Systematic Errors in Budgeting Capital Outlays

Abstract

IN recent years, surveys of capital expenditure plans have occupied a prominent place in forecasting economic activity, and considerable effort has been devoted to establishing the sources of discrepancies between plans and realized expenditures. This paper deals with systematic errors that arise from the planning process itself. Such errors may be distinguished from discrepancies between plans and realizations that result from changes in the economic environment or from shifts in business expectations about earnings, sales, or other economic variables. More specifically, the discussion focuses on the reasons for consistent tendencies to underor over-estimate plant and equipment outlays and, in particular, on the alleged relation between size of firm and such tendencies. suggested hypotheses are tested against data for the electric utility industry. While discussion of consistent biases in investment forecasts is scattered through a large number of sources, the most detailed studies of the problem were carried out by Friend and Bronfenbrenner I and by Foss and Natrella.2 In both, data from S.E.C. -Department of Commerce surveys of capital expenditure plans were used. Both pairs of authors found the accuracy of forecasts to be positively correlated with the asset size of firms and with the scale of investment programs.3 (Scale was measured by the volume of planned investment relative to fixed assets.) Except for firms in the top size class (those with total assets of more than $50 million), Friend and Bronfenbrenner found a tendency to understate planned relative to realized investment. Foss and Natrella found that large firms overestimated their future investment expenditures, though large firms with plans for only small outlays generally underestimated their outlays. Small and mediumsized firms underestimated their future expenditures when their prospective investment programs were small or moderate-sized but showed no consistent tendency to underor overestimate when these programs were large. Friend and Bronfenbrenner regard the tendency to underestimate expenditures as a consequence of omissions from capital budgets of small or contingent items.4 They explain the more accurate predictions of large firms in terms of three factors. First, large firms have many projects with the result that positive errors for some projects cancel out the negative errors on others. Second, large firms are able to allow in their budgets, on the basis of average experience, for such contingent expenditures as those occasioned by breakage. Third, capital budgeting procedures of small and large firms differ: the latter plan further in advance and their budgeting procedures are more formalized and less flexible hence, deviations from plans are less likely. Foss and Natrella agree that variations in capital budgeting procedures have probably contributed to differences in the forecasting performance of large and small firms. However, they conclude that a positive association (present in the period covered by their study) between firm size and size of investment program was a strategic factor in producing these differences. They also suggest that supply shortages which characterized the post-war economy may have been a central factor in explaining ' Irwin Friend and Jean Bronfenbrenner, Plant and Equipment Programs and their Realization, Conference on Research in Income and Wealth, Studies in Income and Wealth, XVII (Princeton University Press, I955). Also, Investment Programs and their Realization, Survey of Current Business, XXX (December I950). 2Murray F. Foss and Vito Natrella, The Structure and Realization of Business Investment Anticipations, Conference of the Universities National Bureau Committee on Economic Research, Quality and Economic Significance of Anticipations Data (Princeton University Press, I960). 'On the other hand, Eisner working with data from the McGraw-Hill surveys, found no clear relation between scale of investment plans and accuracy of forecasts. However, he did find a distinct relation between accuracy of forecasts and size of firm. Robert Eisner, Plans, and Capital Expenditures: A Synthesis of Ex Post and Ex Ante Data, in Mary Jean Bowman, Expectations, Uncertainty, and Business Behavior (Social Science Research Council,