.
Strategic. Capital projects in this category support management's vision of what the organization is to become, not what it is currently. Projects in this category reduce costs and generate revenues. They also expand capacity to accommodate the introduction of new products or services. Strategic capital projects involve long-term nonroutine investments that chart the strategic direction of the enterprise. The "new" organization may require implementation of some of the concepts and methods discussed in previous chapters, such as reengineering and continuous improvement, enterprisewide modeling, total quality management (TQM), just-in-time (JIT), material requirements planning (MRP), electronic data interchange (EDI), elimination of constraints, and increased throughput.
For manufacturing and for-profit service firms, long-term profitability is the objective of capital projects. For projects in the legal and social responsibility category, however, profitability may not be a consideration. But, even in this category, if the objective can be achieved in two or more ways, techniques are available to rank alternatives and thereby aid the decision-making process. The same can be said for replacement capital projects. In this and the two subsequent chapters, the concentration will be primarily on the strategic category of capital projects.
Source: Allen H. Seed III, "Investment Justification of Factory Automation," in Cost Accounting for the '90s: Responding to Technological Change (Montvale, N.J.: Insti-tute of Management Accoun-tants, formerly the National Association of Accountants, 1988), p. 86. With permission.
Essentially, capital budgeting involves making choices. Given a range of choices, doing nothing represents an alternative course of action. Managers, however, often ignore the impact of taking no action by assuming that the status quo will be maintained. However, this is seldom the case. As Henry Ford said, "If you need a new machine and don't buy it, you pay for it without getting it."1 The following material will help clarify what Henry Ford meant.
Capital assets are the engine of long-term growth and profitability. Time and again, companies that skimp on capital investments have found themselves unable to compete. Evidence abounds (e.g., see studies conducted by economists J. Bradford De Long and Lawrence Summers) that enterprises invest in capital assets now to ensure that they will be around tomorrow. William Wheeler, a partner in Coopers & Lybrand, believes that American industry needs to triple its capital spending: "If we don't start investing in the latest technology big time, we're going to end up being bypassed again." A Columbia University finance and law professor says, "Even when you are losing money, you've got to invest a fortune just to maintain market share." Robert Cizik of Cooper Industries says, "We're No. 1 in the world in files (Nicholson files). But, if I produced them the same way as five years ago, I'd be out of business. You've got to constantly update the capital base." A National Science Board study warns, "The United States is spending too little, not allocating it well, and utilizing it ineffectively."2
Exhibit 22-1 shows cash outflows during the early years and cash inflows during the later years. The traditional estimates show the net cash flows between line A and the zero baseline. What happens, however, if management doesn't make capital investments? Most likely, the competition will step in and start taking away business. So the real difference is the difference between A and B, not between A and the baseline.3
The exhibit illustrates a concept called the moving baseline.4 The moving baseline graphically shows that assuming the status quo will continue can lead to disastrous results, as indicated by line B. If management does not make capital investments, the enterprise will steadily lose ground in the marketplace and fail to generate cash flows. For example, the failure of American steel, railroad, and various manufacturing companies to upgrade their production facilities has proved to be a mistake. One can only imagine what the current status of these companies would be had they made the right kind of capital budgeting decisions. Today, with shorter product life cycles, rapid technological change, and stiff worldwide competition, capital budgeting decisions are even more difficult than in earlier times.
This analysis shows that in a competitive market nothing stands still. Competitors innovate, invest, and attempt to gain market share. Consequently, an enterprise must continually invest to stay even with or exceed the competition. Even in the maturity stage of the product life cycle (see Chapter 14), capital projects may have to be implemented to prevent sales of certain products from falling.
Because capital budgeting decisions are among the most important and difficult decisions that managers face, a methodology is recommended to assist managers in making the best decisions. The capital budgeting methodology, suggested in this book and shown in Exhibit 22-2, applies to all manufacturing, service, and not-for-profit organizations. It involves the following four stages:
Planning capital projects and estimating key variables. In capital budgeting, probably not enough attention is paid to the linkage between strategic and operational goals of an enterprise and the planning and identification of capital projects. In the first stage, planning is conducted to generate capital projects that appear to support an enterprise's goals and strategic plan. Feasibility factors, benefits, and cash flows of each capital project are estimated. This first stage is the primary subject of this chapter.
Performing financial analysis of each candidate capital project. In the second stage, capital budgeting financial analysis models are applied to evaluate projects to determine how financially attractive they are. This second stage is discussed in Chapter 23.
Scheduling, controlling, and managing development and implementation of each capital project. This third stage involves the close monitoring of resources, costs, quality, and the capital project budget. In addition, a feedback loop is necessary to ensure that the project stays on schedule and is implemented in accordance with a target date. This third stage is presented in Chapter 24.
Conducting a postimplementation audit of each capital project. In the fourth stage, the management accountant determines the amount of variance between earlier estimates and what actually occurred. The postimplementation audit is also treated in Chapter 24.
Planning for capital projects is a process of generating capital project requests that appear to support the vision of the enterprise. Providing the capital project requests is the responsibility of managers throughout the enterprise.
For an enterprise to compete successfully, it must develop a vision of the future that supports continuous improvement. If capital projects are not compatible with the enterprise's vision,5 they should be dropped from further consideration.
