Journal of Building Performance ISSN: 2180-2106 Volume 2 Issue 1 2011

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EVALUATION OF THE CAPITAL BUDGET PLANNING PRACTICE OF

CONTRACTORS IN THE CONSTRUCTION INDUSTRY

I.O. Famakin* & N. Saka

Department of Quantity Surveying
Federal University of Technology, Akure Nigeria
Corresponding Author: [email protected]

ABSTRACT

Poor and unrealistic budgeting has been traced to the inefficiency and neck-deep poverty
of contractors in the construction industry, this attributes to the economic decline of firms
and capital disappearance in the industry. This research work seeks to evaluate the
capital budget planning practice of contractors in the Nigerian construction industry. The
research made use of questionnaires for data collection and the statistical tools employed
in the analysis are frequency tables, percentages, cumulative percentages, and mean
score ranking. The variables used for the evaluation include long-term capital budgets,
capital budgeting manual/written procedures, formal bodies responsible for screening and
reviewing projects, capital budgeting personnel and regular minimum rate of return
review. The study revealed that about 50% of contractors do not make plan for long-term
capital budgets and therefore cannot handle large projects. It is recommended that
contractors make plan for long-term capital budgeting and devote more personnel to
capital budget planning to ensure that they can handle the numerous large construction
projects in the industry.

Keywords: Capital Budget, Contractors, Construction Industry, Planning processes.

Introduction

Capital budgeting is one of the key issues in corporate finance (Truong, Partington &
Peat, 2006). It is an integral part of the corporate plan of an organization, which reflects
the basic objectives of an organization (Osaze, 1996). One of the most important
decisions to be taken by a financial manager is corporate capital budgeting (Ryan, 2002).
Capital budgeting is one of the fundamental parts of the budgetary process employed as
a tool for planning, controlling and allocating scarce resources among competing
demands in any locality (Sekwat, 1999). Capital budgeting involves making investment
decisions concerning the financing of capital projects by firms (Elumilade, Asaolu, &
Ologunde 2006).

Capital budgeting is an important management process that certainly influences the long-
run survival and value of a firm, because of the amounts involved are so large that
managers need to carefully plan and evaluate expenditures for capital assets (Lam, K.,
Wang & Lam, M., 2007) . Capital budgeting in a developing economy is very vital and
must be approached with all sense of diligence. The rate of economic development in the
third world has been relatively slow and needs to be accelerated (Elumilade, Asaolu, &
Ologunde 2006). The capital investment decision is more than investment in capital
assets such as fixed assets, e.g., land and buildings, plant and equipments etc.; it can
include intangible fixed assets (e.g., research and development) and working capital. The
capital investment decision is therefore one of the most critical and crucial decisions that
any country or organization can take to achieve economic development (Osaze, 1996).

Elumilade, Asaolu & Ologunde (2006) opined that technological backwardness and
poverty are the resultant effect of poor and unrealistic budgeting in African countries
including. Lack of financial control and poor management have contributed significantly to
the high level of insolvencies experienced in the construction industry when compared
with other industry sectors (Mutti & Hughes 2002). Mutti and Hughes (2002) further
suggested that models available for cash flow management and forecasting can be used
as a starting point for managers in rethinking management practices.

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This paper seeks to evaluate the capital budget planning practice of contractors in the
Nigerian construction industry with a view to ascertaining the ability of contractors in
Nigeria to meet up with the challenges of carrying out large construction works.

Theoretical Background

Insolvency in construction

Most contractors in Hong Kong are suffering from business reduction, profitability
deterioration and struggling very hard to retain their financial performance (Chan, Tam &
Cheung, 2005). Mutti and Hughes (2002) reveal that the number of firms in the industry
and the differences in the degree of risk has been identified as the most responsible
factor for the high proportion of liquidation in the construction industry. Mutti & Hughes
(2002) also noted that the level of insolvencies in the construction industry is high,
ranging from about 12.5% to 60% when compared with the total industries which is due to
the fact that the construction industry has a large number of company leading to a greater
likelihood of high failure rates.

The period of instability in financial operations have made companies retain their policy
through the maintenance of sound financial structures, reflecting the proliferation of
government financial regulations, backed up by the aim of a controllable and dynamic
investment pursuit for the sustenance of national economy. Empirical studies emerging
from established theoretical apparatus have filled up the vacuum in business procedures,
which continually arouse the interest of experts in making positive contributions required
to compare the financial condition and performance of various firms. It is also important to
be conscious of the fact that, the idea of rigorous pursuit of firm’s stabilization through
debt funding unravelled the negligence of financing decision in business organizations
(Elumilade, Asaolu & Ologunde 2006).

