What is the Capital Budgeting Process?

It is a complex process that may be divided into the following phases:

I. Identification of Investment Opportunities: Mere identification or possible alternatives is not all that is required in any search for investment proposals. The best proposal needs to be discovered and considered. Capital expenditure proposals should come from different segments of the enterprise. Personnel working at different levels in the organization should be encouraged to participate in the discovery of the best available proposals for capital outlays within the limits of their authority, knowledge, and experience. It is better if management establishes well-defined guidelines for searching investment proposals so that no useful idea remains uncommunicated and no redundant proposal passes through the processing stage.

Proposals regarding capital expenditure do not originate at the level of the controller or the budget committee. The requirements for fixed-assets expenditure are forwarded by the managers of different operating units or departments. It is, however, better if such proposals are accompanied by commercial and technical assumptions on which these are based and duly supported with details relating to the following matters;
(a) Market potential for the product and yearly sales forecasts for different years.
(b) Raw material requirements and their supply position.
(c) Technical details relating to physical facilities and flow diagrams.
(d) Financial implications.

Capital expenditure proposals may also originate at the top management level of the company. The Chief Executive may carry out a survey relating to physical facilities, new market, development of new products, stage of technology, and the like. Such efforts may lead to the discovery of certain useful alternatives that should be screened and evaluated in the same way as originating at lower levels.

II. Assembling Investment Proposal: Economic performance like return on investment as calculated in a number of ways under different methods furnishes the most important criterion used for evaluating fixed assets investment proposals. But here also the technique to be used for evaluating economic performance should be clearly defined and communicated. There are also occasions when non-economic criteria like competition, risk, legal requirements, and social responsibilities become the over-riding considerations in evaluating different investment proposals. But it does not mean that criteria once established holds good under all circumstances and for all times to come.
Relevance and reliability of criteria should be continuously reviewed.

All those proposals which are conflicting and do not deserve further consideration are rejected so that only useful alternatives are analyzed in detail. Economic evaluation generally plays an important role in the screening process. Along with the screening, there is also the need for blending together and unifying different capital projects under the total capital expenditure program. In this way, conflicting and duplicate proposals would be eliminated and taken together all of them contribute to the accomplishment of some higher objectives. Co-ordination will be greatly facilitated in different proposals for capital outlays are related to each other.

III. Decision Making: It would be useful if different proposals are properly classified and diagnosed before their evaluation. Investment proposals may be classified on the basis of the degree of risk involved or the extent to which they are postponable. In terms of reasons for the expenditure, the proposals may be classified as to whether they result in replacements, betterment, or additions to assets. In the process, certain mutually exclusive and conflicting proposals will be eliminated. If the firm enjoys sufficient resources to finance all the remaining projects which are profitable, ranking them in order of preference is not a serious problem. But in reality, the number of proposals is generally larger than the number of funds available with the firm, and the controller wants to recommend only the most desirable of them. As a matter of fact, some of the good proposals are also rejected even when they are profitable.

IV. Budgeting Capital Expenditure: Capital budgeting refers to the process of planning the investment of funds in the long-term assets of the enterprise. Its purpose is to help management control capital expenditure. With the help of capital budgeting, management is able not only to reject poor investment decisions but also to select, in order of priority the projects which are most profitable and consistent with the objectives and targets set. Additions, replacement, and betterments require additional funds to be committed to long-term assets and are thus included in the capital budget which is typically prepared for a year. The capital budget is a snapshot of the plan and projects for the coming year for which approval is sought. The capital budget should be flexible so as to eliminate some of the projects already included but allow the addition of new projects that deserve consideration. The inclusion of certain projects in the capital budget and its approval by the management does not mean that actual expenditure has been authorized. Rather, it offers an opportunity to look at each project even from the viewpoint of the total organization. There is also the need of reconciling the capital budget with other budgeting activities of the enterprise, for example, cash revenue and expense budgets.

V. Implementation and Controlling of Projects: Another important aspect of planning and control of capital outlay is to devise a procedure to exercise control over projects while in process. Controlling projects in the process generally falls within the purview of the financial manager. He is concerned with laying down the procedure to ensure that completely satisfies the norms with respect to cost, time, and purpose of the expenditure. Variations from approved plans together with reasons should promptly be reported to responsible authorities for deviations. The observations and up-to-date progress report provide sufficient information to the management about the exact stage and status of all major projects.

VI. Follow-up and Performance Report: The project manager or the manager originating the investment proposal, is responsible for submitting its completion report on the basis of which management normally proceeds to carry out the post-completion audit. Follow up implies comparing and reporting actual results with the projected result of the investment proposal so as to evaluate the performance and outcome in proper perspective. It is required, however, that procedures and format of follow-up should be clearly defined and communicated. The frequency and duration of the audit should also be clearly indicated. Audit personnel should also be provided with broad guidelines as to the extent of economic and non-economic evaluation they are expected to carry out.

Leave a Comment

Your email address will not be published. Required fields are marked *

Scroll to Top