Club industry capital budgeting practices in the 21st Century.

Many general managers of clubs wear various different hats during the average business day. At times they wear the human resource director hat, at times the hat of the marketing manager, and, at other times, the hat of the operations manager. Occasionally they must also don the hat of the financial manager, where most of the issues revolve around current items such as cash, receivables, and inventory.

At times, however, the general manager encounters a financial management issue that involves capital budgeting. Capital budgeting involves the purchasing of buildings, equipment, and/or land. Capital budgeting projects have a double-edged significance in that they involve long-term commitments on the one hand and relatively large dollar amounts of cash on the other hand. Often the major question is: "Is the proposed purchase cost justified?"

Findings

In order to investigate the current capital budgeting practices of private clubs, we developed a questionnaire and mailed it to 3,000 members of CMAA. Six hundred and twenty-three questionnaires were returned resulting in just over a 20% response rate.

Most of the respondents (90%) held the position of general manager while most of the remainder held the title of club manager or controller. It appears that virtually every respondent was knowledgeable about their club's capital budgeting practices. Most of the respondents (almost 80%) were employed by country clubs with the remainder being involved with city, golf, yacht, or other types of clubs.

The size of clubs varied in terms of number of members with 37% of respondents' clubs having between 250 and 500 members, while 31% of respondents had between 501 and 750 members. Thirty-seven percent of the respondents' clubs had gross revenues of between three and five million. The next largest category of respondents' clubs (28%) had between five and ten million in gross annual revenues. See Table 1 for greater detail regarding the respondents and their clubs.

Four capital budgeting questions were asked as follows:

1. Does your club undertake a formalized cost/benefit study prior to acquiring property and equipment?

2. If you use a formalized cost/benefit study for only major items, what is considered to be major?

3. If a formalized cost/benefit study is made, what capital budgeting approach is used?

4. If the payback approach is used, what is the maximum allowable payback period?

The basic elements of the three major capital budgeting approaches --payback, net present value (NPV), and internal rate of return (IRR)--are shown in Table 1. An illustration is used on pages 44-45 to demonstrate the three approaches. The proposed equipment purchase in this illustration would pay for itself in just 2.5 years using the payback approach. The NPV is $5,162.80 and the IRR is 28.6493%.

Over 80% of the respondents indicated that a cost/benefit study is conducted prior to acquiring property and equipment. About 37% of those respondents reported that the study conducted was an informal one; that means they considered the costs and benefits but not the relationship used with one of the capital budgeting approaches as explained in Table 1. A quarter of those respondents conducted a formal study only for major new acquisitions. About 20% of the clubs consider the costs and benefits for all capital expenditures. All this also means that in the case of about one out of five of the clubs, no cost/benefit analysis is undertaken prior to the capital budgeting decision.

Does the use of a cost/benefit analysis of capital projects differ based on the respondents' demographics, such as type of club, size in revenues, or size in members?

We found that there were significant differences in terms of both "size of club in members" and "size of club in revenues" in relation to how clubs studied capital projects. We did not, however, find any significant differences between either "type of club" or "profitability of club" in relation to how clubs studied capital projects.

We categorized "small clubs" as those with annual revenue of less than $2,000,000. Twenty-six percent of these clubs do not study the cost/benefit of their capital projects. Thirteen percent of the large clubs (annual revenues over $5,000,000) do not conduct a cost benefit study for capital projects. Sixteen percent of the remaining clubs with revenues between $2-$5 million do not use cost/benefit analysis when considering capital projects.

We noted similar results regarding clubs that informally study the cost benefits of capital projects. While 42% of the smaller clubs conduct an informal study, 36% of the larger clubs, on the other hand, conduct an informal study of capital projects.

How does the "size of club in terms of number of members" compare to the conducting of cost/benefits for capital projects? We found that the larger clubs (greater than 1,000 members) conduct more studies than the smaller clubs (less than 500 members).

Over 250 respondents reported that at their club a cost/benefit study is conducted only for major items. What, however, do they consider "major?" Forty-four percent of the respondents defined "major" as being over $10,000 and one out of four defined it as over $1,000. Another 13% defined major as over $50,000 and 8% defined it as over $100,000. The remaining 10% of the respondents provide other dollar amounts as their response. When comparing demographics such as type, size, and profitability to "what is major," we found a significant difference based only on annual revenue, meaning the larger the club the larger amounts the club considered to be major. For example, 16% of the smaller clubs defined major as expenditures greater than $50,000 compared to 30% of the larger clubs.