The first steps in any capital budgeting decision are to determine the enterprise's vision, then redesign and reengineer activities. Whether designing a new activity or reengineering an existing one, management must determine which tasks will be performed by people and which by machines. Management is faced with an ever-widening range of choices, from activities requiring very little automation to those requiring a great deal. Once the plan to improve the activities is complete, various capital projects are requested and evaluated. Those that can leverage an enterprise redesign by performing value-added activities more effectively, efficiently, and economically should he selected. (A review of Chapter 11 on activity-based management may be helpful at this point.)
Reengineering is the radical redesign of an organization's activities and processes. Done properly, it produces extraordinary gains in lead time, productivity, quality, and profitability. Union Carbide used reengineering to cut $400 million out of fixed costs in three years. GTE's aim is to use reengineering to double revenues while reducing costs by 50 percent.
Reengineering starts fresh. It doesn't start with what exists followed by fine tuning old activities. Reengineering starts from the future and works backward, unconstrained by existing activities. The organization is changed to match the vision of what it wants to become. “Don’t fix stuff you shouldn't be doing in the first place,” says Robert M. Tomasko, author of Rethinking the Corporation.Your company wants to reengineer. It's going to turn itself inside out and glue itself back together-faster, smoother, leaner, and more competitive. Who's going to do it? Texas Instruments, Aetna Life and Casualty, and American Airlines are among a growing number of corporations that have created a chief reengineering officer.6
To do otherwise is to use a “fire-ready-aim” approach instead of a “ready-aim-fire” approach. Here “ready” and “aim” refer to the enterprise's vision, redesign, and goals, while “fire” means engaging capital budgeting decisions that support the “new” enterprise. The logical sequence in planning for capital projects is shown in Exhibit 22-3.
A Capital Project Request Form, illustrated in Exhibit 22-4, is used by managers of various activities, such as engineering, production, logistics, marketing, and finance, to request approval of capital projects they believe are necessary to support the enterprise. The Capital Project Request Form serves as a trigger for requesting funds for a capital project. Normally, these forms are submitted to upper management for general review and cursory evaluation. The requests are usually submitted two to six months in advance of the final commitment of capital funds, assuming the request is approved by senior management.
The Requested Capital Projects Report, shown in Exhibit 22-5, includes a list of capital projects that have been tentatively approved by a budget or steering committee. (Such a committee is usually composed of a group of managers who decide which capital projects will be implemented, postponed, or rejected. The committee also oversees capital project development and implementation and resolves conflicts.) This report is supported by individual Capital Project Request Forms. Capital projects are then subjected to further evaluation, as explained in the next section.
For capital project requests to qualify as candidates for financial analysis, they must achieve acceptable feasibility and benefit factor ratings. The projects that pass this screening process are assigned estimated cash flows necessary for financial analysis.
What is the feasibility or likelihood of a capital project being a success? Or putting it negatively, what are the risks of failure inherent in a capital project? A thorough analysis of the feasibility factors of a capital project will significantly reduce the chance of failure and unpleasant surprises.
TECHNICAL FEASIBILITY. Technical feasibility refers to the likelihood of the capital project working as advertised. Technical feasibility addresses the issue of whether the technical aspects of a proposed capital project are practical and achievable. Usually, technical feasibility is a more critical issue if the technology involved in the capital project is generally new or new to the enterprise. For example, will a new expert maintenance system help the maintenance crew uncover and fix maintenance problems more efficiently? Will the new local area network actually enable the company to replace a costly computer mainframe? Will robots reduce labor costs and improve quality? What about technical obsolescence? Will it occur faster than expected?
OPERATIONAL FEASIBILITY. Operational feasibility concerns whether existing procedures and employee skills are sufficient to develop, implement, and operate a proposed capital project. If not, can enough skills be acquired, people trained, and procedural changes made to make a capital project operational? Also, employees affected by a new capital project may be resistant to change. The importance of gaining user buy-in to a proposed capital project should not be underestimated. Users who have bought into a project will make the necessary changes, participate in development and implementation, and undergo disruption in their daily routine to ensure a capital project's success.
ECONOMIC FEASIBILITY. The economic feasibility factor raises a fundamental question: Will top management commit sufficient funds to acquire, develop, and implement a particular capital project in view of the competing requirements of other capital projects within the organization? Management typically discovers that the number of capital projects that meet the enterprise's needs exceeds the availability of funds. A new computer-integrated factory may be technically feasible for an enterprise, but top management's ability to support such a project economically may be doubtful.
Economic feasibility is not directly related to financial analysis (treated in the next chapter); that is, how financially attractive a project is. Rather, economic feasibility represents an enterprise's commitment to a capital project and its ability to fund that project. For example, a capital project may be very attractive from every viewpoint, but a company may not have the necessary economic resources available to support it. Or, for a myriad of reasons, top management may riot be willing to support the project financially or otherwise. Unless an enterprise has a long-term commitment to acquire, implement, operate, and upgrade a capital project, the chance of its failure is high.
SCHEDULE FEASIBILITY. Any capital project is subject to development and implementation risks. Schedule feasibility determines if a proposed capital project will be developed and implemented within a specific timetable. This feasibility factor simply means that a capital project must be implemented by a target date. If not, the capital project will have to be modified or the target date changed. A large portion of Chapter 24 is devoted to methods of keeping a capital project on schedule.
TANGIBLE BENEFITS. Tangible benefits can be traced directly to a capital project. Such benefits help achieve tactical and operational goals. For example, a new computerized order-entry system may reduce processing costs by 20 percent. Or a new manufacturing cell may reduce scrap and rework costs by 60 percent. Tangible benefits are capable of being appraised at an actual or approximate value.
