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PUBLIC BUDGETING & FIN. MNGMT.

, 8(3), 428-552 FALL 1996

CAPITAL DECISION-MAKING: ANALYSIS AND JUDGMENT


Ali Farazmand and Jon Patraic Neill*

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.

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 rational-
comprehensive analytical techniques such as net present value (NPV),
____________
*Ali Farazmand, Ph.D., is Associate Professor, School of Public Administration,
Florida Atlantic University. His teaching and research interests are in organizational
studies and public budgeting. Jon Patraic Neill, MPA, is Controller, Provident
Consumer Financial Services, Inc.

Copyright 8 1996 by PrAcademics Press


CAPITAL DECISION-MAKING 429

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
430 FARAZMAND & NEILL

experience in a facility built for a capacity of 20,000 workers, and with


infrastructure needs not unlike those of a town or city. Although not directly
cited, Mrs. Delaina S. Kern of Cincinnati, Ohio, provided valuable expert
input on the realities of corporate capital budgeting.
These unpublished data are supplemented by a review of published
research on the topic of capital budgeting process methods. Results of these
studies are cited to reinforce assertions of the thesis.

DEVELOPMENT OF THEORY
"Quantitative analysis has become a major element of public
management" (Meier & Brudney, 1993: xvii). The history of quantitative
analysis in the public sector in fact has its roots in the values of the seminal
work by Woodrow Wilson (1887). From the outset, an emphasis on
objectivity and scientific decision-making led to an orientation toward
quantitative analysis which can best described as "cost-benefit" analysis in the
broadest sense of the term.
Cost-Benefit analysis is a "systematic means of estimating the costs and
benefits of projects over their life" (Axelrod, 1988: 115). It was not until
1936 that such analysis was formally applied in Federal legislation as the basis
of decision-making. In that year it was mandated that the only approved
water resource projects would be those in which the estimated benefits
exceeded the costs (Axelrod, 1988).
Elsewhere Patton & Sawicki (1993: 369) stated that "the beginnings of a
formalized, scientific approach to the evaluation of planning and policy
problems can be traced back to the 1930's." Through the boom economy of
the post-World War II years into the 1970s, quantitative analysis was the
dominant theoretical approach for program evaluation. However, by 1972
strong arguments were put forth for the qualitative or subjective approach to
evaluation. Cost-Benefit theory was challenged to grow beyond its traditional
economic analysis to encompass "social-political impact components" (Patton
& Sawicki, 1993: 370). This was an important development in the practical
use of this theory, as it is self-evident that such an nalysis would be more
difficult to quantify.
In the 1980s the debate on quantitative, analytical techniques turned
toward the issues of value impacts and the role of stakeholders (Patton &
Sawicki, 1993). These important recognitions subtly shifted the focus from
CAPITAL DECISION-MAKING 431

analytical techniques toward the process in which evaluation takes place.


Values, or basic beliefs of worth, were seen as subjective interpretations that
could alter the outcome of quantification (such as the estimated future
benefits of a project which is the basis of cost-benefit analysis.)
Furthermore, despite efforts of objectivity there was a recognition that
"results will be used politically, no matter how scientific they try to be"
(Patton & Sawicki, 1993: 371). An emphasis on the inclusion of stakeholders
in the evaluation process can be seen in examples such as the Cincinnati
capital budgeting process where neighborhood groups' input is systematically
sought and incorporated (Shirey, 1994: 2).
The state of the theory in the 1990s can be described as at a crossroads
in which the traditional quantification techniques have yet to be reconciled to
the qualitative influences on the budgeting process. For example, the current
finance textbook of the International City-County Management Association
(ICMA), acknowledges that "although simple in theory, public investment
decision-making is not very easy in practice... nevertheless, some estimate of
the value of benefits can be made." (Aronson & Schwartz, 1987: 402). This
tension is reflected in statement that cost-benefit analysis is "a useful tool,"
but it is "no substitute for seasoned judgment and sensitivity to social,
economic, and political values" (Axelrod, 1988: 116).
Where then in capital budgeting theory is the line of demarcation
between analysis and judgment? Fundamentally the issue stands unreconciled
as a simple dichotomy of quantitative versus qualitative; objectivity versus
subjectivity; numbers versus values. It is a dichotomy that is not unfamiliar
to public management which attempts to incorporate the methods of private
enterprise into the realities of the political arena.
Simple concepts underlie cost-benefit analysis. "It involves such factors
as placing a current monetary value on project benefits and costs that will
take place in the future" (Axelrod, 1988: 115). This analysis is designed to be
rational and comprehensive. The issues that arise in this analysis tend to be
centered on the estimate of benefits. Cost tends to be fairly clear; one can
quantify the costs of a new baseball stadium in dollars. This cost will be
incurred based upon a building contract that would occur over the following
few years. Benefits in the public sector are caught up in unanswerable issues
such as: What is the dollar benefit of the project to the public? What are the
benefits today? What are the benefits for the future? What are the benefits
of this project relative to the benefits of other spending alternatives such as
432 FARAZMAND & NEILL

