Capital budgeting is planning capital expenditures and evaluating and selecting the best paths to follow from various alternatives.
The capital budgeting process differs from the annual budget process in that a proper capital budgeting plan will cover the plan for equipment purchases, needs, repairs, maintenance, etc., over several years. In contrast, the capital expenditure part annual budget process anticipates the Company’s plan for all company equipment resources over a one-year term.
Capital Budgeting Process
The first step in the capital budgeting process is determining which capital expenditures to include.
- De minimis expenses. Management should determine the capitalization policy dollar amount. For example, if the capitalization policy were set at $500, any purchases less than that amount would be directly expensed and excluded from the capital budgeting process as it would be an annual small tool or repair and maintenance expense.
- Job costs. All specific equipment job costs should be excluded from the capital budgeting process. If an estimator needs a particular piece of equipment that has use for that job only or plans on a certain amount of small tools, then these items are job costed to that specific contract or job.
- Repair and maintenance versus capital expenditures. Management needs to know the difference between repairs and maintenance expenditures and capital expenditures. Capital expenditures generally create a new asset or add life to an existing asset. These types of expenditures will create benefits for more than one year. Typical repair and maintenance items do not create a new asset or add life to an existing asset. These expenditures would be necessary to repair an asset so its useful life would not decrease beyond original expectations. For example, purchasing a new engine for a vehicle might appear to be a repair because it does not create a new asset. Still, a new engine would extend the expected initial life of the vehicle. Therefore, this expense would be considered a capital expenditure and included in the capital budget.
Categorization and Department Head Responsibilities
To best determine the priority of capital needs, each department head should outline and describe its capital needs and classify them as follows:
- Category A: Asset purchases needed within the near term (one year). Purchases must be made this year.
- Category B: Asset purchases required within two to five years. Purchases will be made more quickly if funds are available or a discount opportunity arises.
- Category C: Asset wish list. Assets or capital expenditures desired but not currently necessary. These assets should be purchased if efficiency dictates or should be recharacterized as Category A or B in future budgets.
Management should establish policies relating to purchase order requirements, competitive bidding procedures, purchase authority, and replacement policy. For example, how often should vehicles be replaced? Who will approve the final purchase decision? Who will investigate the best options and perform actual purchases?
Inventory and Department Head Involvement
Department heads should take an inventory of all assets under their control. This listing should be compared against the overall company asset listing to see if any assets are missing or need to be deleted or added to the comprehensive listing. The department heads should then develop a listing of asset needs according to the above three categories. This listing should include estimated cost, date needed, and what assets will be traded in or sold, if applicable.
Once asset needs have been identified, the next step in the capital budgeting process is to investigate and obtain financing. The following should be considered:
- Lease/buy analysis. A lease/buy analysis should be performed if leasing is an option. Cash flow requirements, holding period, and economic benefit are elements to consider.
- Equipment line of credit. Management should investigate obtaining an equipment line of credit from a financial institution.
- Seller financing. Management should inquire about the availability of seller financing relating to the specific assets purchased. Interest rates and terms should be compared with other traditional financing sources to make an informed decision.
Integration with Annual Budget Process
After the above steps are completed, and the capital budget is formalized, it should be integrated into the annual budget. The capital budget should be projected for as many as five years in advance. The capital budget should be reviewed annually, and the above procedures should be performed annually and modified accordingly.