INTANGIBLE BENEFITS. Intangible benefits cannot be easily traced to a capital project. Such benefits help achieve strategic goals, such as improving customer service. Measuring intangible benefits is more difficult than measuring tangible benefits because intangible benefits are not easy to perceive and are generally long term.
Together, tangible and intangible benefits ensure that the enterprise will attain its vision and its strategic, tactical, and operational goals. Successful realization of these benefits is essential to ensuring the enterprise's success. Exhibit 22-6 lists a number of benefits most enterprises agree are important and thus strive to achieve, but this list is not exhaustive.
BENEFITS VERSUS COSTS. Many managers tend to focus on the costs of a capital project rather than on evaluating its benefits, especially the intangible benefits. This tendency often leads to the least-cost decision. The least-cost capital projects, however, may prove to be the most expensive in the long run. The capital budgeting methodology emphasizes that a “benefits first, costs second” project evaluation strategy is more appropriate. Indeed, it is the tangible and intangible benefits of a capital project that provide the enterprise its competitive advantage.
Some authorities believe that intangible benefits cannot be measured financially. For example, they may question how a company can measure the monetary benefit of its investment in a day-care center for its employees' children. Admittedly, placing a monetary value on such benefits is difficult, but it can he done.
Presumably, the day-care center will help reduce absenteeism, employee turnover, and training, which will, in turn, improve production performance. If it can be established that absenteeism, employee turnover, and training are costing the company $5,000,000 annually and that 30 percent of these costs arc due to the lack of day-care centers for employees, then a $1,500,000 ($5,000,000 x .30) cost savings can be estimated with a fairly high level of reliability.
Any capital budgeting decision is fraught with uncertainty. The objective of the capital budgeting methodology is to address and reduce this uncertainty in a rational, measured manner. Using the capital budgeting methodology, the day-care center project would be subjected to analysis and measurement, which should lead to elimination of bias, increased commitment throughout the enterprise, appropriate levels of funding, and scheduled implementation. Moreover, after such projects are implemented, audits are performed that help management evaluate the accuracy of the estimated benefits and costs. Knowing that postimplementation audits will be conducted may cause managers to be very careful in making estimates. Further, these postimplementation audits provide information that will help decrease uncertainty and increase capital budgeting skills in the future, resulting in reduced risk of failed projects.
One approach to determining the benefit factors is to relate the physical and financial size of a capital project under consideration to the benefits it is likely to produce, as illustrated in Exhibit 22-7. An example of a small investment is a robot; a mid-size investment would be a manufacturing cell; and a large investment, a total computer-integrated factory. Investments for such capital projects may range from a few hundred thousand dollars to over a billion dollars. For example, Caterpillar is investing $1.5 billion in a worldwide factory modernization program called “Plant With a Future.”7
Generally, a smaller investment, such as the acquisition of a robot, provides mostly tangible benefits. For example, if a robot replaces a worker, the worker's wages and fringe benefits and the reduction in scrap resulting from worker error can be easily calculated.8
Normally, a larger capital investment, such as a manufacturing cell, provides a mix of tangible and intangible benefits. For larger, more integrated projects, the tangible and intangible benefits contribute toward increases in revenue as well as reductions in costs.
Cash outflows occur from investment in a capital project and the cost of operating it over some period of time. Cash inflows stem from benefit factors. Cash flows, both inflows and outflows, related to capital project size are shown in Exhibit 22-8. Generally, a small capital project pays back relatively quickly. A larger capital project may take ten times longer to produce positive cash flows. Management may therefore be disinclined to make large, long-term investments in capital projects.
On the other hand, managers must eventually secure the longer-term capital project investments if they are to stay in business. Such larger capital projects have longer lives, extended periods of returns, and also rely more heavily on intangible benefits.
To obtain better and more realistic estimates, managers' judgments about capital projects should be elicited in a systematic manner. The goal is to enhance objectivity and downplay subjectivity by translating managers' judgments and instincts into numbers. To perform realistic capital budgeting, the management accountant must be involved in the measurement or estimation of all feasibility factors and tangible and intangible benefits.
Management accountants must be concerned with the ambiguity that may occur whenever numbers are associated with judgment. Otherwise, they get “Garbage in, Garbage out” (GIGO). Nevertheless, in reality, judgment plays a major role in any decision-making process, from awarding gold medals at the Olympics to selecting capital projects for implementation.
When evaluating the merits of capital projects, it is important to gain a consensus of judgments. This can present a difficult problem when people's knowledge and judgments differ. Two approaches can be used to resolve this problem:
JOINT INVESTMENT DECISIONS METHOD. The joint investment decisions (JID) method brings together managers, a facilitator, a scribe, and observers to provide agreed-on judgments. A typical JID layout is shown in Exhibit 22-9. The JID room is a separate room configured specifically for JID sessions. Managers sit at a U-shaped table. Separate tables are provided for the facilitator, scribe, and observers. White boards are used to capture dialogue. Flip charts may also be utilized, and flip chart paper may be hung on walls to keep the session on track and generate discussion. A workstation, or a PC, can capture questionnaire data and display results. The workstation is also used later to run the capital budgeting financial analysis models discussed in the next chapter.
No telephones, beepers, or other means of communicating with the outside world are allowed in the JID room. The objectives are to isolate the participants from day-to-day business activities and to focus on capital budgeting. The desirable outcome is a consensus on judgments relative to capital projects.