education? Cost analysis and Benefit analysis are soon divorced due to
"irreconcilable differences."
The primary tools of cost-benefit analysis are net present value (NPV),
internal rate of return (IRR), payback period (PB), and cost- benefit analysis
(CBA). These analytical approaches have common concepts in their
formulas: the cost of the project, the dollar benefit of the project, and the
cost of money (i.e., interest rate). These values are then "discounted", or
decreased, so that future monies are reduced to their worth right now; that is,
their present value. Discounting is based upon the economic assumption that
a dollar received today is worth more than a dollar received tomorrow; for
example, inflation of 3.0% would indicate that a benefit received next year
would be worth only 97.0% of the same benefit received now. The logical
flow of quantitative capital budgeting analysis generally follows this pattern:
1. What is the net present value of the project? The formula sets NPV
equal to the present value of the benefits minus the cost of the project
(Aronson & Schwartz, 1987: 401).(1). A positive net present value
means that the benefits outweigh the costs and the project should be
approved . While it is best to have as large a positive NPV as possible,
the NPV is also a function of the size of the investment. More analysis
is needed in the investment decision since a ranking based upon NPV
would necessarily favor the large projects.
2. What is the internal rate of return? The formula solves for the interest
rate that brings the present value of the benefits into equality with the
initial outlay (Aronson & Schwartz, 1987: 402).(2) If the internal rate
of returns meets or exceeds the cost of borrowing, then the project is
economically feasible. The larger the return, the more beneficial the
project.
3. What is the cost benefit ratio? Cost-benefit analysis (in the narrow
meaning of the term) looks at the NPV in a slightly different format. The
present value of the benefits divided by the cost equals the cost-benefit
ratio. A project would be acceptable if the benefits equaled the cost;
i.e., a ratio of 1:1 or 1/1 = 1.00.
4. What is the payback period? That is, how many years will it take to
recoup the investment outlay. This will occur in the year in which the
sum of the benefits equals the initial cost of the investment.
CAPITAL DECISION-MAKING 433

A MUNICIPAL CAPITAL BUDGET: THE CITY OF CINCINNATI


What is the role of quantitative analysis in a municipal capital budget,
and what other factors are included in the process? The City of Cincinnati,
Ohio, produced a 1995/1996 recommended capital budget that is useful for
this study since it described not only the criterion used to judge projects, but
also ranked those criteria by their importance in the decision-making process
(Shirey, 1994: 2).
An overview of the process used in the case of Cincinnati will help to
illustrate what key steps were involved in getting to the point where these
criterion were applied. These steps correspond to points in the capital budget
decision-making process where projects were, by default, eliminated. This
demonstrates the power of the process in project selection.

Defining Capital Items in the Capital Improvement Plan


The first step of elimination is in the definition of a capital good. The
city of Cincinnati defined a capital project as having "useful lives of at least
five years and a minimum cost of $10,000" (Shirey, 1994: 1). What is
unique about the public sector is that there is no universal definition of what
belongs in the capital budget. Cincinnatis definition is derived from what the
city wants to see in its capital budget, not by a generally accepted accounting
definition (Bailey, 1994).
The private sector, by comparison, has rigorous definitions of what a
capital item is, and companies are given little latitude to make their own
definitions (Williams, 1994). For example, a $5,000. software package that
enhances worker productivity has a useful life of four years and is a capital
good by private sector Generally Accepted Accounting Principles (GAAP).
This same item would be excluded from the capital budget of Cincinnati on
the basis of both its cost and its useful life.
Therefore, the first cut in the capital budgeting decision-making process
does not occur with analysis (quantified or not), but rather with a simple
definition. The software package, clearly an investment with long-term
payoffs, is relegated to the operating budget where it must compete with
current year expenses for funding.
Projects that are defined as capital goods by the city are then eligible to
compete for a position in the Capital Improvement Plan (CIP). The
Cincinnati version is a six-year plan for 1995-2000 which is funded in biennial
434 FARAZMAND & NEILL

