Capital Budgeting as a Management Control System

Nicos Sykianakis
Technological Institute of Piraeus
niksyk@teipir.gr

Various studies have shown that accounting data are often used to justify already
made investment decisions rather than to inform the decision-making process itself
(Aharoni 1966; King 1975; Hirst & Baxter 1993; Shank 1996). In the context of
making capital investment decisions, the management accounting system serves
other purposes as well. Accounting could be seen as ritual and symbol, securing the
compliance of organisational members to the company’s set procedures, such as
the capital budgeting system. Capital investment could therefore be broadly
acknowledged as having a controlling rather a decision-making role. The current
case study research paper aims to depict that similarly, foreign direct investment
budgeting acts as a management control system.

Keywords: management control, foreign direct investment decision-making, case study.

The role of formal analysis in Capital Investments

The complexity of investment decisions narrows the role of formal financial analysis in the
process. Financial analysis is unable to examine all the variables related to capital investment
decision-making and specifically marketing and strategic issues that may be difficult to
quantify but are key decision determinants (Barwise et al. 1989). Strategic investment
decisions were characterised in regard to their knowledge of markets, products, technology
and competition rather than using formal strategic analysis techniques (Carr et al. 1994b).
Therefore, sophisticated formal MIS does not necessarily result in better decision-making
(Carr et al. 1994a).
Relying mainly on financial information for making strategic investment decisions is of limited
help (Jones & Dugdale 1994; Carr & Tomkins 1996), since it neglects the strategic and
organisational considerations that characterise the issue. Nixon (1995) blamed financial
methods such as ROI or DCF, for failing to incorporate qualitative and strategic parameters
that may favour investments with long-term benefits for the organisation. Strategic
management accounting information is not necessarily produced by accountants, but can
come from operational staff (marketing, sales or production) as well (Lord 1996). This kind of
information is informal, unstructured and ‘soft’, thus management accountants may be
reluctant to produce or use it. Often, the use of management accounting information in capital
investment decisions concerns primarily implementation and operational purposes, rather
than reaching a decision itself (Nixon 1995).
Because formal financial analysis may not have primary relevance in making investment
decisions, it does not necessarily mean that these accounting systems should be modified to
become relevant. Formal accounting systems serve other purposes apart from making a
decision (Dugdale & Jones 1995). Practitioners may be concerned with estimating cash flows
rather than with the financial appraisal techniques because cash flows serve as a post-hoc
rationalisation of the decision. Accounting numbers are important as a basis for discourse and
argument, because they lead to scrutiny of the assumptions that lie behind them (Dugdale &
Jones 1994). The construction of cash flows is a social process since it enables negotiation
and constant revision, and often expresses the consensus achieved between conflicting
views. The use of accounting figures and the role of accountants may not be to make the

© Monash Business Review Volume 3 Issue 3 – November 2007 1

decision, but to ensure that the project’s managers have taken into account financial
considerations in their analysis (Dugdale & Jones 1995).
Therefore, formal analysis and accounting information used could serve various purposes
(Burchell et al. 1980; Boland & Pondy 1983; Ansari & Euske 1987; Langley 1990). First it is a
tool for implementing the decision and co-ordinating staff in that direction (functional use).
Second, it is a way of disseminating the decision and persuading other participants in the
negotiation part of the process (symbolic use). Finally, formal analysis may be used politically
such as when presenting contradictory suggestions in order to promote or postpone a
decision. Hirst and Baxter (1993) recognised the role of accounting in rationalising, justifying
and legitimising investment decisions already made.
The current paper aims to explore the role of management accounting information in making
foreign direct investment decisions. It has been suggested that the foreign direct investment
(FDI) decision-making process is less sophisticated that the domestic equivalent (Pike &
Dobbins 1981) because the FDI process emphasises strategic analysis over financial
analysis, and therefore bears various biases that set it apart from a purely rational decision
model (Boddewyn 1983). Therefore, the controlling role of the capital budgeting system will
be presented.