If managers' judgments differ, they are permitted to make a case for their position in an effort to reach a consensus. In reaching a consensus, managers must also follow established ground rules, such as majority vote or averaging the judgment measures to achieve a single number.
For the JID session to be effective, none of the participants can pull rank, no matter what their authority is outside the JID room. All egos must also be left behind. The facilitator must have the ability to encourage communication among participants, resolve conflicts, and keep the JID session focused. Generally, management accountants who understand group dynamics make good facilitators because they can remain independent and objective. When managers are reluctant to volunteer their judgments, an auction-type procedure may be helpful. The facilitator proposes a judgment value and asks managers to provide feedback.
The scribe's function is to record and document findings of the JID session. The observers serve a consultative role. They are present to answer technical questions that may arise. Examples of observers are equipment operators, engineers, market forecasters, computer experts, and vendor representatives. JID sessions offer several advantages:
DELPHI METHOD. The Delphi method employs a panel of managers to provide answers to a series of questionnaires. These questionnaires are used to elicit management judgments about the feasibility and benefits of a capital project under consideration.
Unlike the JID sessions, which are based on an open forum, the Delphi method is based on a closed group process in which people present their arguments and judgments while remaining anonymous. In Delphi, the participants review the questionnaire results and request adjustments without disclosing their identity.
Managers are chosen based on their expertise in a given field. Anonymity of the managers is maintained by administering the questionnaire to the managers by mail or by phone. In some situations, managers may participate in real-time by interacting via a computer-based network. The managers never meet during the Delphi, and their names are known only to the management accountant conducting the study.
The reason for anonymity is to avoid bias due to peer and superior influence and the “bandwagon” or “groupthink” effect. By maintaining the confidentiality of each participant, the Delphi method enables each participant to communicate more freely, allows more people to participate, and prevents unproductive disagreements. .
Group decision support (GDS) systems can support JID and Delphi methods. GDS systems are usually configured in a meeting room with PCs or work-stations connected by a local area network. The microcomputers are arranged around a U-shaped table, with a facilitator station and projector screen at the front of the room. The microcomputers are used to provide each participant the ability to:
Responses can be in an open forum setting like JID, or a closed forum setting like Delphi. However, most responses, especially those involving brainstorming ideas, voting, and ratings, are communicated anonymously. Thus, ideas are more likely to be evaluated based on their merit, independent of the source. Criticism is less likely to be seen as a personal attack. Shy people are less afraid to participate, and extroverts are less able to dominate. By forcing the participants to write their comments, ideas tend to be more concise and more focused. Moreover, cross talk, side talk, and chit-chat are reduced. Management accountants participate in many group decisions, such as strategic planning, operating budgets, capital budgeting, reengineering, quality management, and so forth. GDS systems provide tools that help groups collaborate in these areas. Vendors of GDS systems (sometimes referred to as “groupware”) are Andersen Consulting (CSTaR), Collaborative Technologies (VisionQuest), Dickson, Anderson, and Associates (SAMM), IBM (TeamFocus), and VentanaCorporation (GroupSystems).9
The managers are polled until a consensus is reached. The definition of consensus varies among organizations. The method of determining when the desired degree of agreement has been reached needs to be established before the Delphi process begins, however. For example, a consensus is reached when the majority of managers provide the same input values. In some companies, if a consensus is not reached after three rounds, the capital project under consideration is postponed or abandoned.
GROUP DECISION SUPPORT SYSTEMS. By using group decision support (GDS) systems, as described in the accompanying Insights & Applications on the next page, Boeing has cut the time needed to complete a wide range of team projects by an average of 91 percent. Other users, such as IBM, Dell Computer, General Motors, Price Waterhouse, and J. P. Morgan, have also experienced similar results. When one considers that managers spend from 30 percent to more than 70 percent of the day in meetings, GDS systems promise some real savings in time and cost. It is probably safe to assume that people who work in industry and academe would gladly welcome a system that can improve the quality and productivity of meetings and move the group closer to the truth and a consensus The Feasibility and Benefit Factors Worksheet
Each management accountant must decide which method to use in eliciting management judgments about proposed capital projects. In any case, the objective is to provide a systematic, documented, and fair method for the first stage of the capital budgeting methodology.
Assuming that a consensus (as defined by each organization) is reached in either the JID or Delphi sessions, the results are entered in a Feasibility and Benefit Factors Worksheet, as illustrated in Exhibit 22-10. In this case, management is considering a small capital project, such as a robot.
RATING A SMALL CAPITAL PROJECT. The Feasibility and Benefit Factors Worksheet provides overall feasibility and benefit ratings. For this particular capital project, management believes technical and operational feasibility factors (weighted at 30 and 40 percent, respectively) are more important than economic and schedule feasibility factors (20 and 10 percent), respectively. These relative weights are typical of small capital projects, which normally are less costly than large capital projects and have more predictable implementation schedules.
After the calculations are made, the overall feasibility factors rating is 9.3, which is excellent. Had the overall feasibility rating been lower than, say, 2.0, management might have decided to reject the capital project at this point and not consider it further. A capital project that has a weak overall feasibility rating will cause problems no matter what benefits and dollar values are assigned to it later.
If a capital project proves to be feasible, management's next step is to rate each benefit factor and assign weights to each benefit according to its importance. The weights assigned to each tangible and intangible benefit factor will normally not change regardless of the size or type of capital project being evaluated. The weighting represents the enterprise's vision, as well as its strategic, tactical, and operational goals.
