Capital Budgeting Means Quantified Planning

Capital Budgeting

Budgeting means quantified planning that guide's the organization's future activities toward the achievement of its goals. The end result of this planning process is a budget. Budgeting is often related, if not interchanged, with profit planning. It is a plan on how to acquire and use the resources of an entity during a certain future period.

Capital Budgeting is the process of identifying, evaluating, planning, and financing capital investment projects of an organization. It involves capital investments which require large sum of cash outlay and usually for a long period of time. This is different from the periodic operating planning or setting of desired operating figures. This is budgeting with a difference.

What is an investment? Needless to say, decisions involved in these procedures are concerned of capital investments. An investment is any project a firm or company spends a certain amount and from which it expects something in return, a return on investment. These investments, so to speak, are no longer part of the operating activities of an entity to which it periodically expects to generate most of its revenue. Therefore, decisions on capital investments should be exercised wit extra care because it usually requires relatively large amount and commitment of resources, such commitment being long-term and once a decision is made, it is very difficult to reverse. Simply stated, capital investment decisions involve critical analysis that require thorough evaluation and analysis. Hence, capital budgeting.

Let us take for example an investment in health care organizations. The nature and characteristics of this kind of endeavor warrant a careful analysis of the investment alternatives. A set of systematic procedures is necessary to ensure that all capital investment proposals are evaluated considering the organization's goals and policies so that the best alternative is undertaken. The penalty for an unwise decision is usually severe. This is why most capital investment decisions are made by top-level management.

With the interest already fixed on health care, first thing to do is to identify the potential project to invest in. Proposals usually come from within the organization. These proposals serve as the potential projects for evaluation and inclusion in the over-all plan for the period. The investment is logged on testing clinics. The next step is to estimate the costs and benefits of the project as well as the expected revenues or cost savings that may be generated. With these estimates, the project will be evaluated. If the estimates from the investment project are found to be viable, then the development of the capital budget for the particular project commences. The project investment will be included with the master budget of the entity along with the other investments. The process ends on reevaluation. Because of the long-term nature of capital investment projects, the estimates are coupled with certain risks. In view of this, an approved project must be reviewed periodically to determine if the project meets the original expectation.

During the process, certain analysis and procedures may be conducted for the evaluation. The procedures vary in every firm. Consideration should be made on the particular investment being evaluated. In evaluation of revenue and related cost, a break even analysis may be used. The focal point of this analysis is the computation of the breakeven sales, where the total revenue equals the total costs. There is neither profit nor loss. This is the point where cost should be controlled to cover projected earnings as well as generate revenue to cover projected costs.

The main concern, however, in every business engagement or project is profitability. The goal is to generate the highest amount using maximized resources. As mentioned earlier, the return on investment is the concern of capital budgeting. The rate of return on investment is the measure whether the project is earning, based on industry averages. It is computed by dividing computed income over amount of investment or capital employed. Other test of profitability using the computed income may be a return on sales or a return on assets which may also be a measure of operating efficiency. Also, there is a return on average owner's equity.