The Effect of Cognitive Style and Sponsorship Bias on the
Treatment of Opportunity Costs in Resources Allocation Decisions
H. Alfian
(Fakultas Ekonomi Universitas Lambung Mangkurat, Banjarmasin)
ABSTRACT
The current research seeks to identify factors that may potentially influence the way managers respond to opportunity costs when relevant data are not explicitly provided. Identification of such factors should enhance our understanding of why some managers respond to opportunity costs in ways that may be inconsistent with normative economic theory. This information could then be used to identify those situations in which structural and procedural precautions are necessary to correct limitations and biases in human information processing and so ensure the correct treatment of opportunity costs.
Disability of individual processes of perception dimension of Jungs’ typology on research of Chenhall & Morris (1991) to explain difference of managers’ way to making decision, lead us to research questions are: first, which cognitive style combination have a proclivity to incorporate implicit opportunity costs in their economic analysis? Second, used of two dimensions of cognitive style, will project sponsorship encourage managers to ignore negative economic signals derived from opportunity costs that are nevertheless relevant to the resource allocation decision?
A laboratory experiment with 2x4 factorial designs was used to investigating the effect of cognitive style on the managers’ decision of opportunity costs in situation of absence sponsorship or not. The results indicated that intuitive managers tended to incorporate opportunity costs in their decisions whereas sensation individuals appeared to focus more on the directness of the relationship between expenditure and a project to determine the relevance of the cost. Opportunity cost implications tended not to be identified by the sensation group. Evidence was found that sponsorship moderated the influence of cognitive style on decision to include opportunity costs.
Keywords: Cognitive style, sponsorship bias, and opportunity cost
1. INTRODUCTION
The incorporation of opportunity costs into resources allocation decisions is stressed in normative approaches to both management accounting (Horngren & Foster, 1987) and capital budgeting (Brealy & Myers, 1984). However, empirical evidence on the way managers respond to opportunity costs has revealed a variety of behaviours. Some studies have demonstrated that managers do include opportunity costs (Neumann & Friedman, 1978; Friedman & Neumann, 1980), while others have questioned whether decision makers correctly include the concept in their resources allocation decisions (Becker et al., 1974; Buzzell & Chussil, 1985; Northcraft & Wolf, 1984; Kaplan, 1986). Several studies have demonstrated that decision makers tend to include opportunity cost data only when explicitly provided (Friedman & Neumann, 1980; Northcraft & Neale, 1986). However, research on decision making in organizations indicates that managers frequently lack knowledge about alternatives (March, 1987). Typically, managers do not have explicit and relevant information on a well-defined set of alternatives. March (1987) refers to the identification of alternatives as the main uncertainty facing managers in the decision making process. Chenhall & Morris (1991) examined how managers treat opportunity costs in the common decision situation where explicit information on these costs is lacking. Chenhall & Morris (1991) argued that decision makers’ cognitive style[1], and the existence of project sponsorship, will influence their response to opportunity costs in situations in which the relevant information is implicit.
The current research seeks to identify factors which may potentially influence the way managers respond to opportunity costs when relevant data are not explicitly provided. Identification of such factors should enhance our understanding of why some managers respond to opportunity costs in ways that may be inconsistent with normative economic theory. This information could then be used to identify those situations in which structural and procedural precautions are necessary to correct limitations and biases in human information processing and so ensure the correct treatment of opportunity costs.
The paper argues that decision makers’ cognitive style, and the existence of project sponsorship, will influence their response to opportunity costs in situations in which the relevant information is implicit. In particular, the research considers the extent to disability of individual processes of perception dimension of Jungs’ typology on research of Chenhall & Morris (1991) to explain difference of managers’ way to making decision, lead us to research questions are: (1) Which cognitive style combination have a proclivity to incorporate implicit opportunity costs in their economic analysis? (2) With combination of two dimensions of cognitive style, will project sponsorship encourage managers to ignore negative economic signals derived from opportunity costs that are nevertheless relevant to the resource allocation decision?
The remainder of the paper is structured as follows. First, evidence on the treatment of explicit and implicit opportunity costs is discussed and theoretical reasons are advanced as to why opportunity cost signal, which adversely affect a project, may be ignored. This involves consideration of the effects of cognitive style and sponsorship bias.
2. LITERATURE REVIEW
2.1. Opportunity Cost
Opportunity cost is the forgone benefit that could have been realized from the best forgone alternative use of a resource (Maher et al., 2006, p.30). Opportunity cost is a concept that is fundamental to determining which items are to be included in the cash flows of resource allocation decisions. Opportunity cost has been defined as “the cash it (a resource) could generate for the company if the project was rejected and the resource sold or put to some other productive use” (Brealy & Myers, 1984, p. 87). Thus, opportunity costs arise from alternative future uses of existing assets as well as from alternative uses of future out-of-pocket cash flows.
