The Use of Capital Budgeting Models in Utility Estimation - Research Paper Example

Running Head: Capital Budgeting Capital Budgeting s Capital Budgeting Human resource programsoften have no investment, thereby rendering useless capital budgeting indices, such as return on investment (which is the ratio of total returns to original costs). Hunter et al. gave two examples to illustrate their point. The first example involved a decision to replace a low-cutoff method of selection with top-down hiring, a change that yielded a substantial utility gain (e.g., Hunter & Hunter, 1984, 72-98). The second example was a situation in which a company abandoned an in-house testing program in favor of a free assessment program offered by state employment services using the General Aptitude Test Battery. Hunter et al. assumed that such a strategy would improve test validity (and hence utility) while reducing cost. They stated that, in both situations, no investment costs to the organization are incurred and therefore it is impossible to compute capital budgeting estimates of utility, such as return on investment. To address this criticism, we must carefully define the concept of investment and then distinguish it from the cost concept more familiar to psychologists conducting utility analyses. To help clarify this distinction, we describe three types of alternative choice problems faced by managers who must decide on alternative courses of action within the human resource function (Anthony & Reece, 1983). The first type of alternative choice problem involves consideration of the costs of alternative courses of action. The second type of problem involves consideration of both revenues and costs. This is the problem that Hunter et al. (1988) described in their two examples. The third type of problem involves investment as well as revenues and costs. The capital budgeting model of utility proposed by Cronshaw and Alexander (1985) is congruent with this third type of alternative choice problem but not with the first two types. Three key terms are incorporated into the preceding description of alternative choice problems: cost, revenue, and investment. If the applicability of Hunter et al.'s (1988) critique to capital budgeting models of utility is to be fully evaluated, the reader must understand how finance managers and accountants use these terms. Cost refers to the amount of resources used for any purpose (Anthony & Reece, 1983). Costs incurred in an accounting period are either assets or expenses. An asset is defined as a cost that yields benefits to the organization beyond the current accounting period (usually 12 months). For example, a machine that is expected to have a useful life of 10 years is classified as an asset because it is expected to produce outputs (such as machined parts) that benefit the organization by bringing in revenue over a long period of time (in this case 10 years). An expense is defined as a cost that yields benefits to the organization only within the current accounting period. For example, the cost of electricity for the machine for one month is classified as an expense because the resulting benefits accrue only over the short term. This distinction between accounting for a cost as an asset or as an expense has important implications, which are discussed shortly. Revenue refers to the inflow of funds that results from the sale of goods and services to the firm's customers. An investment is the acquisition of an asset resulting in a future stream of expected cash inflows (i.e., revenues). For the example of the machine purchase given earlier, parts produced with the machine would be sold to customers, and the resulting stream of revenues would be received over the 10-year life of the machine. Normally, investment in an asset is made in a lump sum (which Cronshaw and Alexander, 1985, called original cost) at the beginning of a project. Conventional utility analyses used by industrial psychologists (e.g., Cronbach & Gleser, 1965; Schmidt, Hunter, McKenzie, & Muldrow, 1979) often contain terms for both revenue and cost. However, costs must not be equated solely with expenses because human resource interventions undertaken by industrial psychologists usually have long-term effects, often over a number of years. In effect, the firm is purchasing human assets (Flamholtz, 1985), which in turn generate revenue flows over future periods. A manager considering such a purchase is indeed evaluating an investment opportunity. As a consequence, the capital budgeting indices proposed by Cronshaw and Alexander (1985), which are used to evaluate investment decisions, are appropriate and relevant. We now address Hunter et al.'s (1988) criticism that "for human resource programs, there is often no investment, making [capital budgeting] procedures inapplicable" (p. 523). Hunter et al. argued that no costs exist when, for example, an organization uses a free assessment program offered by a state employment service