capital budgets. The CIP "is a plan for capital investment in Cincinnatis
future through improving City streets, bridges, recreation facilities, parks,
health facilities, and buildings" (Shirey, 1994: 1). The stated goal of these
projects is to "enhance the delivery of services and the quality of life in
Cincinnati" (Shirey, 1994: 1).
Two points deserve special emphasis at this juncture. First, the CIP is
"a policy statement by the City Council of the future direction for the City of
Cincinnati" (Shirey, 1994: 1). Second, in order for quantitative analysis to
perform its function of project screening and project selection (Garrison,
1988), it must be able to quantify the value of a "bridge" and determine how
that will affect the "quality of life" for the citizens.
The use of CIPs highlights the context of public sector budgeting as
being in the domain of politics. From political policies the decisions to accept
or reject capital projects are made. The orientation of public capital
budgeting is therefore not in rational-comprehensive Cost-Benefit analysis
(such as we might see in private industry), but rather locked into the political
process itself. And it is significant that most cities (an estimated 87%) do use
a CIP (Forrester, 1993).
Given that the Cincinnati CIP is a policy statement reflecting political
values, what role does quantitative analysis have in politics? It is asserted that
the benefits of a bridge and the goals of quality of life are essentially issues
involving qualitative considerations which are not only best left to the
judgment of elected representatives, but may in fact be unquantifiable. The
launching point for the discussion of decision-making techniques in the
Cincinnati capital budget comes in the context of a CIP. The CIP asserts the
primacy of political policy driving the a capital budget in which municipalities
are given the discretion to decide what they include in it.
The capital budget must foremost be formulated within the context of
available resources. This is especially true for the "General Capital Budget"
which is funded from taxes and debt, as opposed to projects supported from
enterprise funds, special revenue funds, or federal and state matching funds
(Shirey, 1994). As can be seen in Table 1, the source of funds will often
dictate the use of funds. This reality limits discretion in capital budgeting.
As there are certain inherent limitations due to the source of funds, so
too are there analytical limitations due to the use of funds. Equipment, which
is very conducive to cost-benefit analysis, is a relatively small piece of the
General Capital Budget. As can be seen in Table 2, infrastructure accounts
CAPITAL DECISION-MAKING 435

TABLE 1
City of Cincinatti Capital Budget: Source of Funds, FY 1995-96
(In Millions of Dollars)
___________________________________________________________
Fund Types FY 1995 FY 1996
-----------------------------------------------------------------------------------------
Panel A: General Capital $39.5 $42.3
-----------------------------------------------------------------------------------------
Panel B: Enterprise Funds
Water Works 23.3 20.0
Parking System .1 .1
General Aviation .1 .1
Golf .4 .5
Riverfront Stadium 1.4 1.9
Stormwater Management 2.0 1.4
Metro Sewer District 13.6 20.0
Total Enterprise Funds 40.9 44.0
-----------------------------------------------------------------------------------------
Panel C: Special Revenue Funds
Community Development
Block Grants 15.9 15.8
HOME 3.4 3.4
Emergency Shelter Grants 1.0 .5
Special Housing Fund 1.4 1.4
Total Special Revenue Funds 21.7 21.1
-----------------------------------------------------------------------------------------
Panel D: Matching Funds
State/Federal Roads & Bridges 36.6 10.3
FAA .1 3.5
ISETA 1.0 .9
Ohio Capital Funds 14.6 (*)
Total Matching Funds 52.3 14.7
-----------------------------------------------------------------------------------------
Total Capital Budget 154.4 122.1
___________________________________________________________
* States capital allocation not yet committed.
Source: Shirey, J. F. (1994), City of Cincinnati Recommended 1995/1996
Biennial Capital Budget, Cincinnati, OH: City of Cincinnati, p. 9.
436 FARAZMAND & NEILL

for over 70% of this budget, but it is very difficult to quantify in terms
of benefits. More difficult yet is Economic Development and Housing &
Neighborhoods. Environment, which is primarily projects needed for
compliance to federal, state, or local regulations, is essentially unquantifiable.

Capital Requests and Evaluation Criteria


The capital budgeting process involves more than the development of
a CIP that balances revenues and expenses. In Cincinnati, project
consideration for the 1995/1996 biennial capital budget started with a list of
"previously identified capital improvements taken from the current" capital
plan. New requests were incorporated into the plan by input from City
Council, city department heads, and citizens (Shirey, 1994: 1-3).

TABLE 2
Use of Funds- General Capital Budget
__________________________________________________________
Types of Capital Projects Budgeted Amount As % of Total
(in $1,000) Capital
Expenditures
-----------------------------------------------------------------------------------------
Infrastructure $28,100 71%
Equipment 7,216 18%
Housing & Neighborhoods 1,928 5%
Economic Development 1,656 4%
Environment 600 2%
Total 39,500 100%
___________________________________________________________
Source: Shirey, J. F. (1994), City of Cincinnati Recommended 1995/1996
Biennial Capital Budget, Cincinnati, OH: City of Cincinnati, p. 8.

