Question

While the operating budget process is underway in June, the capital budget process must also begin. Describe what should be happening in the capital budget

Answer 1

While operating budget process is done on an annual basis and focuses on the activities important for the day-to-day running of the company, a capital budget focuses on long term asset purchase or disposition and generally has a time horizon of 5-10 years. The main objective of the capital budgeting process is to maximize profit either increasing revenues or by reducing costs.

A capital budget process typically has 5 steps , as follows :

1. Identifying and evaluating potential business opportunities : The process starts by identifying potential opportunities available. An organization will most likely have numerous choices to consider. For instance, if an organization is looking to grow its presence to newer locations, it may choose to expand at its current location or acquiring a bigger space in another area. Accordingly, every alternative must be assessed to perceive what makes the most budgetary and strategic sense. After evaluating all such opportunities, the organization has a list of identified opportunities that it may want to pursue.
2. Estimating Implementation and Operational costs : Once they have identified a list of opportunities, the next step revolves around estimating the cash flows in terms of implementation and operational costs required. This requires extensive research and evaluating both internal and external options. For example, if a company is planning to upgrade its ERP systems, then it needs to understand from existing employees about the repercussions of a changed ERP system and involve any training as well R&D costs. Along with this, it would also take all pricing quotations from various vendors to understand the cost breakup for implementing changed systems.
3. Estimating Cash flows : Once the operational and implementation costs are identified, a firm needs to estimate the cash flows. These should ideally lead to increased cash inflows (more revenues) or decreased cash outflows( reduced costs).
4. Identifying risk components : The next step involves assessing risk associated with the alternatives as well as the degree of such risk. Various options to mitigate such risks are also identified at this stage. Once the cash flows are matched against risk assessment , the organization makes a decision whether to go ahead with the identified opportunity or not.
5. Implementation : Finally, the last step revolves around implementation of the alternative., if the organization decides to go ahead with it. A detailed implementation plan, divided into various phases, is laid our for implementation, including a timeline with key project milestones to be achieved over a particular period of time.