The capital budgeting process is a critical component of any company’s financial planning. It helps an organization determine where the company should focus its resources to achieve the highest return on its investment while still maintaining a safe and healthy work environment. This article walks you through the ins and outs of capital budgeting, including the pros and cons of each method, as well as best practices to keep in mind.
What is Capital Budgeting?
Capital budgeting is the process of determining how much to allocate to projects and employees based on the expected returns to invest in the short-term and the long-term. This can be done by using any of a number of methods, each with its advantages and disadvantages.
Decisions based on actual cash flows
The most common method for capital budgeting is making fixed-sum contracts, sometimes known as fixed-price contracts. With a fixed-price contract, the firm determines the price of the goods or services to be provided, and the contractor determines the amount to be delivered. The total amount to be budgeted is known as the contract price. However, this method does not take into account opportunity costs, such as labor time invested in designing, producing, and marketing products or services. When calculating an organization’s cash flow, the only cost that is factored into the equation is the amount actually delivered.
Cash flow timing
For many industries, the best time to contract for goods and services is late in the business cycle. For example, if an organization builds a new branch office in the summer, it could contract for the equipment in the fall, but cash flow from the contract would be low in the winter, when business is at a standstill. Another downside to this method is that the amount budgeted may be more than needed. If the branch office does not need the specified equipment, but the firm insists on using it, then the contractor may be overpaid.
Cashflows are based on opportunity costs
In contrast, cash flow timing is based on opportunity costs, which is the time spent designing, manufacturing, and marketing products or services that generate no cash flow. This method accounts for these opportunity costs, allowing the firm to budget for what it needs to succeed. With opportunity costs, the cash flow is computed on an after-tax basis. This is because the accounting rules allow for this deduction, even though it is not reflected in the cash flow. Opportunity costs are often referred to as “intangibles.” While this method has its advantages, it is also the most complicated. The accountant must keep track of the costs of all the past, present, and future opportunities that the firm faces. This can be difficult and time-consuming, so some companies use opportunity costs only when all other alternatives have been exhausted.
Financing costs ignored from calculations of operating cash flows
Another method for capital budgeting is the use of cash flow forecasts. While these may seem like a good idea in times of economic uncertainty, they have certain limitations. Forecasting cash flows is difficult and inexact, so some companies use them only as a last resort. Most companies use this method only when they know they will not be able to change their cash flow forecast during the process. This method relies on an organization’s management and financial management staff to be firm and accurate in forecasting the company’s cash flows. If they make an error, the forecast is not considered valid. Forecasting is never easy, and there is always the chance of a miss. If the forecast is off by a significant amount, the organization may not be able to make repayments on its debt, which could lead to financial ruin. These costs should be included in the administrative cost section of the business plan and be budgeted accordingly, but they should not affect the amount allocated to project or employee capital budgets.
Capital budgeting is the process of determining how much to spend on projects and employees, based on the expected returns. This can be done by using any of a number of methods, each with its advantages and disadvantages. Projects and employees with high return on investment should be priority projects, while those with low return should be given less resources. Budgets should account for opportunity costs, financing costs, and cash flow forecasts.