Capital Budget Planning Process

A strategic plan is the principal strategy of the firm identifying the business the firm is in
and where it intends to position itself in the future. Strategic planning translates the firm’s
goals into specific policies and directions, self priorities, specifies the structural, strategic
and tactical areas of business development and guides the planning process in the
pursuit of solid objectives. A firm’s vision and mission is encapsulated in its strategic
planning framework (Dayananda, Irons, Harrison, Herbohn, & Rowland 2002).

Strategic planning has always been one of the most crucial functions in any organization.
An essential element in a company’s overall strategy is its financial plan, which should be
designed to ensure the provision of adequate finance for the company’s needs.
Budgeting is a fundamental part of planning. Annual budget forms a vital part of any
corporate plan and financial control cannot be exercised without budgets (Dayananda et
al., 2002).

Capital budgeting is a systematic decision process whose goal is to ensure that

resources are allocated within an organization in such a manner so as to guarantee the
long-term economic survival and growth of that organization (Chandan, 1984). More
specifically, the capital budgeting process identifies prospective investments, selects
investments based on some decision criteria, and plans for the implementation and
financing of the selected investments. Therefore, a capital budget is a plan for future
investments and as such it is similar to the methodology of life-cycle cost analysis. With
specific reference to buildings, capital budgeting evaluates the impact of facilities on the
ability of the enterprise to meet its long-term goals and objectives.

Capital budgeting procedure is based on firm’s perception of planning for financial

increment due to successful market performance, customers’ satisfaction and retention,
capacity to launch new products or possibility of improving old ones (Elumilade, Asaolu &
Ologunde 2006). Bodernhorn (1959) advocates that difficulties emanate from capital

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budgeting. Bodernhorn notes the obstacle of making decision in budgeting of capital and
observes that the formulation of such decision is centred on the available investment
opportunities that will make firm to accept or reject a project.

According to Dayananda et al., (2002), capital budgeting is a multi-faceted activity and

the critical nature of capital planning requires a systematic approach to investment
decision making. However, the classification of capital budgeting as part of the strategic
planning process suggests that it is difficult to formalize a methodology that can be
applied in all cases. The several sequential stages in the capital budgeting process are
depicted in the form of a highly simplified flow chart as shown in figure 1.

Capital Budget Planning Practice

According to Lam et al., (2001), the planning and administrative aspects of capital
budgeting should cover:

Long-term capital budgets

It is one of the core corporate strategies to be incorporated in a company’s business plan

usually covering between three – five years review of the investments and financial
prospects of the firm.

Capital budgeting manual/written procedures

It involves companies or organizations having an existing up-to-date systematic capital

budgeting manual or written procedures.

Formal bodies responsible for screening and reviewing projects

It involves identifying potential projects and screening them to ensure they measure up to
the corporate policy and objectives (short or long term), resource availability, technical
and financial feasibility of the organization.

Capital budgeting personnel

This involves devoting a full time staff member exclusively for capital budgeting. For
instance in large organizations, project/contract managers are responsible for project
finance and general managers for capital budgeting while in small organizations, the
manager performs the two responsibilities.

Regular minimum rate of return

This involves a regular review of the minimum rate of return require from implemented
projects by the firm.

Research Methodology

The data for the study was collected through the administration of well structured
questionnaires to contractors in Lagos State, Nigeria. The state was chosen as a result of
large concentration of construction taken place in the locality and also most organizations
in the other states of the federation have their head office located in Lagos state. The
total population for this study included all registered contractors with the Federation of
Construction Industry (FOCI) practicing within Lagos state of Nigeria from which a
sizeable number was selected to serve as a good representation of the population under
study. The population consisted of 108 contractors registered with FOCI practicing within
Lagos State. Of this number, 70 contractors were selected and questionnaires sent out to
them using the non-probability sampling. 52 questionnaires were returned indicating a
return rate of 74.3%.

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The data was analyzed using the calculation of descriptive statistics to present the
frequencies and mean of responses to questions with fixed responses to determine the
characteristic information of respondents, capital budget planning process and capital
budget control measures. The medium of presenting the findings of the research is the
use of tables.

