I/EC
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Reviewing Investment Performance after Decision What are the proper purposes of a post-investment audit? by James B. Weaver, Atlas Powder Co.
| T IS A good management principle to have an audit procedure to review the significant outcomes of every major management decision. The investment decision is no exception; most companies have a procedure to review the performance of an investment sometime after it is put into operation. However, many of the usual procedures seem to be devised for purposes for which they are not useful and seem to avoid some of the most helpful results which can be achieved from such audits.
Audit the Decision?
The usual purpose of any audit or control procedure is to find out what is "wrong" when compared with some standard and then to take steps, where necessary, to correct that wrong. An audit of the financial books ends with the agreement that those books are "correct." Audit procedures on investments seem to have been set up by tooclose analogy to the foregoing procedures, in many cases. Measurements are usually made concerning the profits from installed equipment, which are purported to show whether or not the forecast return on investment has been achieved. If the equipment is as profitable as forecast, the implication is that the decision was "right"; conversely, if profitability is far below forecast, the implication is that somebody pulled a boner. This is incorrect ; no way is known for showing after the fact whether or not most decisions were the best decisions possible. In the same vein, good decisions may lead to unprofitable investments. This is because profitability calculations are based on forecasts, and the perfect crystal ball has not yet been invented. Just because an investment turns out
to help the company, there is no proof that the decision basis was proper or the decision the best available. The converse likewise holds. As has been described in previous columns, every investment evaluation must be a comparison of forecast cash flows between at least two alternative cases. Only one of these cases can really come to pass. Two alternative cases reduce essentially to two series of forecasts. After an investment is undertaken, almost none of the forecasts in the base or no-investment case can be verified. Furthermore, certain forecasts in the investment case cannot be verified for a long tine. The entire length of operation of the investment is one of the critical items to be forecast ( I / E C , p. 43 A, Pt. I, March 1958). The sales volume and price in every year of operation are also critical to investment profitability. Any audit made before the plant had ceased operation would still have to forecast some of the elements which had not yet come to pass. For these reasons, the profitability calculation cannot be audited, nor can the propriety of the decision. If the purpose of an audit is to reconsider decisions, why not also audit rejected investments? In some investments, the entire propriety of the decision depends on estimates which never come to pass. The best example is a replacement investment, made to save maintenance expense. The replacement would be justified based on an estimate of the rising maintenance cost on the old equipment, for as many years into the future as it could possibly be made operable. If the replacement is made, these maintenance costs will never be experienced, and the forecast which serves as the real basis for the decision cannot be confirmed.
Proper Purpose of Audit
An audit may nevertheless be useful. Some estimates made during the justification (those for the investment case, assuming the investment has been made) can be checked by such an audit. This review can serve two useful functions. First, comparisons of these forecasts with actual conditions which prevailed should permit improvement of subsequent forecasts, assuming that there is a good feedback of such information to the responsible estimating group. Additional correlations among the elements, and of these elements with other associated conditions, can be investigated if actual data are gathered. A second value of such audits is that the techniques used for profitability evaluation can be improved, for use next time, as areas of cost are discovered which may have been omitted in previous estimates. Note that both purposes are aimed at improving future decisions—a usual purpose of audits. Dollar Limit
Just as the investments below certain dollar limits require less approval formalities, so audits should be less formal on relatively smaller projects, and probably should be omitted entirely on projects below a certain amount. Those who believe that each decision can be reevaluated by such an audit may seek to have too many investment evaluations audited. The number of such audits per year should be held within reason, as a research endeavor to assist future investment evaluations and decisions. Timing of Audits
The sooner an audit is made, the less useful it is to the major purpose of improving future forecasts, for VOL. 52, NO. 4
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APRIL 1960