2.1.1. Explicit Versus Implicit
Research on the treatment of opportunity costs has investigated whether managers include them in ways consistent with normative economic theory (e.g. Becker et al., 1974; Neumann & Friedman, 1978; Friedman & Neumann, 1980; Hoskin, 1983; Northcraft & Neale, 1986). While the evidence on the treatment of opportunity costs is somewhat mixed, decision makers seem to include them if the opportunity cost data are provided explicitly. Becker et al. (1974) found that subjects in an experimental situation made decisions that indicated they either ignored or discounted opportunity cost information. Neumann & Friedman (1978) modified the experiment by presenting explicit information about opportunity costs and found that this triggered subjects to use it. Two studies of Friedman & Neumann (1978 and 1980) found that subjects did use opportunity cost information when the information was provided explicitly. However, the subject did not try to impute amounts of potential opportunity costs when no information was provided regarding their magnitude. The authors concluded that opportunity cost was included only when it was explicitly available. Further evidence confirming the view that individuals tend to include explicit opportunity cost is provided in studies by Hoskin (1983) and Northcraft & Neale (1986).
2.2. Cognitive Style
Cognitive style is the concept and the way individual perceive opportunity cost defined as the way an individual processes, transforms and restructures stimuli received from the environment to shape a resulting response (Doctor & Hamilton, 1973). The importance of studying personality and cognitive style in accounting emphasized the need to understand user characteristics in order to design better information systems (Gul, 1984; Brownell, 1981; Dermer, 1973; Benbasat & Dexter, 1979). Gul (1984, p. 246) summarized the purpose of studying individual characteristics by stating that research into the effects of personality seeks to “facilitate the preparation of accounting information that is most suited to the user’s information processing needs.”
2.2.1. The Framing of Resources Allocation Decisions
Tversky & Kahneman (1981) proposed that psychological factors influencing the perception of decision problems produce shifts of preference when different individuals consider the same problem. They refer to these preferences as “decision frames”, and claim that the formulation of frames is controlled partly by the personal characteristics of the decision maker.
In the current research cognitive style is used to explain how individuals, with an intuitive (IT and IF) cognitive style, frame the decision of cost relevance in ways that enable implicit opportunity costs to be perceived, whereas sensation (ST and SF) managers frame the problem in ways that lead to the incorrect treatment of opportunity costs and consequently wrong decisions
2.3. SPONSORSHIP BIAS
In this study sponsorship bias is identified as one aspect of the social context which may influence the way in which manager process information related to resource allocation decisions and that this influence may modify the effect of cognitive style.
The importance of sponsorship bias to the current study is that managers who include implicit opportunity costs in non-sponsorship situations, may be motivated to exclude when they sponsor the project. This effect is based on the proposition that once a commitment to a project has been made, managers are likely to maintain their advocacy for the project with great stability and tenacity, even when faced with negative signals. March (1987) commented on the propensity of managers to see things that are consistent with their viewpoint and noted that responses may include selective perception and rationalization.
3. METHODOLOGY
3.1. Research Design
A laboratory experiment with 2x4 factorial designs with Friedman & Neumann’s (1980) multiple time-series research design was employed to investigating the effect of cognitive style on the managers’ decision of opportunity costs in conditions with and without sponsorship bias. Myers-Briggs Type Indicator (MBTI) used for determining subjects’ cognitive style.
Cases and scenario was written that asked each subject to make a series of twelve sets of decisions between two products having unequal margins. At the outset of the experiment, each subject was asked to assume the role of a middle-level manager who must recommend one of two mutually exclusive products. The subjects were told they would be given some data and that it was economically feasible to request up to two items of additional information, but that any information in excess of two items was prohibitively expensive. This scenario was followed by a set of instructions.
3.2. Subjects
The subjects were students of executive programme Master of Management (MM). The programme was designed for the general manager and this was reflected both in the varied backgrounds of the participants and the content of the programme. All had prior experience with capital resource allocation decisions and with sophisticated capital budgeting techniques, including discounted cash flow analysis. A few were already general managers, others were being prepared for this responsibility.
4. RESULTS AND DISCUSSION
4.1. Results
A total of 131 of students’ executive programme Master of Management (MM) are participated in the experiment consist of 84 male and 47 female. The treatment group of 66 subjects was provided with sponsorship cues. The control group of 65 subjects had no sponsorship cues. Random assignment of subjects assisted in equating the treatment and control groups on condition other than sponsorship bias, thereby enhancing the internal validity of the study. All subjects completed the MBTI cognitive style instrument. The first phase is the identification of subjects’ personality types using MBTI questionnaire.
4.1.1. Results of Manipulation Check
Two steps of manipulation check are conducted to decide total samples for hypotheses testing. In the first step, nine subjects is eliminated since they made the wrong decision for the first choice for each case more than once-showing that they do not understand the case and they are not a margin maximizer.
In the second step, another four subjects is eliminated since them as they made the wrong decision for the second case more than once. Thus, the final samples used for analysis are 118 subjects.