In an effort to promote government responsiveness, a sub-process


involving citizen input was established. Early in the budget process, citizen
participation was encouraged by "submitting five written Community Priority
Requests" from each neighborhood group (i.e., municipal subdivision).
This input was then sent to the appropriate city department for inclusion in
their capital budget requests (Shirey, 1994).
Since "there are many priorities which compete for limited resources"
(Shirey, 1994: i), the capital budgeting process in Cincinnati includes a Capital
CAPITAL DECISION-MAKING 437

Committee which serves as an arbiter as the city administration develops the


capital budget. The committee consists of the department heads from Public
Works, Public Utilities, Economic Development, Water Works, and the
Metropolitan Sewer District.
The committee made the first review of city budget requests from the
various city agencies. Next, the Capital Committee analyzed the budget
requests in the context of on-going projects and infrastructure needs. A
budget was developed that matched the available resources, and was
forwarded to the City Manager for his review and approval. The result was
the recommended 1995/1996 Capital Budget for the City of Cincinnati.
Evaluation criteria for capital projects were determined by the Capital
Committee. The Cincinnati budget included the criteria the committee used
to analyze projects, as well as the importance or priority attached to each
method. These methods will be reviewed in detail, as it is an assertion of the
thesis that quantitative techniques of analysis are of lesser importance in
public capital budgeting decisions. In priority sequence, they are (Shirey,
1994: 1-7):
- Hazard Elimination. The most important criterion for deciding
whether or not to make a capital investment was hazard elimination: "to
eliminate or reduce definite and immediate health and safety hazards."
It is not surprising that in public sector capital budgeting such a values
statement should usurp all other considerations or cost-benefit results
(Shirey, 1994: 2).
- Legal Mandates. This criterion is discussed in the narrow, legal sense
of complying with a court order or "other specific legal directive" such as
a consent decree (Shirey, 1994: 2).
- Regulatory Compliance. Recently addressed by Congress as the
"unfunded mandates" issue, compliance to federal and states regulations
has been acknowledged to be a strain on local resources. Cincinnati
defines these costs as "self-initiated improvement in compliance with a
federal, state, or local rule or regulation affecting capital assets" (Shirey,
1994: 2).
- Project Completion. Priority is given to "finish phased projects with
related, and already committed or expended funding" (Shirey, 1994: 2).
- Preserving Existing Assets. The city goal is to preserve existing assets
which at first glance sounds like maintenance expense (not a capital
item), but the narrow construction of this category follows the private
sector GAAP definition of capital costs. This category of expenditure is
438 FARAZMAND & NEILL

to prevent failure or "to systematically, according to schedule, improve


assets which if not periodically improved would fail," and to extend
useful life or "to improve an asset by making a capital investment to
increase the assets service life" (Shirey,1994: 2). Such capital projects
are typical users of traditional quantitative techniques such as NPV and
IRR. Although these decisions can be made on the basis of operational
or engineering concerns, it is here where these techniques are most
appropriate as costs and benefits tend to be best defined.
- Cost-Benefit Justified. "To make a capital investment which is
supported by benefits equal to or greater than the cost of the
investment." The benefits may be in "jobs, revenue, cost savings,
matching funds, etc." (Shirey, 1994: 2). This criterion for project
approval presumably would include cost-benefit calculations such as
NPV, IRR, cost-benefit analysis, and payback period.
- Service Betterment. "Projects designed to accommodate growth in
service demand, or to otherwise increase the quality of service provided
by the capital asset" (Shirey, 1994: 2).
The significance of these seven ranked criteria for making capital budget
decisions is important to the thesis of this article. First, de facto decisions
(such as legal mandates) are made throughout the capital budgeting process.
Second, decisions in project selection do not always incorporate quantitative
analysis techniques, but rather are guided by fund sources and political
values. Finally, some categories of capital budgeting simply do not benefit
from analysis such as NPV and IRR.

Project Justification
If not through traditional quantifying means, then how are projects
selected? In the private sector, NPV and IRR can guide decision-making in
capital budgeting. Favorable analytical results justify the expenditures. In
public capital budgeting there is a greater emphasis on justification, i.e., how
to select among the many worthy projects.
A review of the Cincinnati CIP reflects this emphasis on justification.
For example, the highest priority in the Water Works CIP for 1995 is a
"Anthony Wayne/Center Hill Water Main". The project sheet describes the
funding needed over a six-year period, a description of the project, as well as
sections entitled "Project Justification" and "Operating Budget Impact."
Project justification reads: "The existing water system in this area cannot
support additional development." Furthermore, "contractual agreements,
CAPITAL DECISION-MAKING 439