Once a rating is calculated for both tangible and intangible benefits, both benefit category ratings are weighted. For example, a small capital project, such as a robot, truck, machine, or personal computer, simply does not possess the potential to produce a high level of intangible benefits. Thus, for a small capital project, the tangible benefits category will typically receive a weight of 90 percent or more, while 10 percent or less is assigned to the intangible benefits category. The overall benefit rating for this small capital project is a respectable 8.12 on a scale of 1 to 10, with 10 being most important. This rating means that the small capital project being evaluated in Exhibit 22-10 is a B-grade candidate that has the potential to provide the enterprise with some tactical and operational advantages.
RATING A MID-SIZE CAPITAL PROJECT. The Feasibility and Benefit Factors Worksheet for a mid-size capital project, shown in Exhibit 22-11, follows the same format as the worksheet for a small capital project. The ratings, however, may be significantly different because the capital project in question is not only different but larger. Economic and schedule feasibility factors are likely to be more important for a mid-size capital project because of its size and longer life. A mid-size capital project is also likely to possess more potential for intangible benefits than a smaller capital project.
In this case, the overall feasibility rating of 6.1 is not particularly strong, a grade of C- at best. Management may question the feasibility of the capital project at this point and reject or postpone it. In the example, management has decided to continue evaluating the project. The tangible benefit rating of 4.6 is not particularly strong, and the intangible benefit rating of 5.4 is moderate. Because a mid-size capital project generally possesses more potential for producing intangible benefits than a small capital project, the intangible benefits receive a weight of 40 percent, compared to 10 percent in Exhibit 22-10, while tangible benefits receive a weight of 60 percent. The overall rating for this mid-size capital project is a moderate 4.92.
RATING A LARGE CAPITAL PROJECT. Investment in large capital projects, such as fully automated factories, can easily exceed $100 million. Some very large projects can exceed $1 billion. The equipment involved is more complex, technically and operationally, than traditional pieces of stand-alone equipment. The benefits associated with such projects are usually more strategic and intangible. Enterprises make these kinds of capital investments to completely reengineer the enterprise in an effort to gain a competitive advantage.
The implementation schedule is much longer for large capital projects than for small and mid-size capital projects. GM's Saturn project, for example, required five years to implement. Returns to the enterprise also occur over a longer period of time, in the 10- to 20-year range. Such capital projects arc more costly, longer term, and riskier and, therefore, require management's full attention in the analysis and rating process. The Feasibility and Benefit Factors Worksheet, demonstrated in Exhibit 22-12, provides an excellent tool for achieving this goal.
In the worksheet, management has determined from a great deal of analysis that technical and operational feasibility factors should be assigned a rating of 7. Management believes that the technology is viable and that rigorous training programs will develop the skills necessary to make the new capital project operational. Because the cost of a large capital project is not as certain as that for a small capital project, management has rated the economic feasibility factor conservatively. The higher weight assigned to the economic feasibility factor reflects management's concern about the full cost involved. The time required to implement a large capital project is also more uncertain than that of a small capital project. Consequently, the schedule feasibility factor receives a conservative rating and a fairly high weight for a large capital project because management is concerned about the project's schedule for implementation.
The new capital project promises excellent tangible and intangible benefits, which are reflected in the ratings in the worksheet. Because the project has the potential to reap strategic-based benefits, especially those directed toward increasing revenues, the intangible benefit category receives a 60 percent weight, and the tangible benefit category receives a 40 percent weight.
Each capital project is prioritized in accordance with its overall feasibility and benefit rating. This prioritization process is performed using a priority grid, as shown in Exhibit 22-13. Based on their overall ratings, capital projects can fall into one of four categories. Those in the low-potential category, with overall feasibility and benefit ratings of less than 2, are not worthy of further consideration and are thereby rejected. Those in the moderate-potential category, with overall feasibility and benefit ratings between 2 and 5, are worthy of further consideration, although they may be postponed until the next fiscal period. In Exhibit 22-13, the mid-size capital project (MS) with an overall feasibility rating of 6.1 and an overall benefit rating of 4.92 is such a project.
Capital projects in the high-potential category, with overall feasibility and benefit ratings between 5 and 8, should be given immediate consideration. In Exhibit 22-13, the large capital project (L) with an overall feasibility rating of 6.2 and an overall benefit rating of 8.92 is such a capital project.
Finally, those capital projects that receive overall feasibility and benefit ratings of greater than 8 are also worthy of immediate attention. These are considered superpotential capital projects. In Exhibit 22-13, the small capital project (S) with an overall feasibility rating of 9.3 and an overall benefit rating of 8.12 is such a project.
The Capital Projects Portfolio Statement, illustrated in Exhibit 22-14,includes those capital projects that fall into the superpotential, high-potential, and moderate-potential categories. The Capital Projects Portfolio Statement contains the capital projects that have passed a major hurdle of the capital budgeting methodology. After associated cash flow estimates are made, they will be ready for financial analysis, as presented in Chapter 23.
An important part of capital budgeting is estimating the timing (i.e., pattern) and quantity of cash flows for each capital project being considered. Erroneous estimates may result in erroneous decisions regardless of the financial models used in Chapter 23.
