The Post Audit aspect capital budgeting

An important aspect of the capital budgeting process is the post-audit, which involves (1) comparing actual results with those predicted by the project’s sponsors and (2) explaining why any differences occurred.

For example, many firms require that the operating divisions send a monthly report for the first six months after a project goes into operation, and a quarterly report thereafter, until the project’s results are up to expectations. From then on, reports on the operation are reviewed on a regular basis like those of other operations.

The post-audit has three main purposes:

1. Improve forecasts. When decision makers are forced to compare their projections to actual outcomes, there is a tendency for estimates to improve. Conscious or unconscious biases are observed and eliminated; new forecasting methods are sought as the need for them becomes apparent; and people simply tend to do everything better, including forecasting, if they know that their actions are being monitored.

2. Improve operations. Businesses are run by people, and people can perform at higher or lower levels of efficiency. When a divisional team has made a forecast about an investment, its members are, in a sense, putting their reputations on the line and will strive to improve operations if they are evaluated with post-audits. In a discussion related to this point, one executive made this statement: “You academicians worry only about making good decisions. In business, we also worry about making decisions good.”

3. Identify termination opportunities. Although the decision to undertake a project may be the correct one based on information at hand, things don’t always turn out as expected. The post-audit can help identify projects that should be terminated because they have lost their economic viability.

The results of post-audits often conclude that (1) the actual net present values of most cost reduction projects exceed their expected net present values by a slight amount, (2) expansion projects generally fall short of their expected net present values by a slight amount, and (3) new product and new market projects often fall short by relatively large amounts. Thus, biases seem to exist, and companies that understand them can build in corrections and thus design better capital budgeting programs.

Our observations of businesses and governmental units suggest that the best-run and most successful organizations put great emphasis on post-audits. Accordingly, we regard the post-audit as being one of the most important elements in a good capital budgeting system.