service area expansion and population/land use projections require installation


of new water mains for adequate service" (Shirey, 1994: 352). Although
NPV and IRR analysis would be appropriate to a capital project in an
enterprise fund, other values can be seen in the justification of this project.
First, governmental responsiveness is seen in the concern for development
capability and service. Second, legal mandates and agreements influence this
choice. Third, technical engineering evaluations control much of the decision-
making in water works projects.
In another example, a computerization project for the City Council is
justified due to it being "a continuation of a City Council-requested project
which standardizes information technology" (Shirey, 1994: 47). Here the
justification rests on it being a continuation of a project in progress. Both
these examples follow the criteria statements discussed above, and are not
necessarily being guided by financial analysis.
The CIP project sheets do, however, include a section on "Operating
Budget Impact." This is an important feature of the budget, as it
recognizes the interrelationship between capital and operating budgets. In
fact, elsewhere in the budget there is a comparison of operating costs and
capital expenditures, with a recognition that there is over time a near 1:1 ratio
between dollars spent on capital goods and dollars needed for their
maintenance (Shirey, 1994: 39-40).
Cost-benefit analysis does not appear to be the preferred method in
discussing operating budget impacts to the Cincinnati budget. This is
important since the application of NPV is to estimate the value in dollars of
net savings in the operating budget due to added capital expenditures
(Garrison, 1988: 643-666). No such estimated savings due to capital
investment were generated in the budget report. The analysis in Table 3
pointed to just fourteen projects of the 217 total (6.5%) that were primarily
justified by Cost-Benefit analysis.
The discussion of Water Works water main project gets to the heart of
the matter in the statement on the operating budget impact: "Additional water
will be sold but it is not possible to estimate how much additional growth will
take place in the area served or to assign dollar values to the benefit" (Shirey,
1994: 352).
This statement is one that the authors of this article are inclined to
support. The argument by the Water Works is very important: it is not
possible to estimate the benefits derived from this project. If such an
estimation can not be done, then NPV, IRR, cost-benefit analysis, and
440 FARAZMAND & NEILL

TABLE 3
City of Cincinnati: Justification of Capital Projects, FY 1995-96
(N= 217)
___________________________________________________________
Agency A B C D E
-----------------------------------------------------------------------------------------
Building 1 1 0 0 0
Council 0 1 0 0 0
City Manager 4 1 0 0 0
City Planning 3 1 1 0 0
Economic Development 2 0 18 0 1
Health 3 0 1 1 1
Law 0 2 0 0 0
Housing 2 0 6 0 1
Parks 2 0 2 2 0
Personnel 1 1 0 0 0
Utilities 2 0 18 9 3
Public Works 12 3 27 13 3
Recreation 5 1 12 5 0
Computer Center 0 13 0 0 0
Safety 1 2 15 9 5
Totals 38 26 100 39 14
___________________________________________________________
Notes:
A = Environmental, health, or regulatory reasons
B = Increased efficiency via computerization
C = Economic development, service betterment
D = Preserve assets through maintenance
E = Cost-benefit Analysis justified
Source: Shirey, J. F. (1994), City of Cincinnati Recommended 1995/1996
Biennial Capital Budget, Cincinnati, OH: City of Cincinnati.
CAPITAL DECISION-MAKING 441

payback period analysis can be futile tools to capital budgeting decision-


making. These techniques are, of course, necessary for such estimates of
value.
Fundamentally, if these quantitative techniques are not used in such a
self-supporting enterprise fund which closely resembles a private-industry
business making a facility purchase, then where are they useful? And if these
techniques are not useful, then how do we evaluate and justify capital
expenditures in the public sector? It is argued that the Cincinnati
methodology (although certainly not unique) is the correct direction to be
moving in.
Further observations from justification analysis shed light on the capital
budgeting process. First, the Metropolitan Sewer District (not included in
Table 3) had fifty-eight projects which like the Water project were clearly
cost-benefit justified. Second, in addition to technical considerations another
unstated justification was efficiency gained from computerization projects.
Computerization tended to be a justification in and of itself.
Third, the stated criteria of the city for project selection (Shirey, 1994:
2) proved somewhat inadequate. There are varied reasons for this statement.
It is difficult to ascertain the line between "hazard elimination" and
"regulatory compliance." They are often one and the same. There was only
one instance of "legal mandate" through a court case. Again, there could be
an overlap between legal mandates and regulatory compliance. Only two
projects had "project completion" as a primary or secondary reason for
justification.
As stated above, cost-benefit calculations were limited to 6.5% of the
justifications. By and large the justifications fell into the "service betterment"
category which vaguely covers the concept of economic development, and
into "preserving existing assets" through capital maintenance projects.

Political Approval of the Budget


The capital budget process does not end upon the submission of a
balanced recommended budget of the City Manager to the City Council of
Cincinnati. This point can best be described as the start of the political
approval process.
442 FARAZMAND & NEILL

In Cincinnati, there are a series of public meetings for citizen comment


on the capital budget. The final funding decisions are then made by the City
Council. This is followed by the necessary approvals of the CIP and funding
ordinances, and with a mid-term review of the biennial budget. The
Cincinnati capital budget also has one unique aspect in recognition of the
political power structure in the city: capital projects are also itemized
according to what neighborhood of the city that they benefit, or if the benefit
is of a city-wide or region-wide nature (Shirey, 1994: 1-7).