Results and Discussion

Findings are discussed on the capital budget planning practices of contractors in the
Nigerian Construction Industry as revealed by literatures. Meanwhile, only 52 of the 70
questionnaires administered were retrieved and used for the data analysis, representing
74% of the expected responses.

The table 1 shows the characteristic information of respondent organization indicating the
size of the firm through the number of employees, the registration category and the
nature of construction works executed by the respondent firms.

Table 2 shows the capital budget planning process which covers areas such as long-term
capital budgets, up-to-date capital budgeting manual or written procedures, formal bodies
responsible for screening and reviewing projects, capital budgeting personnel and regular
review of minimum acceptable rate of return (Lam et al., 2001).

The result of contractor’s long term capital budget indicates that more than half of the
contracting firms that responded to the survey had ‘a capital budget which looks beyond 2
years’.

The result of the availability of an up-to date capital budgeting manual reveals that only
about 30.8% of contractors have an up-to-date capital budgeting manual which is in use.
The level of staff governing administrative operating procedures among contractors
shows that about 69.2% of respondents had a formal system governing administrative
procedures.

From the survey, it shows that 65.4% of the respondents have formal bodies responsible
for screening and reviewing of their projects signifying the level of importance attached to
screening and reviewing of projects by contractors in the Nigerian Construction Industry.
It is also worthy of note that over 90% of respondents devote at least a unit of the
organization to capital budgeting because of the perception that the personnel strength
devoted to capital budgeting may influence the achievement of organization policies and
goals.

Table 2 revealed that half (i.e. 50%) of respondents review their minimum acceptable rate
of return yearly. It was also observed that the minimum acceptable rate of return by
respondents ranges from 6% to 25%.

Table 3 shows the basic factors to be considered in planning for long capital budgets. It is
revealed from the table that sufficient foresight is the most important factor to be
considered when planning for long capital budgets.

Capital budgeting control measures

Lam et al., (2001) reveals that capital budgeting control and evaluation entails the
following: (a) pre-operational control (i.e. evaluation of projects due to cost overrun) (b)
monitoring of project performance, and (c) post-completion audits.

The survey reveals that majority of contractors (i.e. about 88.5% of respondents) will
reconsider an investment whose estimated costs will likely exceed the budgeted costs
while about 11.5% will reject such offer. None of the respondents volunteered to accept
such proposal. This confirms that the reconsideration of cost overruns was very popular
in contracting firms irrespective of the size of the firm.

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Table 5 indicates the importance place on monitoring project performance by contractors.

The result shows clearly that project performance monitoring is a very high and common
phenomenon among contracting firms. This is regarded as one of the cost control
systems used in the construction industry, particularly for controlling small projects so as
to provide feedback information for similar projects in the future. Firms place high
importance on the benefits of the post-completion audits as indicated in table 6.

Conclusion

Following the evaluation of capital budget planning process among contractors, the study
shows that one of the most important planning process is the horizon of contractor’s
capital budget and the personnel strength devoted to capital budgeting revealing that the
horizon of a contractor’s capital budget and personnel strength devoted to capital
budgeting determines the extent of firm’s financial growth and its ability to handle large
construction projects.

From the foregoing, about 50% of contractors do not have the ability to handle large
construction projects, hence, it is recommended that contractors make plan for long-term
capital budgets and devote more personnel to capital budget planning to ensure that they
can handle the numerous large construction projects in the industry.

