Capital Decision-Making: Analysis and Judgement

Article excerpt

ABSTRACT. Quantitative analysis, the traditional technique for capital budgeting evaluation, is experiencing widespread disuse in decision-making. This is asserted to be due to the inability of cost-benefit analysis to quantify benefits received from public investments. Such analysis fails to take into account qualitative factors and political considerations. Research of a municipal capital budget found only 6.5% of the projects to be primarily justified by cost-benefit analysis. The various processes and structures used in public capital budgeting are argued to be of significance in determining budgetary output.

Ali Farazmand and Jon Patraic Neill*

INTRODUCTION

Capital budgeting is the term that is "used to describe action relating to the planning and financing of capital outlays" (Garrison, 1988: 643). This private sector description is significant because it implies a range of activity that goes into the capital budgeting process. The traditional emphasis, however, focuses on quantitative techniques and analysis in treatment of capital budgeting decision-making.

The issue that is probed in this article is: Where does the orientation of capital budgeting in the public sector lie? Is it with the rationalcomprehensive analytical techniques such as net present value (NPV), internal rate of return (IRR), payback period (PB), and cost-benefit analysis (CBA)? Or does the answer lie elsewhere- buried within the less formal, value-laden, processes that produce the capital budget decision?

The thesis put forth is that public sector capital budgeting decisions are formed in a process that relies on input that is highly qualitative in nature and strongly influenced by non-financial considerations. The role and benefits of traditional quantitative analysis is argued to be a limited one. If this is true, then implications for the treatment of this topic are profound.

What would then be the approach to capital budgeting? The vision asserted is for greater study and understanding of the processes and decisions that are unique to capital planning and decision-making. In an advanced stage, this may mean the development of a normative, or standardized, capital budgeting process. That is, what steps and actions should be taken by any public sector entity when formulating the capital budget?

Although developing the components necessary for a normative capital budgeting process is beyond the scope of this article, the argument will be made for a greater emphasis on process and a lesser emphasis on quantitative analysis. This will be approached through a case study from both the public and the private sectors, as well as a discussion on traditional quantifying techniques and their value in public sector decisions.

METHODOLOGY

The methodology relied upon the study of the capital budget process in public sector and private sector scenarios. The latter utilized the City of Cincinnati's proposed 1995/1996 Capital Budget. This budget is notable for its descriptive explanation of the capital budget process the city employed, and for ranking the criteria that were the basis for decisions.

The budget was analyzed to determine the basis of project justification. This was done by a review of each capital project write-up for all the city agencies, with the exception of the Cincinnati Water Works which is a city-owned enterprise. The project justifications were then classed into a category of justification based upon the city's criteria for the basis of decisions. Although such analysis necessarily involved some judgment calls, the one-page project write-ups tended to follow certain justification themes.

The private sector case is based upon the co-author's experience within the capital budgeting process in private industry. This example includes experience in a facility built for a capacity of 20,000 workers, and with infrastructure needs not unlike those of a town or city. …