Capital budgeting is the process that companies use for decision making on capital project. The capital project lasts for longer time, usually more than one year. As the project is usually large and has important impact on the long term success of the business, it is crucial for the business to make the right decision.
Capital Budgeting Process
The specific capital budgeting procedures that the manager uses depend on the manger’s level in the organization and the complexities of the organization and the size of the projects. The typical steps in the capital budgeting process are as follows:
- Brainstorming. Investment ideas can come from anywhere, from the top or the bottom of the organization, from any department or functional area, or from outside the company. Generating good investment ideas to consider is the most important step in the process .
- Project analysis. This step involves gathering the information to forecast cash flows for each project and then evaluating the project’s profitability.
- Capital budget planning. The company must organize the profitable proposals into a coordinated whole that fits within the company’s overall strategies, and it also must consider the projects’ timing. Some projects that look good when considered in isolation may be undesirable strategically. Because of financial and real resource issues, the scheduling and prioritizing of projects is important.
- Performance monitoring. In a post-audit, actual results are compared to planned or predicted results, and any differences must be explained. For example, how do the revenues, expenses, and cash flows realized from an investment compare to the predictions? Post-auditing capital projects is important for several reasons. First, it helps monitor the forecasts and analysis that underlie the capital budgeting process. Systematic errors, such as overly optimistic forecasts, become apparent. Second, it helps improve business operations. If sales or costs are out of line, it will focus attention on bringing performance closer to expectations if at all possible. Finally, monitoring and post-auditing recent capital investments will produce concrete ideas for future investments. Managers can decide to invest more heavily in profitable areas and scale down or cancel investments in areas that are disappointing.
Complexity of Capital budgeting Process
The budgeting process needs the involvement of different departments in the business. Planning for capital investments can be very complex, often involving many persons inside and outside of the company. Information about marketing, science, engineering, regulation, taxation, finance, production, and behavioral issues must be systematically gathered and evaluated.
The authority to make capital decisions depends on the size and complexity of the project. Lower-level managers may have discretion to make decisions that involve less than a given amount of money, or that do not exceed a given capital budget. Larger and more complex decisions are reserved for top management, and some are so significant that the company’s board of directors ultimately has the decision-making authority. Like everything else, capital budgeting is a cost-benefit exercise. At the margin, the benefits from the improved decision making should exceed the costs of the capital budgeting efforts.