References

Bodernhorn (1959). On the problems of capital budgeting. Journal of Finance, 14(4), 473-492.
Chan, J. K. W., Tan, C. M. & Cheung, R. K. C. (2005). Construction firms at the crossroads in Hong Kong:
Going insolvency or seeking opportunity. Engineering, Construction and Architectural Management, 12(2),
111-124.
Chandan, G. (1984). Capital budgeting: theory and practice. The Engineering Economist, 30 (1), 19-46.
Dayananda, D., Irons, R., Harrison, S., Herbohn, J., and Rowland, P. (2002). “Capital budgeting: financial
appraisal of investment projects. Capital budgeting: An overview. The Edinburgh Building, Cambridge
University Press CB2 2RU, London.
Elumilade, D. O., Asaolu, T. O., and Ologunde, A. O. (2006). Capital budgeting and economic development in
the third world: The case of Nigeria. International Research Journal of Finance and Economics, 136-140.
Ghalot, P. S., and Dhir, B. M. (1992). Construction Planning and Management. New Delhi: Wiley Eastern
Limited.
Lam, K. C., Runeson, G., Ng, S. T., Hu, T. S., Cheung, S. O. & Deng, Z. M. (2001). Capital budgeting planning
practices of building contractors in Hong Kong. Journal of Construction Management, 19, 569-576.
Lam, K. C., Wang, D. & Lam, M. C. K. (2007). The capital budgeting evaluation practices (2004) of building
contractors in Hong Kong. International Journal of Project Management, 25, 824-834.
Mutti, C. D. N. & Hughes, W. (2002). Cash flow management in construction firms. In: Greenwood, D (ed.), 18 th
Annual Conference, 2-4 September, University of Northumbria. Association of Researchers in Construction
Management, 1, 23-32.
Osaze, B. E (1996). The Fallacy of ROI as a Performance Measure. First Bank of Nigeria Plc. Bi-annual review,
Vol. 4, No. 9, pp 40-44.
Ryan, A. P. (2002). Capital budgeting practices of the fortune 1000: How have things changed. Journal of
Business and Management, 8(4).
Sekwat, A. (1999). Capital budgeting among Tennessee municipal governments, Government Finance Review,
15(3), 15-19.
Truong, G., Partington, G., & Peat, M. (2006). Cost of capital estimation and capital budgeting practice in
Australia.

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Appendix

Table 1: Characteristic information of respondent organization

Size Frequency Percentage

Less than 50 20 38.5

Number of employees 51 – 150 20 38.5
Above 150 12 23.1
Total 52 100.0

Category A 8 15.4
Category B 24 46.2
Registration Category Category C 7 13.5
Category D 7 13.5
Category E 6 11.5
Total 52 100.0

Building 18 34.6
Civil engineering 8 15.4
Nature of Construction Heavy/Industrial
2 3.8
Work engineering
Building/Civil
24 46.2
engineering
Total 52 100.0

Table 2: Capital Budget Planning Processes

Frequency Percentage
Not applicable 14 26.9
1 – 2 years 10 19.2
Horizon of contractor’s capital 3 – 5 years 24 46.2
budget 6 - 10 years 4 7.7
Above 10 years 0 0.0
Total 52 100.0

Not available 14 26.9

Available but not defined 14 26.9
Availability of up-to-date capital
Available but obsolete 0 0.0
budgeting manual
Available but not in use 8 15.4
Available and in use 16 30.8
Total 52 100.0

Highly formal 8 15.4

Level of staff governing Formal 28 53.8
administrative operating Slightly formal 8 15.4
procedures Informal 6 11.5
Not available 2 3.8
Total 52 100.0

Highly formal 20 38.5

Formal 14 26.9
Level of screening and reviewing
Slightly formal 14 26.9
of projects
Informal 2 3.8
Not available 2 3.8
Total 52 100.0

None 4 7.7
Personnel strength devoted to A unit 12 23.1
capital budgeting A department 24 46.2
A section 12 23.1

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Total 52 100.0

Monthly 4 7.7
Bi-annually 2 3.8
Review of minimum acceptable
Yearly 26 50.0
rate of return
Biennially 2 3.8
Dependent on project 18 34.6
Total 52 100.0

Less than 5% 0 0.0

6 – 10% 14 26.9
Minimum acceptable rate of 11 – 15% 18 34.6
return on investments 16 – 20% 12 23.1
21 – 25% 8 15.4
26 – 30% 0 0.0
Total 52 100.0

Table 3: Factors considered in planning for long capital budgets

Factors N Mean Standard deviation Rank

Sufficient foresight 52 4.27 1.07 1

Thorough prediction 52 4.15 0.87 2
Inflation 52 4.00 1.09 4
Risk 52 4.12 1.06 3

Table 4: Evaluation of projects due to cost overrun

Frequency Percentage

Accept 0 0.0

Reconsider 46 88.5

Reject 6 11.5
Total 52 100

Table 5: Monitoring of project performance

Rank
Project performance N Mean Standard deviation
1
Productivity of labour 52 4.77 0.58
3
Productivity of plant 52 4.54 0.90
4
Usage of materials 52 4.46 1.02
2
Inflow of project cash flow 52 4.73 0.45
5
Outflow of project cash flow 52 4.27 0.91

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