ADMINISTRATION OF CAPITAL BUDGETING BASIC INFORMATION

How Capital Budgeting Works?

Although the administrative process of capital budgeting may differ from one firm to another, it involves five basic steps. The first step is the planning, or origination and specification, of capital investments.

Because capital investments are considered essential to a firm’s profitable long-run growth, managers constantly search for new methods processes, plants, and products. These projects usually come from various sources, including the following:

1. New products or markets, and the expansion of existing products or markets.

2. Research and development.

3. Replacement of fixed assets.

4. Other investments to reduce costs; improve the quality of the product; improve morale; or comply with government orders, labor agreements, insurance policy terms, and so forth.

The second step in capital budgeting is the evaluation of the proposed capital investments. Firms differ in their routine for processing capital budgets, but most evaluate and approve the projects at various managerial levels. For example, a request for capital investment made by the production department may be examined, evaluated, and approved by:

(1) the plant managers, (2) the vice president for operations, and (3) a capital budget committee or department, which may submit recommendations to the president.

The president, after adding recommendations, may submit the project to the board of directors. This routine is often complemented and simplified by a uniform policy and procedure manual presenting in detail the firm’s capital budgeting philosophy and techniques.

The third step in capital budgeting is the decision making based on the results of the evaluation process. Depending on the size of the projects, some decisions may be made at a high level, such as the board of directors (if they are large projects), or at a lower level if they are small to medium-sized projects.

The fourth step is control. The firm includes each of the accepted projects in the capital budget and appropriates funds. Periodically, control is exercised over the expenditures made for the project. If the appropriated funds are insufficient, a budgetary review can be initiated to examine and approve the estimated overrun.

The control step can be extended to include a continuous evaluation process to incorporate current information and check the validity of the original predictions.

The fifth capital budgeting step is the post audit. This involves a comparison of the actual cash flows of a capital investment with those planned and included in the capital budget.