You would expect there to be a close correlation between capital expenditure and return on investment – but studies show this isn't the case, as human bias often gets in the way of rational decision-making. A Deloitte study of the biggest US companies over a 20-year period found no meaningful correlation between capital expenditure as a percentage of revenue and return on invested capital (ROIC). What does this say about capital allocation? Is it measured as part of a carefully planned process? This article in February's Deloitte CFO Insights series says that 60 per cent of finance executives say they are not confident in their organization’s ability to optimally allocate capital. Does this mean there is too much room for human bias in the decisions that guide capital allocation?
There are numerous different types of bias but some that show up during the capital planning process include: optimism bias, expert bias, and narrow framing. Here's how they can affect the outcomes of capital allocation:
CFOs overly optimistic
A study of CFOs found that they tend to give overly optimistic predictions for the performance of stock markets but, more importantly, they also think that their own projects will have higher ROICs than is actually the case. Deloitte's CFO Insights article notes: “...people defer to overconfident and optimistic predictions due to our distaste for uncertainty. If the CFOs provided a broader, vaguer estimate, they may fear perceptions that they weren’t up to the task.”
It's important to keep one's feet firmly planted in reality by using data of past performance and compare past projections to reality. It's also important to stick to data rather than allow persuasive narratives influence capital allocation decisions.
While the advice here is not to completely ignore the opinions of experts – experts have an important role to play in all areas of life and business – but to ensure that expert opinion, in relation to capital expenditure, is backed up with robust data. Deloitte states: “When we simply accept an expert’s opinion, or even our own, versus seeking out additional information from a variety of sources, we fall victim to the expert bias.”
To avoid falling into the single-expert trap, CFOs should seek out recommendations from a diverse set of qualified individuals and see how those recommendations stack up against other data.
The third bias discussed in relation to capital allocation is the tendency for people to focus on a single view or attribute when making a decision. Even if an issue is affected by numerous considerations, people tend to want to break the problem down into individual choices. Deloitte notes: “At face value, this may sound intuitive. In practice, though, it can lead to the mismanagement of risk and an isolated view of problems.”
To avoid the 'narrow framing' bias, CFOs should group problems together even if, on the surface, they may seem different. They should also include an evaluation element and use quality metrics that properly align with the organisation’s goals.
CTMfile take: The central message from the Deloitte CFO Insights piece is that financial professionals need to keep robust data analysis central to all decision-making processes. They should seek a wide range of proposals and expert opinions to ensure a broad approach to risk. And narratives should be taken with a pinch of salt.
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