Process of Capital Budgeting
The Capital Budgeting process is the process of planning which is used to evaluate the potential investments or expenditures whose amount is significant. It helps in determining the company’s investment in the long term fixed assets such as investment in the addition or replacement of the plant & machinery, new equipment, Research & development, etc. This process the decision regarding the sources of finance and then calculating the return that can be earned from the investment done.
Six Steps to Capital Budgeting Process
#1 – To Identify Investment Opportunities
The first step is to explore the available investment opportunities. The organization’s capital budgeting committee is required to identify the expected sales in the near future and after that, they do the identification of the investment opportunities keeping in mind the sales target set up by them. There are points which are needed to be taken care of before starting the search for the best investment opportunities. This includes monitoring of the external environment regularly to get an idea about the new opportunities of investment, defining the corporate strategy which is based on the organization’s SWOT analysis i.e. analysis of its strength, weakness, opportunity, and threat and also seeking suggestions from the organization’s employees by discussing the strategies and objectives with them.
Identification of the underlying trends of the market which can be based on the most reliable information, prior to selecting a specific investment. For instance, before choosing the investment to be made in the company involved in the gold mining, firstly the underlying commodity’s future direction is needed to be determined; whether the analysts believe that there are more chances of price getting declined or the chances of price rise is much higher than its declination.
#2 – Gathering of the Investment Proposals
After the identification of the investment opportunities, the second process in capital budgeting is to gather investment proposals. Prior to reaching the committee of the capital budgeting process, these proposals are seen by various authorized persons in the organization to check whether the proposals given are according to the requirements and then the classification of the investment is done based on the different categories such as expansion, replacement, welfare investment, etc. This classification into the different categories is done to make the decision-making process easier and also to facilitate the process of budgeting and control.
The real estate company identified two lands where they can build their project. Out of the two lands one land is to be finalized. So the proposals from all the departments will be submitted and the same will be seen by various authorized persons in the organization to check whether the proposals given are according to the various requirements. Also the same will then be classified for better decision making the process.
#3 – Decision Making Process in Capital Budgeting
Decision making is the third step. In the stage of decision making the executives will have to decide which investment is needed to be done from the investment opportunities available keeping in mind the sanctioning power available to them.
For instance, the managers at the lower level of management like work managers, plant superintendent, etc. may have the power to sanction the investment up to the limit of $10,000 beyond that the permission of the board of directors or the senior management is required. If the investment limit extends then the lower management has to involve the top management for the approval of the investment proposal.
#4 – Capital Budget Preparations and Appropriations
After the step of the decision making the next step is the classification of the investment outlays into the higher value and the smaller value investment.
When the value of an investment is lower and is approved by the lower level of management then for getting speedy actions they are generally covered with the blanket appropriations. But if the investment outlay is of higher value then it will become part of the capital budget after taking the necessary approvals. The motive behind these appropriations is to analyze the investment performance during its implementation.
#5 – Implementation
After the completion of all the above steps, the investment proposal under the consideration is implemented i.e., put into a concrete project. There are several challenges that can be faced by the management personnel while implementing the projects as it can be time-consuming. For the implementation at the reasonable cost and expeditiously the following things could be helpful:
- Formulation of the project adequately: Inadequate formulation of the project is one of the main reasons for the delay in the projects. So all the necessary details should be taken by the concerned person in advance and proper analysis should be done well in advance to avoid any delay in the implementation of the project.
- Use of responsibility accounting principle: For the expeditious execution of the various tasks and the cost control, the specific responsibilities should be assigned to the project managers i.e., the timely completion of the project within the specified cost limits.
- Network technique use: Several network techniques like Critical Path Method (CPM) and Program evaluation and review technique (PERT) are available for project planning and control which will help in monitoring the projects properly and easily.
For prompt processing, the committee of capital budgeting must ensure that management has properly done the homework on the preliminary studies and compendious formulation of the project before its implementation and after that, the project is implemented efficiently.
#6 – Review of Performance
Review of performance is the last step in the capital budgeting. In this, the management is required to compare the actual results with that of the projected results. The correct time to do this comparison is when the operations get stabilized.
With this review, the capital budgeting committee concludes on the following points:
- To what extent the assumptions were realistic.
- The efficiency of the decision making
- If there are any judgmental biases
- Whether the hopes of the sponsors of the project is fulfilled.
Thus, the process is a complex one comprising of the various steps that are required to be followed strictly before the finalization of the project.
Capital Budgeting is used by the companies for making the decisions related to the long term investment and starts with the identification of the different investment opportunities, then collecting and evaluating different investment proposals, then taking decision for selecting the best profitable investment, after that decision for Capital Budgeting and the apportionment is to be taken, lastly, the decision taken is to be implemented and performance is to be reviewed timely.
This has been a guide to Capital Budgeting Process. Here we provide the top 6 steps in the Capital Budgeting along with the examples of each. You may learn more about Corporate Finance from the following articles –