Budgets, a frequently
used tool, have been around for a long time. Operating budgets seem to be
the most common. Although seldom used to their potential, operating budgets
are ordinarily among the first budgets attempted. The numbers for these budgets
are not difficult to obtain, and most managers will give at least some credence
to their usefulness. Cash budgets are not greatly different from operating
budgets in their preparation and use. In cash budgeting, attention is focused
on the receipt and expenditure of cash. However, cash budgets often
are limited to use by fewer people within a business and often are not
formalized until required by shortages of cash or the high cost of maintaining
cash reserves. In periods of better financial conditions, the inefficiency
of having too much cash often is overlooked.
As a result, cash budgets sometimes fall into disuse
during periods of prosperity. Capital budgeting, however, does not fare well
with many businesspeople. This is due in part to the difficulties of preparing
a capital budget. Estimates of cash flows must be pushed farther into the
future and unfamiliar terms, such as weighted average cost of capital and
internal rate of return, creep into the terminology. The calculations
associated with these terms are often unfamiliar; many businesspeople have
learned to operate with no formal capital budget.
However, used
properly, a capital budgeting process can help to reduce the risk of making
the wrong decision. Capital budgeting is useful as a decision tool.
Accountants, and some of your staff and some managers, probably have been
trained to make the calculations necessary for determinations of present
Investing in values, internal rates of return, and payback periods. The
critical work is the gathering of the information necessary to make the capital
budgeting process more understandable and useful to the business.
Life Cycles
Products and projects,
like people, have life cycles, as shown below:
They all go through
similar stages: conception,
birth, growth, maturity, decline, and ultimately death. Each stage requires a
certain degree of attention. The applicability of capital budgeting
concepts to new projects or new products extends beyond application to new
ventures. It can be used to consider the replacement of existing product lines
and even to cost reductions in existing lines in the current or future periods.
Four basic sets of
actions occur in a capital budgeting plan: (1) proposal solicitation or generation, (2) evaluation, (3)
implementation, and (4) follow up. We shall examine each in some detail.
Action-1: Proposal
Solicitation or Generation
- The first step in proposal generation is evaluation of
your present status.
Many factors should be considered when making an evaluation of status. It
is particularly important to pay attention to your position with respect
to the availability of management talent, technological talent, financial
and market positions, sources of labor, and the availability of markets
for your product. Example: Assume you manufacture heavy
cast-iron cylinders for which “the market” is located in
south-eastern-un-belt-states. Therefore, one particularly important factor
is the cost of transportation of the product to the ultimate user. At
least two alternatives are available: Locate the plant in the area where
the product is consumed or acquire manufacturing facilities on low cost
transportation networks, such as rail or water. Another option may be to
redesign the product. For example, assume you find that you can
manufacture the cylinders out of aluminum with the installation of a
tooled steel sleeve instead of the cast-iron cylinder. The product now
requires different raw materials, different processing and handling, and
different packaging and shipping. The new product may change your
marketing plans, and a proposal for capital expenditures may result.
- The questions that you should answer are standard
business planning questions:
“What do we do best?” and “Where are we going?” These
require an evaluation of your business plan. The objectives formulated as
a result of these questions may point out potential projects requiring
capital expenditures. Decisions relative to capital expenditures may be
made at various levels within the organization depending on their size and
significance. Rules for decision making should be in Long-Term Assets and Capital Budgeting
consistently applied at whatever level of management you have established.
- Cost reduction programs may be a rich source of capital
budgeting projects.
Cost reduction programs generally carry with them less risk than any other
form of project, because they have obvious cost justifications. Potential
payback periods and returns on investments can be calculated readily
because the programs are intended to improve the cost efficiency of existing
projects. Such programs, if adopted, help make employees feel that they
are a part of the decision-making process, because a large part of these
proposals usually are generated from line employees.
- Ideas from employees and customers are also often low-risk
sources for increased profitability.
Marketing or sales personnel meet with customers on a regular basis. They
should be able to determine current market needs and may assess demands
not being met. Often these opportunities can be exploited with little
additional cost to you. By taking advantage of unmet market needs head-on,
competition can be avoided and you may successfully expand your market
presence. To encourage new ideas and market opportunities, you may use
either or both of these avenues: (a) Encourage entrepreneurship by
allowing self-interest to work for you. Monetary incentive programs for
sales staff and other employees are extremely effective in generating
growth-producing ideas. (b) Survey customer needs on a regular basis to
learn of potential growth possibilities.
- Competitors are often a good source of potential growth
producing ideas.
Sometimes it is beneficial to let competitors pioneer certain new
products. Letting them take the risks often eliminates these products from
your consideration as a result of their lack of profitability or outright
product failure. Of course, this gives the competitor a head start on
successful ventures.
- Product matrix analysis sometimes will disclose holes
in the market.
- Often new ideas are available through purchase from
independent research and development (R&D) firms or may be generated
by your own R&D efforts.
- Trade shows, conventions, seminars, and publications
are good sources of potential ideas.
In this case, you are not paying for the development of ideas but instead
are picking other people’s brains.
- You may decide on vertical growth—being your own
supplier or marketer.