With regard to the formal approaches used in capital budgeting analysis, payback was the most common, reported to be used by 43% of those conducting a formal study. As far as the use of discounted cash flow approaches to capital budgeting, 25% used NPV while 17% used IRR. Fifteen percent used a combination of techniques such as payback along with NPV or payback along with IRR.

Are there differences when comparing the various capital budgeting techniques to demographics such as size, type, or profitability? The only demographic item that revealed a significant difference in regard to approach used was "size of club in annual revenue."

We expected to find that the larger clubs would make greater use of the more sophisticated capital budgeting techniques such as NPV and IRR. On the contrary, it was the smaller clubs that made greater use of NPV and IRR.

For those clubs that employed payback in their approach, what is their maximum payback period? The most commonly reported payback period, indicated by 44% of the respondents, was 5 years. Nineteen percent reported the maximum payback period to be 3 years, while 14% reported the maximum to be 4 years. Only 3% indicated a maximum payback of 2 years. The average is 4.2 years based on responses from club executives, indicating a specific time frame. The remaining 20% of the clubs stated other payback periods such as "it depends on the life of the item." We found no significant differences among respondents when comparing maximum payback to demographics such as type of club, size of club, and profitability.

Summary

The vast majority of clubs consider the cost and benefits of purchasing fixed assets as part of their capital budgeting decision. Many of these clubs restrict their analysis to major acquisitions. Nearly half of the clubs have defined major as purchases costing more than $10,000. The most commonly used capital budgeting approach is payback; however, a significant number of club executives use the discounted cash flow approaches of NPV and IRR. The average maximum payback period was 4.2 years.

Illustration of Capital Budgeting Approaches

The Ace Club is considering the purchase of a piece of office equipment costing $10,000 that is expected to save the club $5,000 in labor costs each year. Additional annual operating costs of this machine will be $1,000. The expected life of the machine is five years and the machine is expected to have a zero salvage value.

Payback

Payback Period: Cost of equipment/ Net annual cash flow = 10,000/4,000 = 2.5 years

Research study funded by the Club Foundation.

By James W. Damitio, CMA, Department of Accounting, Central Michigan University & Raymond S. Schmidgall, CPA, CHAE, The School of Hospitality Business, Michigan State University 

TABLE 1. Description of Capital Budgeting Approaches

Approach    Formulation            Decision Rule

Payback     Payback Period =       Make investment when
            Cost of Investment     the payback period is
            Annual Cash Flows      less than maximum
                                   allowable by
                                   decision-maker

Net         Compare cost of        Make investment when
Present     investment to the      NPV>0
Value       present value of
            future cash flows

Internal    Discount cash flows    Make investment when
Rate of     using an interest      IRR>the hurdle rate
Return      rate that results
            in NPV=O

Positions of Respondents

General Manager            90%
Club Manager                 7
Controller/CFO               2
Other                        1

Total                     100%

Note: Table made from bar graph.

Type of Club

Country   78%
City        8
Golf        5
Yacht       4
Other       5

Total     100%

Size of Club (Annual Revenues)

$1,000,000              2%
1,000,000-2,000,000     10
2,000,000-3,000,000     16
3,000,000-5,000,000     37
5,000,000-10,000,000    28
10,000,000               7

Total                  100%

Size of Club (Number of Members)

250             4%
250-500         37
501-750         31
751-1,000       12
1,001-2,000     13
2,000            3

Total         100%

NPV (Assume a 10% discount rate)

                          Present
                          Value of
       Net Cash           Net Cash
Year     Flow      PVF    Flows

1        $4,000   .9091    $3,636.40
2         4,000   .8264      3305.60
3         4,000   .7513      3005.20
4         4,000   .6830      2732.00
5         4,000   .6209      2483.60
Subtotal                   15,163.00
Cost of equipment          10,000.00
NPV                         5,162.80

Alternatively EXCEL could be used to determine
the NPV using = NPV (disc. rate, cash flows) + cost

IRR--When the $4,000 annual cash flows are
discounted by 28.6493%, the NPV equals zero.
This means the return on this investment is
over 28%. The IRR can be determined using
EXCEL and the formula = IRR (cost ... cash flows)