Research Findings of Quantitative Analysis in the Public Sector


The traditional quantitative analysis of NPV and IRR is the cornerstone
of capital budgeting (Aronson & Schwartz, 1987: 400-402). Borrowed from
the private sector in an attempt to make capital budgeting more rational and
comprehensive (Khan, 1987; Forrester, 1993), these models exhibit inherent
flaws in public sector application. In this respect their use may be an
anachronism from the period when management science was believed to be
the saviour of public management.

Weaknesses in Traditional Quantification


In 1994 the Government Finance Officers Association stated that "very
little is known about what works well or does not work well in state and local
budgeting" (GFOA, 1994: 48). This in part explains why there seems to be a
lag in which these quantification techniques still predominate textbook
treatment of capital budgeting, but appear to be falling into disuse in practice.

Leading researchers (Forrester, 1993; Khan, 1987; Kee, Robbins &


Apostolou, 1987) have come to the conclusion that municipalities simply
prefer less quantitative techniques. Research by Kee, Robbins and Apostolou
found that NPV and IRR were used as a means to make capital budget
decisons by as few as 4% of municipalities.
The preferred method according to both Kee et al. and Forrester is a
modified version of cost-benefit analysis (in the broad meaning of the term).
It is a "versatile method since values and qualitative factors can be
incorporated into the model" (Kee, Robbins & Apostolou, 1987: 18). Kee et
al. (1987) also reports that one-third of municipalities (all over 50,000 in
population) use no quantitative analysis at all in the capital budgeting process.
The reasons cited for not using quantitative analysis were primarily
political factors and the inability to incorporate qualitative factors into the
CAPITAL DECISION-MAKING 443

analysis (Kee, Robbins & Apostlou, 1987). Khans 1987 research also
concluded that there is a preference for informal methods of capital budget
analysis, again with cost-benefit analysis as the preferred method.
There is one glaring weakness that is common to the four types of
traditional quantification techniques discussed above: they rely on estimates of
future benefits. The words of the Cincinnati Water Works project summarize
this problem: "It is not possible to estimate...or to assign dollar values to the
benefit" (Shirey, 1994: 352).
Still, the effort continues to find ways of quantifying the qualitative
(Patton & Sawicki, 1993), usually with results that are of limited validity and
which would face difficulty in passing through the political end of the capital
budgeting process.
As stated previously, NPV and similar techniques which rely on
estimated future benefits have other analytical flaws. The cost of capital is
recognized to be greater than the borrowing rate of the government. If it
were not so, governments would accept projects that would otherwise be
rejected by private industry simply because they had lower financing rates.
This would lead to government over-spending. Theoretically, the borrowing
rate "is probably not the true social cost of capital to the community"
(Aronson & Schwartz, 1987: 402).
The other theoretical problem alluded to is that discounting gives
preference to the near-term at the expense of the long-term. It reflects the
truism that we "have a preference for benefits sooner rather than later"
(Patton & Sawicki, 1993: 276).
However, should the benefits of infrastructure be discounted in the same
manner as the benefits from equipment purchases? In the former,
infrastructure such as the Brooklyn Bridge becomes even more vital and
valuable as time proceeds- and as it is maintained (i.e., capital appreciation).
In the case of the latter, it is certain that the vehicle purchased today will in a
matter of years lose its value (i.e., capital depreciation) until it is completely
worthless.

A PRIVATE SECTOR CASE


Much has been said recently of the need to run government more like a
business (Chan, 1994). Indeed, Reinventing Government (Osborne &
Gaebler, 1992) is in some respects a flashback to the management science
initiative earlier this century that sought to bring successful techniques from
the private sector into the public sector. This begs the question of how has
private sector capital budgeting influenced public capital budgeting?
444 FARAZMAND & NEILL

An answer to this question is partially found in Grizzles (1989)


explanation of five tools for increasing efficiency. Significantly, only one is
political in nature: "restrict the amount of revenue available to government"
(Grizzle, 1989: 214). The other four approaches are clearly borrowed from
private sector management:
- Run government more like a business,
- Optimize operations through management science,
- Institute budgetary and accounting controls, and
- Provide incentives for public managers to operate efficiently.
The implications of this approach to the public capital budgeting function
are evident: to be more efficient, base the capital budgeting process upon the
private sector model. Emphasis would be given to analysis which would help
determine the optimal decisions to make. The budget result would reflect
projects that were able to demonstrate the higher ranking of NPV and IRR.
In this manner the public manager would be rewarded for controlling the
capital budget through businesslike management science techniques.
The unstated assumptions are that (1) the private sector makes capital
budget decisions in a rational-comprehensive method based upon quantitative
information, and (2) that this is a valid model for public sector management.
These assumptions can be gleaned from the prominent of Public
Administration capital budgeting research, such as Forresters statement that
such rational-comprehensive methodologies "have been used successfully in
the private sector" (Forrester, 1993: 87). The paradigm is that this is a
successful approach that should be normative for the public sector as well.
However, several misconceptions exist about private sector capital budgeting
including the lack of literature on capital budgeting decisions processes and
the lack of a dual perspective which can observe both private and public
perspectives on capital budgeting.
Predominant views from the private sector can be seen in accounting
literature (Siegel & Shim, 1990; Garrison, 1988). For example, Garrison
(1988: 663) studies the "only real difference" between public and private
capital budgeting is in selecting the "proper discount rate to use." A better
wording might be that the "many real differences start with the proper
discount rate to use."
The assertion presented here is that private sector capital budgeting is
less a model of rational-comprehensive decision-making than is typically
presented. If true, this statement would diminish the attractiveness of private
sector capital budgeting as a public sector efficiency tool. Furthermore,
CAPITAL DECISION-MAKING 445

