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CFO Insights: Capital allocation – How to recognize bias in your decision-making

Published on: Feb 22, 2018

CFOs typically rely on their capital planning process to help shape high-stakes decisions. Shareholders, creditors, and employees alike expect management to take this obligation seriously, and get it right consistently.

A look at the S&P 500 suggests just how difficult it can be to consistently drive positive results, however. Take one measure, return on invested capital (ROIC). In a Deloitte study, neither the amount of capital expenditures (as a percentage of revenue) nor the growth in capital expenditure demonstrated any kind of meaningful correlation with ROIC. And given such uncertainty, it may not be surprising that more than 60% of finance executives in a different study say they are not confident in their organization’s ability to optimally allocate capital.

Why is this? On paper, it seems practical enough for everyone throughout the organization to support the goals and priorities set at the top. However, behavioral science, and possibly your own experience, suggest it’s not always that simple. Individuals may be overly optimistic about certain courses of action, rely too much on specific pieces of information, or simply interpret the objective through too narrow a lens.

Within the behavioral science field, these are referred to as cognitive biases, specifically the optimism bias, expert bias, and narrow framing, respectively. While extensively covered within the academic literature, these biases are typically not as salient in matters of capital planning. Yet, the evidence suggests they may be no less prevalent. And in this issue of CFO Insights – the first installment of a two-part discussion on capital allocation – we’ll dissect the attributes that can help identify these biases and highlight how they can manifest throughout the capital planning processes.

This publication was released by our US firm.

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