The capital budgeting process generally revolves around a spreadsheet of wishlist projects. It’s called a wishlist for good reason: frequently, items on the capital budget wishlist do not survive the inevitable budget cutting process, and even projects that are budgeted are often substituted for more critical items.

These capital budgeting vs capital expenditure (CapEx) differences are indicated in the diagram below:

What are the root causes of this capital budgeting discrepancy, what are the impacts, and what is solution to more closely aligning your capital budget and project execution?

Capital Budgeting vs Capital Expenditure Requests

What is the difference between capital budgeting and capital expenditure approval?

Capital Budgeting

Most organizations conduct an annual planning and budgeting process. The goal is to align all areas of an organization towards achieving strategic objectives. Human resource, sales, and operational planning are key elements, but the capital budget is the most critical. Progress and growth are dependent upon effective investment in new capacity and technologies, as well as the sustenance of existing infrastructure.

In determining the optimal capital project portfolio, executives must balance the risk and return expectations of stakeholders with practical resource and financial constraints.

It is only once the capital expenditure budget is set, and the resultant growth and savings forecast, that the overall performance of the organization can be planned.

Capital Expenditure Requests

Typically, including a capital project in the budget does not automatically release funding approval. Items included in the capital budget are not fully designed and evaluated until their inclusion in the budget is confirmed.

A CapEx request form with an attached business case is normally required to formally initiate a project and allocate an approved capital expenditure budget. Approval of a capital expenditure request (CER), also called an Authorization for Expenditure (AFE) or Capital Appropriation Request (CAR), is subject to executive approval.

The required approvers are determined by the delegation of authority matrix and value. The budgetary status of an initiative will, however, impact the CapEx approval sequence, with unbudgeted initiatives normally requiring further levels of approval.

Zero-based Budgeting vs Budget Buckets

The method of capital allocation varies by organization, and ranges from opportunistic budgeting to detailed zero-based budgeting.

Opportunistic budgeting

Opportunistic budgeting is based on a continuous evaluation of high value investment initiatives. No upfront attempt is made to constrain the capital expenditure budget to a set amount for the year.

This discretionary budgeting approach is effective when it allows all valuable projects to proceed and doesn’t arbitrarily allocate capital budget when not really required.

This method of budgeting is commonly observed when executive managers have a high degree of operational autonomy and can make independent capital allocation decisions. This is normally constrained to privately held or small corporations.

There is no budgeting gap in this scenario as there is no pre-defined budget!

Budget Buckets

Bucket budgeting is a common form of capital planning and budgeting in mature environments. In a steady operational state, the requisite amount of CapEx spending is roughly aligned to the annual depreciation charge.

Accordingly, management stakeholders may be confident about allocating budget buckets by operating division. These business units are then able to optimize their expenditure within this overall CapEx budget ‘bucket’ capacity.

The budgeting gap in this case is simply the difference between the actual CapEx and the budgeted amount, and there is no reconcilable analysis of differences.

Zero-based Budgeting

The most prevalent form of capital budgeting is to undertake some form of zero-based capital budgeting. The key principles here are that there is no automatic ‘carry-forward’ of capital expenditure allowances, and that each initiative must be justified on its merits.

In practice, most organizations adopt a hybrid approach: top-down capital budget buckets are assigned, and operating units are required to select the optimal portfolio of projects within this capital capacity constraint.

Zero-based budgeting provides the most granular level of control over capital expenditure and will deliver the highest return on investment, provided that the budget is maintained in a way that provides adequate flexibility to re-evaluate and re-prioritize expenditure as required.

This blog focuses on the capital budgeting gap related to this initial list of ‘budgeted’ CapEx projects and the actual capital projects executed during any given year.

Budgeted vs Unbudgeted CapEx

Budgeted CapEx

If an initiative is included in the capital budget, a budgeted amount will be allocated. Typically, the budgeted capital expenditure is by fiscal year. For multi-year projects, the capital budget amount will be allocated overall and by fiscal year.

An initiative is considered fully budgeted when the detailed business case cost is less in total and by year than the budgeted amount.

Unbudgeted CapEx

Unbudgeted initiatives are those that were not included in the original budget at all or were included for a lower value.

Unbudgeted CapEx initiatives may require additional levels of review but can still be approved if considered sufficiently urgent and valuable.

For CapEx tracking purposes, it is best practice to keep track of both the original annual budgeted amount and the final approved amount.

Budget Transfers and Substitutions

Many organizations are required to keep their capital expenditure within the budgeted capital expenditure limits. They achieve this through a combination of budget transfers and substitutions.

Budget Transfers

Once the business case stage of a capital planning process is reached, or even during the execution phase, it is common to identify likely cost or schedule over-runs.

To ensure the budget allocation does not exceed the anticipated CapEx budget overall, it may be required to initiate budget transfers.

Budget transfers involve the transfer of budget between work breakdown elements of a project, between years, and between projects.

Project Substitutions in Capital Planning

Frequently, unplanned capital expenditure is required on initiatives that were not included in the budgeted project portfolio.

For example, because of environmental changes, and a reassessment of the costs and benefits of the various projects, it is often necessary to adjust the priority project portfolio.

These project substitutions are a natural part of capital expenditure optimization, and the portfolio control mechanisms in place should facilitate the required agility.