differences between the goals and processes of public capital budgeting viz a
viz the private sector render the private sector model of limited value to
public decisions. There exists a disposition to reduce these differences to be
irrelevant.
This challenge to the value of rational-comprehensive Cost-Benefit
methods reflects the co-authors experience in capital budgeting as a financial
analyst for a successful global corporation. This experience affirms a
definition of capital expenditure decisions as "depending primarily on an
assessment (emphasis added) of the projected cash flows from additional
revenues, cost savings, or a combination thereof from the asset to be
acquired" (Kay & Searfuss, 1989: 15.2). The operative word is the definition
of "assessment"- Whose assessment? How was the assessment made? And
how is the assessment reflected in the final decision?
The topic of a capital proposal assessment is usually reduced to a matter
of quantitative analysis in both private and public-oriented texts (Aronson &
Schwartz, 1987; Garrison, 1988; Kay & Searfuss, 1989; Siegel & Shim,
1990). This may reflect the private sector accounting philosophy that this is
the basis of capital assessment, and/or it omits without explanation that this is
simply one step in the assessment process that leads to the final capital budget
decision. In either event, the result is to marginalize other important factors
that exist in the capital budgeting process.
The experience of the co-author was that assessment of capital
acquisition proposals could be subjective in nature. The decisions were
influenced by the process which allowed for qualitative analysis and personal
influence (via the Capital Committee) and were less guided solely by
quantitative analysis. NPV and IRR were in practice used not as the
traditional screening and ranking tools (Thibadoux, 1992), but often as a
formality in the decision process.
Was this an appropriate means of analysis for capital acquisitions? At
first glance it appears that some error is occurring within this company.
However the results, as gauged by success of the firm, indicate otherwise.
The concern surely is in regard to the "qualitative" nature of the decisions.
Analysis of costs and benefits falls into a qualitative-quantitative
dichotomy. According to Miller, quantitative techniques, the enthroned
arbiter of capital budgets, "are those forecasting methods involving data and
mathematical analysis." Qualitative techniques, the right-brained step-brother,
are "those in which subjective estimation predominates." At its most basic,
qualitative output is based upon the judgments that "individuals create in a
relatively unstructured and informal process" (Miller, 1992: 260-261).
446 FARAZMAND & NEILL

It was this tolerance of the ambiguity found in qualitative analysis that


fostered probing of capital proposals. Few seemed to question the calculation
of a NPV; readily did people debate their personal assessment of a project.
This methodology was not without its theoretical guide: managers were paid
to make decisions based upon partial information that involved their
assessments and intuition of marketplace movements. "That is why they are
paid to be managers" (Biemel, 1994).
Herein lies a difficulty that the private sector in fact shares with the
public sector -- the quantification of benefits. It is rare that a significant
capital investment will involve clearly quantifiable costs, benefits, and
alternative actions. Uncertainty will likely increase with the significance of
the decision. A conventional solution to this dilemma is to offer more
quantification --- a natural inclination of accounting.
However, despite a plethora of quantifying techniques (Kee, Robbins &
Apostolou, 1987), there is found a common flaw. Methods which quantify
qualitative input are still of a qualitative essence. Turning such qualitative
data into numbers can be deceptive in that it makes the output look more firm
than the qualitative assessments that produced them.
Where then is the balance between the quantitative and the qualitative?
In the experience of the co-author, NPV and IRR were calculated and it was
useful to do so. However, the thesis is not that quantitative techniques should
be abandoned, but rather to what degree should they be emphasized --
professionally and academically. Further, what is the role of qualitative
analysis and what influence does it play in the process that yields the capital
investment decision? And what relevant factors are presently being
overlooked in the capital budgeting process?
Another perspective from which to consider this quantitative-qualitative
dichotomy is offered. Would a community invest in a bridge rather than a
park based upon the NPV of estimated benefits? Would a company be wise
to invest millions of dollars in constructing a manufacturing facility for a
product which had no market yet-- if not for their expert subjective
estimation.
The power of qualitative input was one factor in the private sector case
cited which diminished the level of rational-comprehensive analysis. Another
major factor involved peculiarities in the capital budget process- the use of a
capital committee.
As with the City of Cincinnati public sector case examined, the
corporation discussed also used a Capital Committee. Like the city, this
committee was comprised of top level management- equivalent to the city
CAPITAL DECISION-MAKING 447