4.2. Discussion
4.2.1. Descriptive Statistics
Result indicates that subjects consider explicit information as a dimension of an important opportunity cost variable. Subjects change their decision as soon as they receive information describing explicit opportunity cost (choice in Decision 3). This results apply on 115 out of 118 subjects analyzed, showing that subject hesitant to relate their decision with opportunity cost when there is no information about the magnitude (explicitly available) as described by table 4.4 (appendix 2).
Results also show that 101 (85 %) subjects ask for the relevant additional information, with 79 (66.9%) subjects using the information correctly in decision-making (table 4.5 - appendix 2).
4.2.2. Additional Analysis
A sample with proportional distribution is used to analyze subjects’ behaviour in resources allocation decisions. The first step conducted is examining dimension process of perception of cognitive styles (sensation versus intuition) – as used by Chenhall and Morris (1991). The total 118 samples consists of 100 subjects’ (84.7%) sensation style versus 18 subjects’ (15.3 %) intuition style as shown in table 4.6 (appendix 3).
The second step conducted is examining dimension process of judgement of cognitive styles (thinking versus feeling). The total 118 samples consists of 83 subjects’ (70.3 %) thinking style versus 35 subjects’ (29.5 %) feeling style as shown in table 4.7 (appendix 3).
The third step conducted is examining combination of sensation/thinking (ST) versus sensation/feeling (SF) which had proportional data structure. The total 100 samples consists of 69 subjects’ (70.3 %) ST cognitive style versus 31 subjects’ (29.5 %) SF cognitive style as shown in table 4.8 (appendix 3).
The two-way ANOVA test provides results as follows. First, there is a statistically significant main effect of sponsorship variable—supporting the expectation that manager’ resource allocation decision is influenced by his involvement in a project. Second, cognitive styles variable do not have a significant main effect in manager’s decision. Finally, interaction of both sponsorship bias and cognitive styles variables has a statistically significant effect on managers’ resource allocation decision (F=6.338 and p-value=0.013), consistent with Chenhall and Morris (1991). It shows that manager’s involvement in a project and his cognitive styles will influence the decision he made.
5. Conclusion, limitation, and implication
5.1. Conclusion
The results of this study provide support for the notion that the treatment of implicit opportunity costs by managers is influenced by their cognitive style. This study also provides support for the proposition that the effect of cognitive style may be confounded by the existence of project sponsorship.
That is, without sponsorship, sensation managers dominantly included the opportunity costs information, a decision which is consistent with the idea that managers were responding to the specificity of the cost. However, sponsorship confounded this effect as the managers who felt commitment to the project elected to exclude the items. The intuitive managers tended to exclude in both situations. This study is consistent with Chenhall & Morris (1991) and Friedman & Neumann (1980).
5.2. Limitation
This study is limited in the same respects as any laboratory study: First, lack of overall generality, indeterminant external validity, lack of motivation, and unfamiliar setting. Second, another limitation was that some undetected mathematical errors may have been made by the subjects. Some subjects may not have understood the task even after excluding learning decision sets. This lack of understanding would have the effect of decreasing the likelihood of correct responses, so that the percentage of decision sets in which opportunity cost information is used would have been understated. Third, combination of intuition/thinking (IT) and intuition/feeling (IF) population are scarce, consequently this study have difficult get the proportional sample size.
5.3. Implication
However, given these limitations, the study does provide some evidence which helps to explain how managers treat implicit opportunity costs and thereby assists in addressing the observation by Kaplan (1986) that opportunity costs is often incorrectly treated in resource allocation analysis.
There are two important implications of the study for the design of administrative systems. One concerns formal systems for the authorization of capital expenditures, and the other, formal organization structures and responsibilities.
The first implication is that capital budgeting procedures must be designed to correct the tendency of sensation managers, who constitute 56% of the managerial population and 62% of financial executives (Myers & McCaulley, 1985 in Chenhall & Morris, 1991), to mis-specify the treatment of existing assets. This is particularly serious because academic texts (e.g. Horngren & Foster, 1987), suggest that financial executives should be responsible for capital budgeting processes and empirical studies confirm this to be so in the majority of cases (e.g. Gitman & Forrester, 1977 in Chenhall & Morris, 1991). Given that capital budgeting procedures will tend to be designed and administer managers with a sensing cognitive style likely that mis-specification of the treatment existing will be embedded into the computer programs and review procedure that constitute the formal processes. Knowing that the errors are due in part to the predominant cognitive style of the managers’ response for the design and administration of the capital budgeting process suggests that the specifying and designing this key component the resource allocation process should be trusted to a multi-disciplinary team contains different skills, priorities, and cognitive style
The second implication concerns an appropriate response to sponsorship bias. The issue complex, on the one hand, capital investment acceptance and ultimate success appear too enhanced by a manager adopting a role “project champion” (Bower, 1972).
[1] Chenhall & Morris (1991) used only one dimension of four dimensions of Jung’s’ typology for cognitive style. The dimension is individual processes of perception dimension.
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