Capital budgeting is the process of determining whether a big expenditure is in a company's best interest. Here are the basics of capital budgeting and how it works.
Capital Budgeting Basics
A company undertakes capital budgeting in order to make the best decisions about utilizing its limited capital. For example, if you are considering opening a distribution center or investing in the development of a new product, capital budgeting will be essential. It will help you decide if the proposed project or investment is actually worth it in the long run.
Identify Potential Opportunities
The first step in the capital budgeting process is to identify the opportunities that you have. Many times, there is more than one available path that your company could take. You have to identify which projects you want to investigate further and which ones do not make any sense for your company. If you overlook a viable option, it could end up costing you quite a bit of money in the long term.
Once you have identified the reasonable opportunities, you need to determine which ones are the best. Look at them in relation to your overall business strategy and mission. See which opportunities are actually realistic at the present time and which ones should be put off for later.
Next, you need to determine how much cash flow it would take to implement a given project. You also need to estimate how much cash would be brought in by such a project. This process is truly one of estimating--it takes a bit of guesswork. You need to try to be as realistic as you can in this process. Do not use the best-case scenario for your numbers. Most of the time, you need to use a fraction of that number to be realistic. If the project takes off and the best-case scenario is reached, that is great. However, the odds of that happening are not the best on new projects.
After you look at all of the possible projects, it is time to choose the right project mix for your company. Evaluate all of the different projects separately on their own merits. You need to come up with the right combination of projects that will work for your company immediately. Choose only the projects that mesh with your company goals.
Once the decisions have been made, it is time to implement the projects. Implementation is not really a budgeting issue, but you will have to oversee everything to be sure it is done correctly. After the project gets started, you will need to review everything to make sure the finances still make sense.