Capital Budgeting as a control system

Investment proposals usually derive from lower hierarchical levels and later are promoted to
the corporate financial staff for evaluation (Bower 1972; Mukherjee & Henderson 1987;
Chalos & Poon 2000). The operational level, especially in decentralised companies, is more
suitable for getting stimuli from the external environment, foreseeing the future needs of the
organisation and suggesting action that should be taken, through business planning
(Ackerman 1971). Top management may wish to control the capital investment decision
process, but their capabilities for direct control are rather limited. They may grant final
authorisation for every investment project, but lack the contact with the market and the
knowledge that operational managers have. Marsh et al. (1988) suggest that group planners
may have no role in proposing, evaluating or implementing investment projects. On the
contrary, their role is found to be indirect by setting a system for project appraisal that is
compatible with the corporate strategy. Finance or planning personnel designs formal
systems, which are imposed under top management’s authority. Therefore, the formal
planning and capital investment systems are acting as indirect control devices set at top
hierarchical levels in order to impose compliance with their directives (Zanibbi & Pike 1996).
Ackerman (1971) noticed that return on investment (ROI) was the main financial measure
applied in capital investment decision-making, despite several limitations anticipated in its
application, since ROI acts as a control mechanisms directly linked with organisational
responsibilities and reward/punishment policies. This interplay influences materially the
process of defining and promoting investment projects. Segelod (1998) has related the
patterns of the capital investment process with developments in the structuring of
organisations. The introduction of DCF methods was directly linked with the generation of big,
divisionalised firms -initially in the US- and served the need for control. The tightening of
corporate financial controls, using management accounting information systems is
commonplace in divisional companies or in companies that grow and are transformed
according to that pattern (Anthony & Govidarajan 2003; Hartmann & Vaassen 2003). As
already discussed, strategy and not finance is often the basic criterion for investment
decisions. The role of financial analysis is secondary and is applied for achieving control and
coherence in a group of divisional interests such as an organisation.
Scapens et al. (1982) found in practice that corporate managers limit divisions’ autonomy
over capital investments by exercising controls on capital expenditure. In practice, capital
rationing may be applied as a way to control the project’s financing and not for selecting
among alternatives projects to be financed (Mukherjee & Henderson 1987). The limits
imposed from corporate management aim at maintaining control of the organisation as a
whole and being in line with strategic planning (Merchant & Van der Stede 2003). Cash

© Monash Business Review Volume 3 Issue 3 – November 2007 2

management, resource allocation and financial planning (treasury) are often functions
remaining at a corporate level. These types of control occur either before the decision (such
as via the investment budget and authorisation procedures) or after the decision (such as
post-audits and performance measurement). The role of formal authorisation prior to funding
projects serves as a ‘monitoring mechanism’ (Scapens et al. 1982, p.71) that assures that
certain procedures are followed, such as the financial analysis.
Case studies on the resource allocation process discussed here have emphasised the
political nature of investment decision-making (Carter 1971; Bower 1972; Marsh et al. 1988;
Hirst & Baxter 1993). Marsh et al. (1988) characterised the forecasting of future cash flows as
a political process. They suggest that bias in cash flow forecasts is not meant to be deliberate
but is linked with the ambiguity of making safe predictions and the underlying uncertainty
behind any investment. Since it is logical for any manager to favour the projects he/she works
on and for every division to desire growth and thus promote such decisions, it can be
expected that projections on sales will be subjective. Project managers have a belief in the
success of their suggested projects based on their business experience and knowledge of the
market and product. This belief is rationalised and justified with the use of accounting
information. Thus, the capital budgeting system has a ritualistic role (Marsh et al. 1988).

Methodology
Viewing the FDI decision process as a social practice, the research method to be used is the
case study approach since it provides an in-depth analysis of the investing company and
allows the researcher the opportunity to study in detail organisational practices and the
decision-making process. Case studies have already being used in the domain of
management accounting, providing useful explanations about practice (see for example: Hirst
& Baxter 1993; Jones & Dugdale 1994; Scapens 1990; Larimo 1995; Miller & O’ Leary 1997).
The case study approach used for this research is mainly descriptive. The current study
aimed at describing the roles of the capital budgeting system and related management
accounting information.
The case study company, Delta is a leader in the Greek ice cream market. The company’s
first investment abroad, in Bulgaria, was ready in 1993. Subsequent investment projects in
Romania and Yugoslavia were completed during late 1990s. These three main FDI projects
form the main focus for this study. Multiple ways were applied for collecting evidence. During
the case study thirty-seven (37) open-ended interviews were performed during the three
research-visits to the research site. Another important source of evidence was documents
and archival analysis. To achieve construct validity (Yin 1984) in this study, multiple sources
of evidence (triangulation) were used during data collection. Also, multiple interviewing about
the same subject was used as a way of overcoming any single respondent’s bias. Internal
validity was achieved with the use of theory and existing literature to explain patterns from the
case study.

The role of financial analysis in the FDI decision process

Most executives interviewed suggested that the role of past accounting data, and financial
analysis in Delta’s FDI decision-making was of limited significance. At times, financial
analyses were perceived as a barrier to investment abroad. According to the Business
Development Director:

“Judging under rational decision criteria, any investment would have been rejected.
Consequently, the FDI decision was based mainly on hunches and feelings rather
than on numbers. Projections of sales and cash-flows were mere hypothesis and
subjective assumptions about the future.”