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COSTS fewer forecasts on which it depended will have come to pass. If there are unforeseen start-up difficulties, no useful purpose is served by having an audit during these difficulties, or during the very early period of operation when the search for optimum operating conditions is still under way. However, knowledge concerning such an extended startup period may be useful to improve your estimates of start-up delays on later investments. The sooner an audit is made after a unit is in full operation, the fewer will be the number of forecasts which can be investigated as compared to actual. A few items can be confirmed fairly rapidly; for instance, the installed cost of fixed investment, the achievement of forecast capacity, the achievement of the first year sales volume and product price, etc. Other items cannot be confirmed in full until the project is complete as a whole and shut down. Therefore, the optimum timing for an audit is probably after an extended period, perhaps a year, of operation at the optimum operating conditions. Earlier audits can be and are made under various assumptions. As soon as the amount of fixed investment is established, the evaluation can be duplicated with the actual fixed investment substituted for the original extimate. All other forecasts incorporated in the original evaluation can remain the same, or revised forecasts can be made if major elements such as sales volume, product price, or manufacturing cost are now expected to deviate from the original forecast. As each additional piece of actual informamation in the proposed case is established, the estimate of profitability can be recalculated, either with the same forecasts of other elements or revised forecasts. The chief danger here is that the nature and extent of audits can go far beyond any useful purpose. Management Prerogative
Those who make decisions based largely on return on investment calculations certainly have the right to see those calculations reproduced after the fact, to the extent possible, so that the calculated profitability can be compared with a minimum 56 A
acceptable rate of return or the company's cost of capital. As long as the utility of this recalculated profitability after the fact is understood, and the assumptions on which it is based, some managements will probably continue to consider it a useful measure of accomplishment after the fact. Forecasts necessary to the base case can remain as they were in the original evaluation or change when some known factors which enter the base case—e.g., utilities costs, sales price—have obviously changed. It would probably be better to indicate, in the original presentation of the investment evaluation, that the profitability of the investment depends chiefly on only a few of the forecasts incorporated into the evaluation. The forecasts can then be shown either to be in the proposed or the base cases, to indicate which can be compared to an actual which will be achieved if the investment is approved. The management can thus be shown what can and what cannot be usefully audited after the investment decision is made. Management's desire to compare actual with forecast can thus most easily be satisfied, with a minimum of wasted effort. Performance Appraisal?
One of the basic concepts of good management is that a man should be held responsible for those things which are under his control and should be freed of responsibility for occurrences beyond his control. However, most personnel as they move up the management ladder are responsible for making forecasts about situations in their purview, and most forecasts lie in a large gray area between controllable and uncontrollable. From most points of view, the future is not controllable by any individual or any company. On the other hand, certain aspects are predictable, so he cannot be relieved of responsibility for making forecasts. He is responsible for incorporating into them the best information available, including the good judgment which is the most essential element of all forecasts. The making of forecasts itself is perhaps the best reflection of whether or not business judgment has been acquired.
INDUSTRIAL AND ENGINEERING CHEMISTRY
Many managements hold their personnel responsible for the profitability of the investments which they have approved. How can this be, as so many of the elements incorporated in the forecasts are uncontrollable? Surely, it is unrealistic to hold anyone responsible for the achievement of any single forecast "right on the nose." Still, it is essential that management personnel make forecasts of events which are essentially uncontrollable. To get the best business judgment into these forecasts (which means that they should be neither conservative nor optimistic) it is important that the maker of forecasts realize that he is not being held responsible for achievement of each forecast in the sense that his job security depends on such achievement. However, conversely, it is obvious that the sum total of all the forecasts made by a man will have a significant effect on his achievement in his job and the management's satisfaction with him. All this is intended to make clear that the audit is by no means intended to be a review of the performance of the personnel who have made the forecasts going into it. In particular, it should be clear that the personnel of the economic evaluation group who combine the forecasts and make a few themselves are not responsible for the outcome of the investment, whether profitable or unprofitable. Those making forecasts and those in the evaluation group are more likely to cooperate with a proper investment evaluation, authorization, and audit procedure if it is clear that they will be judged on their over-all performance rather than on the achievement of any one forecast. Portions of the above based on a discussion of audit procedures by Engineering Economics Division, American Society for Engineering Education, Pittsburgh, Pa., J u n e 1959.
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