Capital budgeting describes the process which companies use to make decisions on capital projects i.e. projects with a lifespan of one year or more. It is a cost-benefit exercise which seeks to produce end results and benefits which are greater than the costs of the capital budgeting efforts.
There are several steps involved in the capital budgeting process. The specificity of the procedures adopted by a manager is, however, dependent on factors such as the manager’s level in the company, the size and complexity of the particular project being evaluated, and the size of the company.
Capital Budgeting Process
The typical steps involved in the capital budgeting process are:
Step 1: Generate ideas – Generating good ideas is the most important step.
Step 2: Analyze individual proposals – Information is gathered which helps to forecast cash flows for each project and then evaluate the project’s profitability.
Step 3: Plan the capital budget – This step involves looking at project timing, scheduling, prioritizing, and coordinating.
Step 4: Monitor and post-audit – How the project is performing is assessed and actual results (revenues, expenses, cash flows etc.) are compared with planned or projected results.
Categories of Capital Projects
Capital budgeting projects may be classified in a number of ways. One common classification is as follows:
- Replacement projects – Sometimes capital budgeting decision involves replacing broken down, worn out or older equipment with newer, more efficient equipment.
- Expansion projects – These increase the size of a company’s business activities, and ultimately the size of the company.
- New products and services – capital budgeting projects which aim to increase a company’s product and service offerings carry more uncertainty than expansion projects.
- Regulatory, safety, and environmental projects – These are usually undertaken due to a requirement by a governmental agency, insurance company or some other external party. Oftentimes they do not generate any revenue for the company, and it may actually be more prudent to shut down that part of the business that is related to the project.
- Other – These projects tend to not be subject to the usual capital budgeting analysis, and include, for example, pet projects of the company’s CEO.
Which of the following is not a typical classification for a capital project?
A. Expansion project
B. Modernization project
C. New products and services project
The correct answer is B.
A modernization project is not a typical classification used to describe capital projects. However expansion projects and new products and services projects are typical classifications that are used.
Reading 34 LOS 34a:
Describe the capital budgeting process and distinguish among the various categories of capital projects