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Does changing decision-makers in midstream inhibit initial cost underestimates for capital projects? Study raises doubts
With alarms being regularly sounded these days about lack of infrastructure investment in both the public and private spheres, some new research provides timely evidence on a perennial issue that bedevils capital projects – namely, how to avoid cost underestimates that can lead to budget-busting cost overruns. Currently playing havoc with Germany's reputation for efficiency, for example, is a new Berlin airport originally scheduled to open in 2010 but still years from completion and billions over budget while a recently completed transit center in downtown Manhattan has been called the largest boondoggle in mass-transit history.
Advice commonly proffered to avoid overruns, in the corporate and public sectors alike, addresses the tendency of decision-makers to escalate their commitment to undertakings that they themselves launched even when they later faced soaring expenditures. Avoid the escalation problem, the counsel goes, by choosing someone other than the original manager to decide continued funding, someone less attached to the project.
That would seem plain common sense. After all, if the party responsible for providing an undertaking's original dollar estimate knows that someone not involved in the launch decision will later be deciding the project's fate, wouldn't that constrain a tendency to understate its cost? Yet, the new research, in the American Accounting Association journal The Accounting Review, suggests otherwise.
"On the one hand the prospect of facing a new superior at the continuation stage could make subordinates more cautious about understating costs in their initial budget proposals," acknowledge the co-authors of the new study, Alexander Brüggen of Maastricht University and Joan L. Luft of Michigan State University. "They might anticipate that superiors who originally funded the projects would be sufficiently committed to them to overlook moderate cost overruns when deciding about continuing funding, but new superiors would be more critical and more likely to cut off funding if the projects’ performance diverges too much from the subordinates’ predictions.
"On the other hand," the professors continue, "the prospect of a new, non-committed, critical superior making the continuation decision could decrease subordinates’ expectations of continuation funding and/or increase their uncertainty about this funding. As a result, subordinates under changing superiors could discount possible later-period reputation payoffs from accurate initial forecasting and focus primarily on gaining initial funding by understating costs. In this case, changing superiors would result in greater initial understatement of costs, which could offset the benefits of improved continuation decisions."
And, indeed, the experiment they conduct to test the two alternatives suggests the latter to be the case. As the authors put it, "We identify a potential limitation on the benefits of the often-recommended practice of assigning responsibility to different superiors for initial funding and continued funding decisions. To the extent that this change in superiors increases the uncertainty and/or decreases the likelihood of future-period funding, it can reduce subordinates’ incentives to secure this future funding by building a reputation for reliable cost forecasting in their initial proposals."
The experiment that yielded this conclusion involved 84 business students who interacted in groups of three over a computer network. Subjects were randomly assigned to be either subordinates or superiors throughout the experiment, which consisted of seven rounds and lasted about an hour. In each round two subordinates were directed to separately propose a capital project to the same superior, who chose to pursue one or the other. All subjects were informed that projects would yield somewhere between 90 and 110 experimental dollars and would cost between 70 and 90 experimental dollars. At each round's conclusion participants were randomly assigned to another three-person group for the next round.
Subordinates and superiors were compensated principally through a percentage of the realized profit per funded project, as determined by the difference between project revenue and cost. Of primary interest to superiors, then, was to select projects that would yield the greatest profit. Of primary concern to subordinates was to get their projects chosen, which would motivate them to forecast the lowest possible cost (since cost would largely decide whether they were funded). Unknown to superiors, subordinates each received private information on what their project would likely cost, an estimate that would guide their private prediction to the superior. Superiors and subordinates would also learn midway through each round how much the project was actually costing, at which point a decision would be made on whether to continue funding it.
And here was the heart of the experiment: who would make that decision. Half the subordinates – those assigned to the Stay condition – had been informed at the outset that midcourse determinations would be made by the same superiors who originally chose to fund projects. The remaining half – those in the Change condition – had been informed the midcourse determination would be made by a different executive.
Unsurprisingly, capital projects were significantly more likely to be chosen for funding by superiors the more subordinates understated their costs, understatement being measured by the gap between subordinates' private information and their cost predictions. Much more surprisingly, the biggest gaps occurred among subordinates in the Change condition – an average gap of 5.22 compared to only 3.66 for participants in the Stay condition, an almost 45% difference. Moreover, the difference between Stays and Changes occurred in every round of the experiment, ranging from a high of 3.07 in round 4 to a low of 0.67 in round 7.
In sum, Profs. Brüggen and Luft observe, the results "provide an important caveat to the previous literature's observation that the practice of changing decision-makers improves capital budgeting performance by limiting the continuation of poorly performing projects (e.g., those with excessive cost overruns). In our experiment, as in prior literature, changing superiors are more skeptical than continuing superiors: they are less likely to be influenced by high second-period forecasts to continue funding underperforming projects. We document a countervailing effect, however. In our setting, large first-period cost overruns are also more likely to occur in the first place, because subordinates’ concerns about the second period increase their first-period understatements."
The new study, entitled “Cost Estimates, Cost Overruns, and Project Continuation Decisions,” is in the May/June issue of The Accounting Review, published every two months by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA and its specialty sections include Auditing: A Journal of Practice and Theory, Accounting Horizons, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Journal of Information Systems, and The Journal of the American Taxation Association.