or replaces a low cutoff score with a higher cutoff score. However, human resource programs usually incur some cost, even if that cost is sometimes trivial in amount. In Hunter et al.'s example of organizations that decide to use state employment services or to reset a cutoff score, some resources (e.g., staff time and allocated overhead) must be spent at the outset to study and implement the changes. These costs are in fact investments because a human asset (e.g., a more qualified workforce) has been purchased. Therefore, even in the two examples of absent investment presented by Hunter et al., costs are incurred in making an investment, even though these costs are sometimes difficult to quantify. In addition, these costs are correctly classified as investment outlays. The preceding discussion should not be taken to imply that all interventions must be classified as the third type of alternative choice problem. For example, an organization may adjust its test cutoff scores on a periodic basis. In that case, in which another adjustment to the cutoff score will be made in the near future (i.e., within one year or less), the second type of alternative choice problem applies-much as was stated by Hunter et al. (1988). That is, the temporary modification of a test cutoff score results in only a short-term benefit to the organization. In these situations, capital budgeting methods would not be appropriate because an expense has been incurred rather than an asset purchased. In summary, contrary to the assertions of Hunter et al. (1988), personnel managers often can compute capital budgeting indices, such as return on investment and payback period, because resources most often are expended to acquire human assets providing benefits over multiple annual periods. Although Hunter et al. correctly pointed out that such capital budgeting indices are inappropriate under the second type of alternative choice problem, the third type of alternative choice problem (for which capital budgeting is appropriate) is undoubtedly encountered with greater frequency in human resource management. Discounting Is Inapplicable Once The Program Reaches Its Equilibrium Utility Level To address this criticism, we first review the concept of net present value (NPV). The NPV method involves discounting future returns to selection in recognition of the time value of money. That is, consideration of the discount factor allows managers to estimate what the value of X dollars at the present time will be at a future time, given a return through available investment instruments equal to the currently prevailing interest rates (Sharpe, 1985). This basic concept is used to discount the stream of future returns to the human resource investment to take into account the time value of money (i.e., under the assumption that it is more desirable to have immediate returns that can be reinvested at the prevailing rate of interest than later returns of the same amount). Therefore, at a discount rate greater than 0%, discounting will always yield lower net returns to the investment than will conventional utility formulas proposed by utility researchers (e.g., Schmidt et al., 1979). Capital Budgeting Figures Could Appear Too Extreme To Be Acceptable To Managers The capital budgeting examples presented by Hunter et al. (1988) yield very high values. For an example in which reliance on validity generalization reduces the original cost of validating the selection predictor, Hunter et al. estimated a profitability index (PI) of 79, 741% and a payback period of one week. Before commenting on the implications of these results, we must point out that Hunter et al. reported an incorrect PI value in their example. The PI is the ratio of the present value of net cash inflows to cash outflows and is interpreted as the project's profitability for each dollar invested (Clark, Hindelang, & Pritchard, 1979; Weston & Brigham, 1981). Therefore, the correct estimate of PI is 797.41. However, this calculation error does not materially affect Hunter et al.'s argument about the magnitude of capital budgeting estimates of utility. Hunter et al. (1988) further suggested that capital budgeting estimates of utility might not be credible to managers because of their extreme magnitude; by doing so, Hunter et al. implied that these estimates should not be reported. However, as Boudreau (in press) noted, some capital budgeting indices (such as discounted net benefits) will produce lower utility values than will simpler indices, such as dollar value of the increase in output resulting from a human resource program. Even when capital budgeting indices yield extreme values, they are a valuable source of utility information, particularly because they offer a standard basis for comparison with nonpersonnel investments. Rather than trying to avoid dealing with the issue of extreme utility estimates, we recommend that psychologists put more work into understanding why these estimates are