department heads. Such a committee is a very important aspect of the capital


budgeting process, as it has the capability to exert influence over the
investment decisions.
This aspect of capital budgeting brings in the factors of organizational
behavior and dynamics into the process. The authors suggest that this is
likely to be an important factor in the determination of the capital budget.
(Admittedly, more research is needed into the effects of process and
individual behavior on capital acquisition).
The experiences of the co-author in private industry are that the capital
committee influenced the outcome of the capital budget. Managers with
greater personal stature in the organization, and/or among their peers, had a
greater impact on budget decisions. Projects without a firm quantitative
justification or qualitative reasoning could be approved based upon personal
influence.
This was, of course, organizational behavior and politics. Just as a
political scientist might describe politics as competition for "scarce resources"
(Thibadoux, 1992: 14.01) of a society, so too is corporate politics competition
for scarce company resources. Although the motivations and situations
differ, the reality of capital budgeting within the context of politics is an
important consideration in understanding the formation of budgets.

CONCLUDING REMARKS
Budgeting is not only the "key to decision-making" (GFOA, 1994: 48), it
is a nuts and bolts manifestation of politics. Quantitative analysis is but a
feature of the capital budgeting process which exists within the context of
politics. Indeed, research shows that much of the non-use of traditional
quantitative techniques stems from their inability to incorporate "qualitative
and political factors" into the decision framework (Forrester, 1993: 88-101;
Kee, Robbins & Apostolou, 1987: 16-22).
This article featured an analysis of capital budgeting issues in both public
and private sector situations. Both cases pointed out similar reasons for why
traditional rational-comprehensive Cost-Benefit quantifying techniques may
be compromised. First, the cases indicated the importance of qualitative data
in the decision process. Second, the cases discussed the influence of personal
factors on the capital committee. Third, competition for resources
demonstrated the context of politics for capital investment decisions.
Hopefully this analysis has pointed toward the need to study and
understand the role that the capital budgeting process may have on capital
budgeting output. Capital budgeting does have unique aspects--capital
448 FARAZMAND & NEILL

proposals, capital planning, and methods of assessment-- that influence


investment formulation.
Questions were also raised concerning the value of the private sector
quantification model for use in the public sector. Although the article noted
similarities between private and public practices, they were similar in their
deviation from the private sector model. Before attempting to answer
"Should government be run like a business?," perhaps it should first be
determined "Does business run like a business should?" That is, in adopting
private sector theory, is the public sector really emulating the manner in
which businesses operate?
Public capital budgeting must exert an identity unique from that of
private sector theory because of the nature and role of politics. Statements
such as "the only real difference" tend to be simplistic and reflect a lack of
cross-fertilization between public and private sector capital budgeting
research.
Quantification will remain at the heart of private versus public sector
differences where the bottom line is dollar. The usefulness of traditional
quantitative techniques for the public sector is limited due to the nebulous
nature of benefits created from public investment. It has been asserted that
one can not quantify effectively what is qualitative. In the terminology of
reinventing government- quantification should not steer the ship, it is but a
paddle helping to row.
Quantification may be a poor oarsman for a further reason. When using
quantitative data for decision-making purposes, it is simple to alter the NPV
equation. Dramatic changes may be made in the NPV analysis output by
simply changing the estimated benefits input into the NPV equation. Even
assuming the highest level of ethical observations, one can estimate and re-
estimate perceived benefits within a broad range of dollar values.It is, in the
final analysis, the estimated benefits to the quality of life for the citizenry that
will determine the dollar values to be used in quantification. Such benefits,
numerically stated in dollars or not, remain essentially qualitative judgments.
The emphasis given to the process of public capital budgeting reflects the
need to develop a normative capital budgeting process which balances
quantitative and qualitative input, and politics is part of the quantitative input.
Even one of the finest Public Administration articles describing the capital
budgeting process opens with the definition of capital budgeting as "a form of
economic technical analysis" (Thibadoux, 1992: 14.01).
Public capital budgeting is poised for new understandings as a topic
outside the shadow of private sector paradigms. From emphasis on the
CAPITAL DECISION-MAKING 449

quantitative to the qualitative; from methods of analysis to development of a


normative process of capital budget decision-making.

NOTES
1. The NPV formula is:
NPV = PV benefits - I,
where I is the cost of the project; and
PV benefits = [B1/(1+i)]+[B2/(1+i) 2]+...+ [Bn/(1+i) n]; where
Bn is annual flow of estimated benefits over n years and i is
discount, or interest, rate for the community.
2. The IRR formula is:
I = [B1/(1+r)]+[B2/(1+r)2]+...+[Bn/(1+i)n]
where r is rate of return.

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