Introduction to the Capital Budgeting Process

What you will learn to do: describe the capital budgeting process

Capital budgeting is the process of considering alternative capital projects and selecting those alternatives that provide the most profitable return on available funds within the framework of company goals and objectives. A capital project is any available alternative to purchase, build, lease, or renovate buildings, equipment, or other long-range major items of property. The alternative selected usually involves large sums of money and brings about a large increase in fixed costs for a number of years in the future. Once a company builds a plant or undertakes some other capital expenditure, its future plans are less flexible.

Stacked logsPoor capital-budgeting decisions can be costly because of the large sums of money and relatively long periods involved. If a poor capital budgeting decision is implemented, the company can lose all or part of the funds originally invested in the project and not realize the expected benefits. In addition, other actions taken within the company regarding the project, such as finding suppliers of raw materials, are wasted if the capital-budgeting decision must be revoked. Poor capital-budgeting decisions may also harm the company’s competitive position because the company does not have the most efficient productive assets needed to compete in world markets.

Investment of funds in a poor alternative can create other problems as well. Workers hired for the project might be laid off if the project fails, creating morale and unemployment problems. Many of the fixed costs still remain even if a plant is closed or not producing. Also, advertising efforts would have been wasted, and stock prices could be affected by the decline in income from the poorly chosen alternative.

On the other hand, failure to invest enough funds in a good project also can be costly. Ford’s Mustang is an excellent example of this problem. At the time of the original capital-budgeting decision, if Ford had correctly estimated the Mustang’s popularity, the company would have expended more funds on the project. Because of an under-commitment of funds, Ford found itself short on production capacity, which caused lost and postponed sales of the automobile.

Finally, the amount of funds available for investment is limited. Thus, once a company makes a capital investment decision, alternative investment opportunities are normally lost. The benefits or returns lost by rejecting the best alternative investment are the opportunity cost of a given project.

For all these reasons, companies must be very careful in their analysis of capital projects. Capital expenditures do not occur as often as ordinary expenditures such as payroll or inventory purchases but involve substantial sums of money that are then committed for a long period. Therefore, the means by which companies evaluate capital expenditure decisions should be much more formal and detailed than would be necessary for ordinary purchase decisions.

The following video provides an overview of the capital budgeting procedures that many companies use:

You can view the transcript for “What is Capital Budgeting: Introduction – Managerial Accounting video” here (opens in new window).

When you are done with this section, you will be able to:

  • Describe the capital budgeting process
  • Understand operating and implementation costs in a capital budgeting analysis
  • Understand the focus on cash flows for capital investment decision making

Learning Activities

The learning activities for this section include the following:

  • Reading: Capital Budgets
  • Self Check: Capital Budgets
  • Reading: Costs for Capital Budgeting Analysis
  • Self Check: Costs for Capital Budgeting Analysis
  • Reading: Focus on Cash Flows
  • Self Check: Focus on Cash Flows