30 October 2012

When Management Wants to Spend, Spend, Spend

When it comes to determining future corporate direction, the strong tendency of management to opt for capital-intensive projects is well documented.

Indeed, this bias stems from a desire among divisional managers to grab more power and establish the type of reputation that comes from successfully running a project of this kind. This desire often flies in the face of headquarters (or shareholders), who normally favour projects that maximise the NPV or added value. Interestingly, many organisational HQs never hear about all available project alternatives, simply because divisions tend to manipulate the approval process by presenting their preferred project (not necessarily the best one) in the most favourable light.

The question of what HQ can do in response to this tendency has formed the basis of an in-depth research project that saw our University of Sydney Business School team examine four practical policies that have been used by companies in the past. Critically assessed and ranked in order of least to most effective, these were:

1 – The Capital Requirement Policy. Used by many companies, this stipulates that any proposed project must require the input of a certain amount of money.

2 - The Naïve Policy. This approach basically has no rules, ensuring that any project proposed by divisions will be approved. Typically, this will be a project that requires the highest capital, but will not necessarily entail the highest NPV or profitability.

3 - The NPV Policy. Requiring that the NPV of the proposed project must exceed a certain threshold, it turns out that this policy still contributes about a four to five percent loss of profit to HQ.

4 -The Hurdle Rate Policy. Used by many companies and quite simple in nature, this states that the profit index of a proposed project must exceed a certain level. If applied correctly, this policy should ensure a mere 0.1% profit loss by HQ.

We were surprised to find that the best approach when assessing the viability of potential projects and countering the arguments of management was in fact the Hurdle Rate Policy. Delivering optimum results, it’s easy to implement and delivers excellent benefits to HQ.

Author: Erick Li – Senior Lecturer, Discipline of Business Analytics. University of Sydney Business School

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