Capital projects are supposed to reduce costs or generate revenue, or both. Decreasing costs and increasing revenues produces cash flows. But cash inflows produced by tangible and intangible benefits are difficult to estimate. The goal of the capital budgeting methodology, however, is to be approximately right rather than exactly wrong.
For example, what are the enterprise's current costs for scrap, rework, returns and allowances, field warranties, and quality inspections? In some enterprises, costs of quality may be as high as 30 percent of the cost of goods manufactured. If the annual cost of goods manufactured averages $800,000 and the present costs of quality average 20 percent, then the total costs of quality average $160,000 per year. If a new capital project will cut the costs of quality in half, then the estimated cash inflow generated by the investment is $80,000 per year.
The expected value technique computes an amount called an expected value of a series of events. In the case of capital budgeting, events are the future cash inflows and outflows related to a capital project under consideration. Because these cash flows occur in the future and are thus uncertain, probabilities are assigned to each possible series of cash flows. Their expected value is calculated in three steps:
An example of how the expected value technique is applied is presented in Exhibit 22-15. Management is considering acquiring an electronic data interchange (EDI) system as part of its new integrated computer-based information system (ICBIS). After a great deal of analysis of both tangible and intangible benefits, management determines that the new capital project will both increase revenues and reduce costs. The total expected value of annual cash inflows from this project is estimated to be $536,000 ($126,000 increased revenues + $410,000 reduced costs).
The required capital investment outlay for the EDI system is $2,100,000. It is estimated that a major upgrade will not be needed for four years. Is the EDI project financially attractive? The methodology for answering this question is presented in the next chapter.
The Cash Flow Estimate Form, illustrated in Exhibit 22-16, is used to record and document cash flow data for the ICBIS. These data are used to perform financial analysis. Later, if the ICBIS is implemented, the form is used as a major document in conducting a postimplementation audit (the subject of Chapter 24) to determine how close the estimates were to actual values.
The emphasis in this chapter has been on estimating cash inflows that are generated by benefits of the capital project. Cash outflows occur because of the investment outlay and operating costs. Usually, the investment outlay can be calculated with a high degree of accuracy. The estimation of investment and operating costs has been addressed in other chapters (see Chapters 5, 7, and 14) and therefore will not be repeated in this chapter.
In making capital project investment decisions, deci- sion makers attempt to make trade-offs between -expected return on investment and risk. These decision problems are characteristically complex. It is -almost impossible for any decision maker to take full account of all the factors impinging on the decision simultaneously. It would be useful to find some way to consider explicitly both the preference structure of the decision makers and the uncertainties that characterizethe investment situation. The use of probabilities and artificial intelligence not only provide quantitative measurements, but also capture the psychological preferences and risk attitudes of the decision makers.
FuziCalc (FuziWare, Inc., in Knoxville, Tennessee) is a hybrid spreadsheet and artificial intelligence engine that enables users to handle “fuzzy” (ambiguous) data and probabilities. With FuziCalc, users input “hard” numbers (e.g., last year's shoe sales) just as they would do in any other spreadsheet. FuziCalc also allows users to input fuzzy numbers (e.g., a range of probabilities of forthcoming shoe sales). After these numbers are entered, users can adjust them according to their beliefs and run what-if analyses. Once a consensus is reached, the spreadsheet component displays the values, such as estimated cash flows.10
Without strategic information systems planning, an enterprise is prone to develop systems that are not goal-congruent. Insufficient methods of setting priorities for proposed systems projects, inappropriate allocation of resources, and unrealistic schedules contribute to the problem. Companies that don't perform strategic information systems planning can usually be recognized by their inability to meet schedules and budget targets, lack of project status awareness by workers and managers, and frequent duplication of effort.
Further, a truism in management is: If you don't plan a project, you wit] never be able to control it. Without a vision and strategy, an enterprise can incur unnecessary costs and time delays in planning new capital projects, such as information systems. One company looked at support costs, throughput, customer support, and even workflow issues. Yet, despite such thorough analysis, the system failed. Why? The organization attempted to build the information system on those factors individually. In other words, there was no comprehensive vision and strategy for what was needed. Another company, on the verge of producing significant new product lines, also needed a new information system. Unfortunately, politics got in the way of good systems planning and design and the end results were time delays, unwanted overlaps, and mass confusion.11
Because cash flows cannot be estimated with absolute certainty, managers responsible for capital budgeting decisions should be aware of the limitations and risks associated with using the cash flow estimates recorded in the Cash Flow Estimate Form. Managers are more likely to recognize these limitations if they are involved in the first stage of the capital budgeting methodology. Managers can also improve their estimating skills by studying the comparisons of actual costs and estimates supplied by postimplementation audits. This feed-back can help managers make better estimates for future projects. Further, feedback from postimplementation audits will often point out the need for a coordinated vision and strategy, as declared in the above Insights & Applications.
An enterprise should make sure its “house is in order” before it considers any capital projects. To put its “house in order,” the enterprise should establish a vision and strategic plan. The enterprise should be redesigned and reengineered to achieve the vision and ensure that strategic, tactical, and operational goals are met.
Managers throughout the enterprise submit Capital Project Request Forms, which describe capital projects that the requesters believe support the enterprise's vision, redesign, and goals. Capital projects that are tentatively approved are included in a Requested Capital Projects Report.
Are the capital projects listed in the Requested Capital Projects Report feasible from a technical, operational, economic, and schedule viewpoint? Do the capital projects hold promise of producing tangible and intangible benefits? What are the cash flows relative to each capital project? Management's involvement helps to answer these questions.
