The Capital Budgeting Process

Learning Outcomes

  • Describe the capital budgeting process
People in a conference room

The capital budgeting process can be logically broken down into three phases:

Phase 1 – Screening

1. Begin with the larger picture. Based on the company’s mission and strategic plan, it is likely that both leadership and management will identify large projects that do not fit into the annual operating budget. For instance, Between 2016 and 2121, Toyota invested over $10 billion in US production facilities in order to meet the demand for its cars. Those investment decisions were part of the company’s larger strategic plan and also included moving some production to Mexico.

2. Identify and evaluate potential opportunities. For any given initiative, a company will probably have multiple options to consider. For example, if a company is seeking to expand its warehousing facilities, it might choose between adding on to its current building or purchasing a larger space in a new location. As such, each option must be evaluated to see what makes the most financial and logistical sense.

3. Screen opportunities. Usually, there is a committee or the board of directors that screens projects, asks tough questions, and narrows down the options based on the information available.

Phase 2 – Analysis

4. Estimate operating and implementation costs. Using both internal and external research, identify all costs, including ongoing operating costs. If your college builds a new science building, it will have to increase janitorial staff and budget for repairs and maintenance as well as insurance, utilities, and other operating costs. Remember that the capital budget will affect the operating budget.

5. Estimate cash flow. If the project won’t directly generate cash flow, such as the upgrading of computer equipment for more efficient operations, the company must do its best to assign estimated cost savings or a benefit to see if the initiative makes sense financially.

6. Assessment. Companies usually use some kind of benchmark in order to assess risk vs. reward. This threshold is often called the hurdle and is expressed as a percentage. A single project will be assessed against this hurdle, while multiple projects will be assessed against the hurdle and each other.

Phase 3 – Implementation

7. Select the project. From the alternatives, the budget committee or board of directors will select the best option and give it the official go-ahead.

8. Implement the project. If a company chooses to move forward with a project, it will need an implementation plan that includes financing, a timeline, cost tracking, and other monitoring processes.

9. Re-evaluate the decision. A critical and often overlooked step in the process is the follow-up, sometimes called an after-action review. This involves exploring what went right in the decision-making process as well as what could be improved, and analyzing whether or not the assumptions, such as cash flows, were reasonably accurate.

In budgeting, managerial accountants primarily focus on Phase 2 of the capital budgeting process. However, it is important to know how a project gets to Phase 2.

For some capital expenses, companies have to move quickly. For example, a healthcare company may have to invest in projects to comply with healthcare regulations and may skip Phase 2 entirely, instead simply implementing what has to be done for the least amount of money.

For other projects, however, companies usually use a fairly rigorous capital planning process beginning with the screening process that documents what the projects are, the problems they are solving, what they will cost, and the value they will generate, along with priorities and broad selection guidelines. They are then moved on to the managerial accountants for analysis.

Click here for a case study in capital planning–an Australian company called Telstra. This video describes their capital budgeting process, especially how the company aligns large projects with the long-term corporate strategy, and how the company monitors and evaluates projects. KPI stands for Key Performance Indicators, PMO is the Project Management Office, and ROI is Return on Investment.

Before we move on to explore steps 4-6 in more depth, check your understanding of the capital budgeting process.

Practice Question