Many of the criteria applied to Delta’s FDI decision-making could be characterised as more
strategic rather than merely financial. The company believes that indicators on the market and
the country in general are critical to the FDI decision. Fundamental information available at

© Monash Business Review Volume 3 Issue 3 – November 2007 3

the screening stage determines materially whether an investment occurs or not. As the
treasurer says:

“If relying only on NPV no investment would have take place in the Balkans. In
reality, the decision to invest is made prior to any formal business plan presentation
and NPV computation, or any study of the project’s financing. The financing study
takes place at the implementation stage. For the decision a feasibility study is
presented containing many gross facts and figures. In the calculation of the future
cash-flows exists an important degree of uncertainty.”

The above statement shows that the application of the NPV method is not a critical factor in
determining the investment decision. The treasurer suggests that the business development
team has the main role in the FDI decision process and that the financial analysts should
accept its arguments and hypotheses. Concerning the profitability ratio requirement and
calculation, Delta specifically applies the Yield on Gross Capital Employed (YGCE).
According to the Business Development Director the YGCE ratio is an important ratio in
Delta’s financial analysis. YGCE is computed as follows:

Operating profit before tax & interest

————————————————
Gross capital employed

This accounting ratio is applied in Delta’s capital investment process, because it is also used
for post-auditing purposes. The YGCE measures performance for a given investment or
business activity, taking into consideration the profit earned from the capital employed in that
specific investment. Consequently, this accounting profitability ratio could be associated with
the need for performance measurement and control on Delta’s separate business units. The
YGCE ratio was introduced in 1992; the same period in which Delta adopted a divisional
structure. Later in 1996, the high growth rates both in Greece and abroad lead Delta to the
adoption of a more decentralized, product-based organisational structure. Previous research
findings (Ackerman 1971; Pinches 1982) related to capital investment practice have explained
the use of profitability measures, by associating them with performance measurement.
Some basic criteria, mostly known at the first stages of the decision process, (such as positive
expectations about the country and strategic position in the market), have to be accomplished
in order for an FDI proposal to be accepted. These criteria are given a more solid and
quantitative expression in figures like growth on sales, market share, break-even analysis and
a satisfactory profitability ratio for the capital employed. The International Marketing Manager
says:
“Market share objectives and break-even analysis are the decisive criteria for Delta
when evaluating a capital investment abroad. Break-even analysis requires a
minimum sales volume, which is determined from demographic and income
characteristics. The sales volume target is estimated approximately and is subject to
the size of the distribution network and the consequent cost of investment.”

From the above quotations it appears that break-even analysis is calculated in the initial
business plan as well. An approximate result may derive from sales estimates, since Delta
considers demographic and market conditions at an early stage, and basic investment costs
could be also be known. Other studies have also found that the economic viability of a capital
investment project is judged at a relatively early stage often using simple calculations and
prior to any detail investment analysis (Jones & Dugdale 1994). In Delta, break-even analysis
is used as a reassurance that the project would yield a minimum amount of sales and profits.
Since future sales is the most sensitive and unknown figure, risk analysis focuses on sales
figures and techniques such as break-even point or sensitivity analysis, applied under various
sales scenarios.
The conclusion from this section is that formal analysis does not have a primary role in Delta’s
FDI decision-making. Any decisions to invest abroad are taken in the early stages of the

© Monash Business Review Volume 3 Issue 3 – November 2007 4

process where market information is received and strategic considerations are made. Formal
financial analysis, such as the application of the YGCE, serves other purposes such as
control, co-ordination of the project’s implementation, and dissemination of the project’s
requirements to participants in the process. These findings from Delta endorse previous
empirical research (Aharoni 1966; Wilson 1990; Wei & Christodoulou 1997) on the role of
financial information in FDI decision-making.

Establishing Management Controls

Delta grew enormously in just a few years, which caused the need for organisational change
via separating functional structure into operational and corporate activities. Management was
decentralised and as a consequence intra-company relations became less personal and more
professional. The imposition of financial controls such as new capital budgeting and reporting
systems was a consequence of that trend. Control of Delta’s foreign operations is achieved
with the use of management control systems (MCS). Capital budgeting, business planning
and accounting reporting are all forms of control systems used in FDI decision-making. In
particular, financial reporting is the basis for control and future planning, mainly in Delta’s
existing foreign business. In planning expansion in existing foreign business, any
assumptions made about future developments in the market or the business must be
supported from past facts and figures.
The need for reliable accounting information system (AIS) to support statutory reporting
derives initially from the company’s external environment (Tzovas 2001). Financial reporting
may be the motivation for the new AIS, but management reporting from abroad was required
as well. Therefore, Delta’s financial & corporate control division introduced a detailed
accounting information system for management purposes. According to the financial director,
in the past each department used to build its own AIS to meet these needs. That occurred
because of Delta’s high rates of growth, which was based on expanding sales networks and
the emphasis on marketing. Decision-making for investments used market criteria and thus,
affected the accounting information required. The financial director emphasises “the need for
a common language for communicating in terms of management accounting.”
The financial controller pointed out the controlling role of the new reporting system in
investment decision-making. It could be used in budgeting and reporting by providing more
precise estimates on future sales, based on which investment proposals are considered.
Previous, locally based reporting systems were not able to provide accurate information for
decision-making. The entire dependency on foreign operations for reporting and the lack of
appropriate controls created the danger of data manipulation or completely inaccurate
projections. With the introduction of more elaborate financial analytical methods it is
suggested that FDI decision-making would be more efficient. In reality the role of these
financial methods is to enhance the influence and control of the corporate structure on the
FDI decision process (Scapens et al. 1982; March et al. 1988; Segelod 1998).

