Written by: Richard Frykberg

What is Capital Budgeting?

Capital budgeting is the equivalent of preparing your “shopping list”. You don’t need one, but you might face the wrath of your partner if you return home without the eggs! This blog looks at the role and importance of capital budgeting to effective capital expenditure management. The best practice for effective capital budget management within SAP is outlined together with proposed tools for connecting your capital budget items and capital expenditure requests (CER’s).

Overview of Capital Budgeting

Capital budgeting is the process of conducting a holistic analysis of your needs and wants and creating a short-list of the most important things that you can afford. Capital budgeting is a critical financial process that goes beyond a simple analysis of needs and wants. It involves making strategic decisions about how to allocate financial resources to various investment opportunities, projects, or assets that will yield returns over an extended period. The process is typically carried out by businesses, organizations, and even governments to ensure that their limited financial resources are allocated efficiently and effectively.

Capital Budgeting versus Operational Budgeting

Capital budgeting relates to capital expenditure (Capex): purchases that deliver long-term financial benefits and are capitalized on the balance sheet of an organization. Operational budgeting applies to on-going business-as-usual expenditure, the benefits, and costs, of which are recognized immediately. Understanding our shopping list analogy, eggs would really form part of our Opex budget, as we’d expect to consume them relatively quickly. A new frying pan, however, may be a better domestic example of a capital budget item, as its benefits will likely accrue over many years!

Demand Management

Capital budgeting assumes that that there will be a demand for capital expenditure. This is invariably the case: as organizations grow, they will need to continuously replace and expand their capital base of fixed assets and intangible property. Collating and ensuring the completeness and validity of your shopping list is important to ensuring that budgeted is not wasted on things you already have or don’t really need and does not miss-out on things that would really benefit the household. Identifying and gathering up all budget requests is an essential part of the capital budgeting process.

Investment Reasons

Like your “shopping list” combines the essentials with a few little luxuries, so too does your capital budget. The primary investment reason may simply be replacement of existing plant and equipment. However, other important investment reasons include savings, growth, compliance, and transformation. Without expanding the capital base, and including new cost-saving technologies, or adapting to a rapidly changing competitive environment, organizations unable to prosper or achieve their strategic goals efficiently.

Resource Constraints

Elon Musk probably doesn’t need to worry about drawing up a shopping list. Budgeting only applies where there are constraints on your resource capacity. In addition to funding capacity, this may include human resource and infrastructure capacity constraints. In our shopping list example, in addition to your credit card limit, you need to consider your carrying capacity and the space in your cupboards when you get home!

Capital Budgeting Techniques

Capital budgeting is a fundamental financial process that aids organizations in making sound investment decisions. When it comes to capital budgeting techniques, two primary approaches are commonly practiced: bucket budgeting and zero-based budgeting. Each of these techniques has distinct characteristics, advantages, and limitations which we look at here:

Bucket Budgeting

The simplest approach is to perform a top-down allocation of a capital budget to amount to each operating unit. This capital budget is based on prior expenditure and would typically exceed the annual depreciation charge when in a growth phase and may be less than the annual depreciation charge when the organization is going through a period of consolidation. This is similar to leaving the credit card behind, and withdrawing a fixed amount of cash, based on prior experience, before heading off on a shopping spree – any temptation to spend beyond the allocated budget is effectively curtailed!

Zero-Based Budgeting

In a zero-based budgeting paradigm, capital expenditure budgets are not simply an extrapolation of prior patterns but are based on a fresh assessment of strategic value of each investment on an annual basis. These zero-based budgets are developed bottom-up based on investment proposals. To enable prioritization of budget allocation, financial metrics such as Payback Period are typically calculated as a basis for project selection. This is akin to preparing a shopping list including all items and then applying an essential vs nice-to-have assessment on each item and then crossing items off with reference to price, until the total is within our financial capacity.

Capital Budgeting versus Capital Expenditure Requests

In a business context, capital expenditure requests are the final approval for the initiation of an initiative. If your “shopping list” is your capital budget, then a capital expenditure request is the phone call you make home to your partner to get approval for an unplanned expenditure on that in-store promotional item.

Benefits of Capital Budgeting

Some of the key benefits of a zero-based capital budget, or a detailed “shopping list” for that matter, are outlined below.

Capital Budgeting Helps with Strategic Prioritization

A key evaluation criterion for the prioritization of investment proposals is the degree of strategic alignment. Projects and items that are most important to achieving strategic priorities should be assigned budget first. The capital budget thus provides an effective representation of funded strategic priorities to help align the activities of an organization. Unfortunately, many nice-to-have luxuries fail to make the list for organizations, or for ourselves!

Capital Budgeting Makes You More Efficient

Without the management control of a budget, every capital expenditure request would need to be reviewed in detail. However, with a budget to reference, approval of expected expenditure within budgeted amounts can be expedited.

Capital Budgeting Allows You to Make More Confident Decisions

The fear of approvers when there is no budget, or when bucket budgeting is employed, is that a more important capital expenditure request may be forthcoming. Most requests have merit; the fiduciary responsibility of management is to pick the very best items. And the worry that there may be a more valuable around the corner is key reason for delay in capital budget approval. And for excessive window-shopping!

Capital Budgeting Should Not be Prescriptive

Whilst a capital budget serves as an important management control and help align all functions of an organization it should never be considered fixed. The overall quantum of the capital budget may be capped as it will be based on an organization’s funding capacity. But the composition of the budget – the short-list of included items – should be flexible in a changing environment.

In the current operating environment, impacted by pandemic after-effects, wars, climate change, advances in technology, supply chain disruptions, resource shortages, inflation and rising interest rate hikes, assumptions have almost certainly changed since the budget was prepared 12 months ago! What is important is that budget can be reassigned effectively and efficiently reconciled to provide management with the confidence that the most important initiatives are being implemented. So substituting a wok for a frying-pan may be a valid outcome!

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IQX CAPEX combines a SaaS solution for demand management and business case development with ready to run Fiori Applications to help SAP customers prepare effective “shopping lists” and get the most out of their key resources and funding capacity.

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