Supplying yourself with components, services, or raw materials is a source
of potential profit. Setting up your own distribution network outlets can
be profitable as well. For example, some utilities have diversified into
fields such as coal production and transportation in order to guarantee a
source of supply and to reduce the risk associated with fuel cost
variations. In this way, vertical integration provides them with
additional revenue-producing sources of unregulated profit. Some natural
gas utilities sell gas appliances. Being “the gas company” gives them an
entrée for marketing the appliances. Customers trust a company that provides
gas to know which are the best gas appliances.
- You may want to grow horizontally through product
diversification or buying of competitors.
- You can expand the use of current technologies. Constantly ask: “What can we do with what we know or
what we do best?” How adaptable is the current technology to meet new
product innovation or new processes? The opportunity here is to have
growth-producing ideas with minimal risks. If you have learned to utilize
your technologies efficiently, further endeavors with known technologies
generally carry less risk than ventures into new and yet untried
technologies.
- Expand the use of your existing equipment. In-place equipment may not be fully utilized.
Increased utilization through subcontracting and selling of time on
equipment or process capabilities will better utilize existing capital
resources with little additional risk. More use of the fixed-cost base
increases efficiency and at the same time produces additional cash flows.
Action-2: Evaluation
of Proposals
After proposals have
been generated, you must evaluate competing proposals in a consistent manner to
determine which proposals merit further consideration. There are basically four
steps in the evaluation process.
The most critical step
is a qualitative evaluation: Is this proposal consistent with the strategic
plan of the business? If not, no future consideration is necessary. If yes,
further analysis is indicated. A lot of time, effort, and money can be wasted
on things that do not fit the direction you are determined to go in.
Define the evaluation
process. Set up a system that will be applied consistently for all proposals:
(a)Estimate costs accurately and in the same way for all proposals, (b)
Estimate the benefits consistently. (c) Use the same time constraints. (d) Use
the same method for calculating the net benefits.
Qualify your
information sources. When gathering information, you must evaluate the
reliability and accuracy of the source of the information. For example: (a)
Engineers often underestimate the time (and costs) necessary, (b) Salespeople
frequently overestimate potential sales. You should ask: (a) Who is
providing the information? (b) How accurate were their last predictions? (c)
How often have I relied on this source before? (d) Do my competitors use this
same source?
Install the process.
To install the process properly, all affected persons must understand how to
use it: (a) Develop capital purchase evaluation forms to be used throughout the
organization, (b) Explain the forms and the evaluation methods to all affected
persons, (c) Use the system consistently to evaluate proposals, (d) Provide
prompt responses to applicants as to why their proposals were or were not
accepted.
Action-3:
Implementation of a Proposal
In the implementation
phase, effective project management requires a firm line of control. First,
define responsibility. You need to know who will be responsible at various
stages in the proposal’s implementation to ensure accountability and control.
It is important to consider the time and the talent of the individuals involved
and to match their abilities to the needs and responsibilities of each key
position in the implementation process. Few things affect the failure or
success of a product more than the match or mismatch of key personnel at
critical steps in project implementation.
Next, establish
checkpoints by setting goals and objectives for milestones at successive stages
in the process. Review your decisions regularly, before the next costly step is
taken and when progress can be compared with established standards. You may
choose to terminate a proposal at some point short of completion if it appears
that the project is exceeding cost projections or failing to meet benefit
expectations.
It may be necessary to
change the budget. This may seem a radical idea. However, if budgets are
managed properly, changing a budget is nothing more than considering better
data as they flow into the system. Budget changing should not become a
self-fulfilling prophecy. Budgets are planning tools, and, as such, comparisons
between actual performance and projected performance often will show how well
or poorly your project is proceeding. Updating budgets for better control is
useful in order to improve the quality of decision making for the project.
When budgets are used
for control, regular feedback of information is needed. The establishment of
reports is another critical element in the implementation phase. The amount of
reporting is a function of balancing the risk of ignorance against the cost of
reporting. When reports are generated on a regular basis, you can ensure
maintenance of adequate control of the project.
Action-4: Follow-up
Neglect near the
concluding stages of a project can result in unnecessary delays, increased
risk, and higher costs for the discontinuation or normal termination of a
product’s life cycle. In the follow-up step, you should review the assumptions
under which the original project was accepted, determine how well those
assumptions have been met, review the evaluation systems that were in place,
and, finally, evaluate the implementation of the project. It is at this point
that an overall review of a project will show you how well it was planned, how
well the budget projected reality, and the necessary areas where improvement in
the system will help better evaluate future proposals.
There is really no
doubt that all projects eventually will find themselves in the decline phase of
below graphic. Predicting when this will occur and planning appropriate actions
for when it does can be time-and money-saving.
An important part of
the follow-up step is the prediction of discontinuance or normal termination
dates for the project. This allows for the timely introduction of proposals for
the replacement project. Capital budgeting is cyclical, allowing you to control
growth on a continuous basis. The follow-up stage naturally reverts back to
proposal generation as each project approaches termination.
Futher worth reading
about capital budgeting:
Source:
accounting-financial-tax.com/2008/09/capital-budgeting/