so extreme. Many capital budgeting estimates of the utility of human resource interventions (such as return on investment) will still greatly exceed estimates for other investments because investments in human resources involve a much higher degree of financial leverage than do typical investments in plant or equipment. That is, investments in human resources are often trivially small compared with the returns realized from those investments. This concept of financial leverage is understandable to all managers in the firm and is a condition that firms in competitive markets attempt to maximize. After managers understand the process by which human resource investments maximize financial leverage, their suspicions about extreme capital budgeting estimates of utility may be allayed. Furthermore, these managers will gain valuable insights into how human resource investments can be used to maximize the net worth of the firm. Conclusion Hunter et al. (1988) performed a useful service by stimulating a debate on the use of capital budgeting models in utility estimation. Any new development of this type should be subject to careful peer review. We take no exception to Hunter et al.'s argument that industrial psychologists should use the method of utility analysis that is appropriate to the situation. In fact, the capital budgeting approach is particularly well suited to this requirement because it is inherently flexible. However, Hunter et al.'s contentions that capital budgeting methods are often conceptually and logically inappropriate and that use of these methods can have unintended consequences for organizations are questionable on logical and empirical grounds. Quite the contrary is true: The capital budgeting literature offers a theory-driven rationale for selecting utility indices when competitively ranking investment alternatives that are often more, rather than less, useful indices of psychological utility. Industrial psychologists and human resource managers should evaluate, and consider for adoption, the full range of utility estimation methods that have been proposed over the past several years (including those methods recommended by the Schmidt-Hunter group, Boudreau, and ourselves). Practitioners should adopt those utility analysis methods that are most useful and informative to managers who must make human resource decisions in the best interests of the sponsoring organization. References Anthony, R. N. & Reece, J. S. (1983). Accounting: Text and cases (7th ed.). Homewood, IL: Irwin. Boudreau, J. W. (1983a). Economic considerations in estimating the utility of human resource productivity improvement programs. Personnel Psychology, 36, 551-576. Boudreau, J. W. (1983b). Effects of employee flows on utility analysis of human resource productivity improvement programs. Journal of Applied Psychology, 68, 396-406. Boudreau, J. W. (1984). Decision theory contributions to human resource management research and practice. Industrial Relations, 23, 198-217. Boudreau, J. W.Utility analysis for decisions in human resources management. in press In M. D. Dunnette (Ed.), Handbook of industrial and organizational psychology. Palo Alto, CA: Consulting Psychologists Press. Clark, J. J., Hindelang, T. J. & Pritchard, R. E. (1979). Capital budgeting: Planning and control of capital expenditure. Englewood Cliffs, NJ: Prentice-Hall. Cronbach, L. J. & Gleser, G. C. (1965). Psychological tests and personnel decisions. Urbana: University of Illinois Press. Cronshaw, S. F. & Alexander, R. A. (1983, August). The selection utility model as an investment decision: The greening of selection utility. Paper presented at the 43rd Annual Meeting of the Academy of Management, Dallas, TX. Cronshaw, S. F. & Alexander, R. A. (1985). One answer to the demand for accountability: Selection utility as an investment decision. Organizational Behavior and Human Decision Processes, 35, 102-118. Cronshaw, S. F., Alexander, R. A., Wiesner, W. H. & Barrick, M. R. (1987). Incorporating risk into selection utility: Two models for sensitivity analysis and risk simulation. Organizational Behavior and Human Decision Processes, 40, 270-286. Flamholtz, E. G. (1985). Human resource accounting (2nd ed.). San Francisco: Jossey-Bass. Hunter, J. E. & Hunter, R. F. (1984). Validity and utility of alternative predictors of job performance. Psychological Bulletin, 96, 72-98. Hunter, J. E., Schmidt, F. L. & Coggin, T. D. (1988). Problems and pitfalls in using capital budgeting and financial accounting techniques in assessing the utility of personnel programs. Journal of Applied Psychology, 73, 522-528. Schmidt, F. L., Hunter, J. E., McKenzie, R. C. & Muldrow, T. W. (1979). Impact of valid selection procedures on work-force productivity. Journal of Applied Psychology, 64, 609-626. Sharpe, W. F. (1985). Investments (3rd ed.). Englewood Cliffs, NJ: Prentice-Hall. Weston, J. F. & Brigham, E. F. (1981). Managerial finance (7th ed.). Hinsdale, IL: Dryden. Read More