The JID method uses an open forum and group dynamics while the Delphi method uses anonymity to elicit management judgments. The Feasibility and Benefit Factors Worksheet is used to quantify and document these judgments. Associated with the worksheet is a priority grid that allows management to quickly visualize the potential of each capital project under consideration. Those capital projects that fall into the superpotential, high-potential, and moderate-potential categories are included in a Capital Projects Portfolio Statement.
Cash inflows stem from benefits. Normally, the greater the benefits, the greater the cash inflows. After subjecting capital projects to a systematic, rigorous evaluation, management will gain a great deal of knowledge about the benefits of each project. Consequently, management is able to assign probabilities for the expected value of cash inflows due to the benefits anticipated over the life of each capital project.
The Cash Flow Estimate Form is used to record the estimated cash flow data. These cash flow data are the key elements used in performing financial analysis, the second stage of the capital budgeting methodology. The Cash Flow Estimate Form is also used to compare estimated cash flow data with actual cash flow data after the capital project is implemented.
First Interstate Bank is considering a capital project request to build a branch bank in the southwestern section of the city. The branch bank will occupy 5,000 square feet of floor space, and the cost estimating parameter is $87 per square foot. The useful life of the branch bank is five years before a major renovation will be needed.
Estimated range of cash inflows for years 1 and 2 is $80,000, $60,000, and $30,000. Each value in this range has assigned probabilities of occurrence of .3, .5, and .2, respectively. For years 3 and 4, the estimated range of cash inflows is $290,000, $180,000, and $60,000 with assigned probabilities of occurrence of .2, .7, and .1, respectively. For year 5, the estimated range of cash inflows is $90,000, $70,000, and $40,000 with assigned probabilities of .2, .6, and .2, respectively.
Required: In the space provided, indicate the category into which each capital project falls: meeting legal and social responsibilities, replacing a present capital asset, or improving the strategic ability of the enterprise.
22.36 Determining tangible and intangible factors. Keith Howard, management accountant at Genco Engineering, has recently been assigned to develop a Feasibility and Benefit Factors Worksheet. Following is a list of benefit factors that Keith has compiled:
22.37 Implementing group dynamics. The study of how people interact in a group setting is called group dynamics. Group dynamics is becoming an important part of modern management accountants' expertise as they become a more and more integral part of the management team. Management accountants need to be able to harness the dynamics of groups in enterprises effectively because groups of people affect the success of many endeavors, such as capital budgeting.
Required: Two major methods used to improve the effectiveness of group planning and decision making are the JID and Delphi methods. Describe both methods and identify how each can enhance the effectiveness of capital budgeting planning and decision making. Also, discuss how group decision support (GDS) systems facilitate each method.
22.38 Using the Delphi method. Kristy Paulsen, project leader for the Frud Cookie Company, is having a problem with cookie consistency. The test batch process worked great-the cookies did not break apart (spoilage) as they were packaged and taste tests exceeded expectations. However, now that the cookies are being produced on a conveyor system, there is a high percentage of spoilage. Kristy asks for your help, knowing that you have worked in several of the company's facilities and know many of the company's experts as well as being familiar with the corporate games. You decide that the best method to assist Kristy is to employ the Delphi method.
22.39 Expected value technique. Buck Andrews has been a top performing sales representative for Corvas Company over the past eight years. John, the district sales manager, asks Buck how he is able to maintain consistently high performance. Buck replies, “Well, I always concentrate my sales efforts on those projects that have the best expected value, developing those projects that have potential for return and dropping projects with little or no return.” Buck provides the following example projects:
22.40 Using the JID method. As a management accountant for Freeway Hydroponics, you suggest to Fred Freeway, the owner, that the company implement the JID method as a way to evaluate the various capital improvement projects the company is considering.
22.41 Applying the expected value technique. Exquisite Foods, Inc. (EFI) sells premium foods to the middle-class market. Three independent marketing strategies are being considered to promote a new product, Souffles for Microwaves, to dual-career families. EFI's policy for promoting new products permits only one type of advertising campaign until the product is established.
a. EFI wishes to select the most profitable marketing alternative to promote Souffles for Microwaves. Recommend which of the three strategies EFI should adopt. Support your recommendation with appropriate calculations and analysis.
22.42 The problem of trying to achieve interrelated goals. [CMA adapted] Duval, Inc., is a large publicly held corporation whose product is well known throughout the United States. The corporation has always had good profit margins and excellent earnings. However, Duval has experienced a levelling of sales and a reduced market share in the past two years, resulting in a stabilization of profits rather than growth. Despite these trends, the firm has maintained an excellent cash and short-term
investment position. The president has called a meeting of the treasurer and the vice presidents for sales and production to develop alternative strategies for improving Duval's performance. The four individuals form the nucleus of a well-organized management team that has worked together for several years to bring success to Duval.
The sales vice president suggests that sales levels can be improved by presenting the company's product in a more attractive and appealing package. He also recommends that advertising be increased and that the current price be maintained. This latter step would have the effect of a price decrease because the prices of most other competing products are rising.
The treasurer is skeptical of maintaining the present price when others are increasing prices, since this will curtail revenues unless this policy provides a competitive advantage. She also points out that the repackaging will increase costs at least in the near future because of the start-up costs of the new packing process. She does not favor increasing advertising outright because she is doubtful of the short-run benefit.