Discussion
This case study endorsed many previous findings on the role of information in the capital
budgeting process (King 1975; Pinches 1982; McIntyre & Coulthurst 1986; Jones & Dugdale
1994; Lord 1996; Shank 1996; Van Cauwenbergh et al. 1996) in its effort to bridge the gap
between theory and practice (Scapens 1990; Northcott 1991; Collier & Gregory 1995). Basic
information used in Delta’s FDI decision-making could be characterised as strategic,
qualitative, and informal, and focusing on elements of the macro-environment. People
interviewed explicitly stated that financial analysis had little importance in making FDI
decisions. While FDI decisions were made based on the country’s situation, strategic
considerations, and the knowledge of the market and the product, still financial analysis was
applied for other reasons. The kind of financial analysis used in Delta to justify and bring
consensus to the process reveals the company’s orientation towards its expansion, growth
and marketing goals. Delta’s mission was to build a strong overall leadership position,
targeting a high market share. This did not mean ignoring profitability, but initially the firm

© Monash Business Review Volume 3 Issue 3 – November 2007 5

allowed a time period of at least five years for the investment to yield a return. This break-
even criterion was decisive for arguing the commercial viability of an FDI project. The way
financial analysis was applied in Delta’s FDI decisions deviates from both the normative
theory, where DCF would be expected to feature, and from survey findings (Klammer et al.
1991; Pike 1996).
Delta’s market orientation could be seen in the fact that sales volume estimates and the
average selling price of ice cream were the basic indicators in the company’s project
analyses. Delta’s approach agrees with previous findings from Dugdale & Jones (1994; 1995)
where the focus of practitioners was on cash flows rather than financial appraisal techniques
as a post rationalisation for a capital investment project. In Delta, investment proposals
included in the business plan were justified based on the expectation of high sales in the near
future.
The NPV analysis was not of any real importance in Delta’s FDI decision-making. The
application of DCF techniques has been associated with the decentralisation of business
operations and therefore can be associated with management control rather than decision-
making (Segelod 1998). Since FDIs are usually managed centrally (Wilson 1990), the
assumption that DCF techniques are important especially in FDI projects (Klammer et al.
1991) may not apply. The application of DCF techniques is more apparent in decentralised
companies that feel the need for strong financial control (Carr et al. 1994b; Segelod 1998).
Another use the capital budgeting system serves is management control (Hirst & Baxter
1993). In making FDI decisions, the capital budgeting and business planning systems provide
reassurance that important issues have been considered either by the project team or by
Delta’s foreign subsidiary. As Dugdale & Jones (1994; 1995) point out, cash flows are used
as a guarantee that whoever proposes a capital investment project has taken into account its
most important elements and financial impact, and is able to support and legitimate his
advocacy of the project.
The control role of capital budgeting over investment expenditures becomes even more
important in divisional structures (Scapens et al. 1982; Marsh et al. 1988; Segelod 1998). In
Delta the need for control in FDIs became apparent during the continuous period of growth in
the 1990s. The reform in the company’s organisational structure led to the decentralisation of
operations. Also, as a result of the various FDI projects, foreign subsidiaries were established.
These developments brought the need for control procedures and new accounting systems,
since the CEO or top managers were no longer able to personally supervise all business
functions. The introduction of a new budgeting and computer information system coincided
with the 1996 re-structuring while a new uniform reporting system was introduced into Delta’s
foreign operations, which would form the basis for any future FDI suggestions. Also,
decentralisation and the need for control over capital investment projects coincided with the
introduction of the yield on gross capital employed (YGCE) ratio, which measures the return
from specific projects. Concluding, decentralisation and professionalisation of Delta’s
management brought the need for financial controls and new MCS, which have increased the
role of the corporate financial structure in Delta’s FDI decision-making.

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