Capital budgets are the key control documents when it comes to the financial planning for long-term investments such as major equipment purchases, land purchases, renovations or new buildings. Capital budgeting identifies how much will be spent for the entire project, tracking each line item separately. It explains how the business will pay for the capital project and determines payback time and method.
Determine Product Scope
Capital budgeting lets project planners define the financial scope of a project. Because capital budgeting begins long before the project begins, it spells out how much money the business plans to spend on each individual aspect of the project. For example, with a renovation, it determines how much it is willing to spend on improving handicap accessibility or installing energy-efficient heating units. Capital budgeting also determines the scope in terms of the length of time the project will take as it also budgets for labor and potential downtime.
Determine Funding Sources
While capital budgeting spells out the details of project expenses, it also details where the money is coming from to pay for the project. These sources might include a capital investment account, cash, bank loans, government or nonprofit grants or stock offerings. Most often, a project will require a mix of those funding channels. The capital budgeting process identifies how much money will be needed from each source and the costs associated with using that funding method.
Determine Payback Method
An important element of capital budgeting is determining the project's payback time. Most businesses expect a new building, new equipment or renovation to eventually pay for itself. Some projects will pay for themselves quicker than others. As there are several ways of calculating payback method, some involving the present value of money and inflation, the capital budget will have to identify which method the company plans to use. It will also include an estimate of how long it will take for the business to realize a return on their capital investment.
Control Project Costs
Capital budgets act as control documents throughout the life of the project. As the project progresses, the project managers track costs and try to ensure that the project stays within budget. When there is an overage or a significant underage, the project managers must provide explanations for the variances and the business must make sure it has money to complete the project.Typically a capital budget for a specific project is maintained until the payback period is complete.
Capital budgets are also used for ongoing capital purchases. These include major repairs, rolling computer upgrades and preventive maintenance. Because some of these type of expenses occur on an emergency basis, capital budgeting allows a business to be prepared in a crisis and not have to incur extra debt. This type of capital budgeting creates a fund that sets money aside for necessary capital expenses, whether they can be anticipated or not.
- FAO Corporate Document Repository: Investment Decisions Capital Budgeting
- "Accounting for Hospitality Managers"; Raymond Cote; 2007
- Accounting for Management: Capital Budgeting Decisions