The sales vice president replies that increased, or at least redirected, advertising is necessary to promote the price stability and to take advantage of the new packaging; the combination would provide the company with a competitive advantage. The president adds that the advertising to be used-television, radio, newspaper, magazine-should be studied closely to determine which would be cost-effective. In addition, if television is used, attention must be directed to the type of programs to he sponsored-children's, family, sporting events, news specials, and so on.
The production vice president suggests several possible production improvements, such as a systems study of the manufacturing process to identify changes in the work flow that would cut costs. He suggests operating costs could be further reduced by the purchase of new equipment. The product could be improved by employing a better grade of raw materials and by engineering changes in the fabrication of the product. When queried by the president on the impact of the proposed changes, the production vice president indicated that the primary benefit would be product performance, but that appearance and safety would also be improved. The sales vice president and treasurer commented that this would result in increased sales.
The treasurer notes that all of the production proposals would increase costs, and this could result in lower profits. If profit performance is going to be improved, the price structure should be examined closely. She recommends that the current level of capital expenditures be maintained unless substantial cost savings can be obtained.
The treasurer further believes that expenditures for research and development should be decreased since previous outlays have not prevented a decrease in Duval's share of the market. The production vice president agrees that the research and development activities have not proven profitable, but thinks that this is because the research effort was applied in the wrong area. The sales vice president cautions against any drastic reductions because the packaging change will only provide a temporary advantage in the market; consequently, more effort will have to be devoted to product development.
Focusing on the use of liquid assets and the present high yield on securities, the treasurer suggests that the firm's profitability can be improved by shifting funds from the currently held short-term marketable securities to longer-term, higher-yield securities. She also points out that cost reductions would provide more funds for investments. She recognizes that the restructuring of the investments from short term to long term would hamper flexibility.
In his summarizing comments, the president observes that they have a good start and the ideas provide some excellent alternatives. He states, “I think we ought to develop these ideas further and consider other ramifications. For instance, what effect would new equipment and the systems study have on the labor force? Shouldn't we also consider the environmental impact of any plant and product change? We want to appear as a leader in our industry-not a follower.
22.43 Evaluating a capital project. Anne Hastings has just been hired as the new director of customer services for Uncle Sam Computer Systems, a mail-order computer software and hardware retailer. Dee Kandus, CEO, assigns Anne to upgrade the customer information system (CIS). Dee provided Anne the following information:
22.44 GDS features. Group decision support (GDS) systems (or groupware) offer a comprehensive array of features that support almost any type of project that requires groups of people working together on collaborative projects.
We see health care in the future being quite different from how we have known it in the past. Without question, the industry's advancement in providing state-of-the-art clinical and operational information to its organizations and medical staffs is a prerequisite for advance-ment in the next decade. Such information will have to be provided in an accurate and timely manner.
The use of advancing technology, as a crucial component to the art and science of medicine, must be anticipated and acted upon. Environmental and community issues will challenge health care organizations to provide cost-effective access to care in a well-coordinated fashion, to maximize the appropriateness and effectiveness of resources dedicated to patients and their families. Organizations will have to strive constantly to evaluate and enhance the coordination of care through the strengths of perpetual quality improvement.
Only the most acutely ill or injured persons will reside in the hospital. This will dictate which services will he offered within the hospital, and that value-added services must be emphasized, particularly on an outpatient basis.
Instrumental to this vision is management's and the medical staff's mutual accountability to one another to optimize health care provided. Fundamental to this process is collaborative innovation in current health care expectations and future advancements.
b. Create a capital budgeting planning team with some of your colleagues. Prepare several capital project requests that you believe support the vision state-ment. Using either the JID or Delphi method, estimate the feasibility and benefit factors of the capital projects. Based on these estimates, prepare a priority grid and a Capital Projects Portfolio Statement. Finally, using the expected value technique, prepare a Cash Flow Estimate Form for each capital project listed in the Capital Projects Portfolio Statement.
3. Allen H. Seed ill, "Investment Justification of Factory Automation," in Cost Accounting for the 90s: Responding to Technological Change (Montvale, N.J.: Institute of Management Accountants, formerly the National Association of Accountants, 1988), p. 85. With permission.
4. Robert A. Howell, "The Controller's Responsibility in World-Class Manufacturing," in Cost Accounting for the 90s: Responding to Technological Change (Montvale, N.J.: Institute of Management Accountants, formerly the National Association of Accountants, 1988), pp. 160-162. With permission
5. Some managers prepare a vision statement to provide a futuristic sense of direction for an enterprise and a mission statement that includes specific actions to be taken to make the vision a reality. In this book, vision and mission statements are synonymous.
7. James A. Hendricks, Robert C. Bastian, and Thomas L. Sexton, “Bundle Monitoring of Strategic Projects,” Management Accounting, February 1992, p. 31. Reprinted from Management Accounting. Copyright by Institute of Management Accountants, Monvale, N.J.
8. Robert A. Howell and Stephen R. Soucy, “Capital Investment in the New Manufacturing Environment,” in World-Class Accounting for World-Class Manufacturing, ed. Lamont F. Steedle (Montvale, N.J.: Institute of Management Accountants, formerly the National Association of Accountants, 1990), p. 156. With permission.
9. Adapted from Joseph G. Donelan, “Using Electronic Tools to Improve Meetings,” Management Accounting, March 1993, pp. 42-45. Reprinted from Management Accounting. Copyright by Institute of Management Accountants, Monvale, N.J.