Control over Budget Reassignments

It is best practice to provide a governance and approval framework over budget transfers and substitutions to ensure that corporate operational and strategic priorities continue to be supported.

For example, there may be strong demand to redirect funding earmarked for innovation to urgent business-as-usual sustenance replacements. Doing so may support the organization in the short-term but fatally impair its ability to compete successfully in the future.

Causes of the Capital Budgeting Gap

CapEx is triggered by both the anticipated and predictable replacement of end-of-life plant and equipment, as well the by unpredictable real-world demand caused by unplanned capital replacements and environmental factors.

These underlying reasons for changing the project portfolio mix are described below.

External Environmental Changes

Actual capital expenditures varies from what was budgeted due to changes in the operational environment.

Technological upheaval, regulatory changes or the actions of competitors may necessitate a re-evaluation and reprioritization of projects.

For example, the introduction of tariffs may impact on your source of supply and demand and may require an urgent reassessment of the location of your manufacturing facilities to enhance cash flow.

Internal Operational Changes

The urgency of capital projects may be radically altered by unanticipated degradation and early obsolescence of your operating capital base.

For example, items of plant may require urgent asset replacement due to breakdown or accidental damage.

Financial Capacity Changes

Capital for investment is sourced from cashflow generated by operating activities and external financing.

Changes in the profitability of your business activities or the support of financial stakeholders may result in reduced or increased funding capacity.

For example, if a new product line outperforms revenues expectations and additional investment in that line is required to keep up with market demand.

Human Resource Capacity Changes

Both business and technical resources are required in the successful delivery of large capital projects and key human resource capacity is a very practical constraint on project portfolio selection.

Changes in the availability of key people will impact on the projects that can be successful delivered.

For example, unanticipated departure of an essential technical resource may require postponement of an anticipated project that relied heavily on their input.

Annual Budgeting and Project Carry Forward

Capital budgets tend to be controlled by accountants like operational expenditure budgets on an annual basis. It is logical to budget operational expenditure, including fixed costs such as rental and variable production costs, on an annual basis, as this accommodates all season fluctuations.

Capital projects, however, seldom fall neatly into a fiscal year, and expenditure is likely to be required at any time of year, and projects will frequently straddle fiscal accounting periods.

For example, some of the projects that were planned for this year might need to be deferred, as the projects that were expected to be completed last year were not done on time and continue to consume capital and human resource capacity.

Reliance on External Suppliers

Most operational expenditure is directly controllable by an organization.

Capital project expenditure, however, is typically highly dependent on external suppliers. Most capital investments involve the procurement of high-value goods and services from once-off or occasional suppliers. These suppliers may themselves be dependent on original equipment manufacturers and an extended supply chain to produce, ship and deliver all required components and services in accordance with the planned project schedule.

For example, delays in any one of a tight network of project activities may cause project schedules to slip beyond the original anticipated timeframes.

Budgeting Estimation Errors

Capital purchases and projects are by their very nature irregular activities. Typically, sponsors only have limited knowledge and experience of the required scope, cost and schedule of the initiatives included in the budgeting phase.

Once the more detailed business case and financial analysis are prepared, the more accurate cost and delivery timeframe estimates may require a rescheduling of projects.

For example, the detailed business case may identify additional scope and cost components of a critical initiative, requiring other, nice-to-have initiatives to be deferred.

Sandbagging of CapEx Forecasts

Once capital allocation to an initiative is approved, project sponsors are highly motivated to use the funding capacity, for fear of it being redirected elsewhere next year.

Sandbagging of CapEx forecasts is where sponsors maintain that the CapEx is still likely to be spent, even as it becomes increasingly obvious that the budgeted investment will not be completed on time.

This is sometimes referred to as the snow plough or shark-fin effect, where the forecast CapEx expenditure shows a suspiciously unlikely, increasingly steep, upward curve in the final quarter of the fiscal year.

For example, when a project starts late, the project manager and sponsor will often continue to forecast that the budget will be spent, and the expenditure forecast gets pushed back into the last quarter.

Affect of Gaps between Project Budgeting and Execution

The consequences of significant gaps between the planned capital projects portfolio and the actual capital projects portfolio can be significant.

Strategic Failure

The big risk of capital project selection is to keep funding urgent sustenance initiatives at the expense of strategically important, longer-term, initiatives.

Every time an urgent unbudgeted initiative is prioritized over a budgeted initiative, great care should be taken to ensure this won’t prejudice achievement of critical strategic goals and objectives.

In the long term, maintaining current business-as-usual operations is less important than investing in next-generation products and services to remain competitively successful.

For example, capital funds and resource may be redirected to the replacement of failed equipment at the opportunity cost of not installing the necessary technology for a new product.

Operational Disconnects

The purpose of annual operations planning is to ensure all aspects of the organization are aligned. Capital investment plans will likely have a direct impact on expected growth, savings, cashflow and human resource requirements.

By agreeing on a strategically aligned capital project portfolio, each supporting area can then make optimal decisions to support this plan. When the actual project portfolio deviates from the plan in an uncontrolled manner, those decisions and actions may no longer be appropriate.

For example, if a budgeted initiative to install new technology does not proceed as planned, then some of the related activity including hiring and training of related staff and the execution of related sales and marketing activities may be wasted.

Resource Under Utilization

Reliable and coordinated execution of a capital plan will tend to deliver better results than erratic re-prioritization and refinement of project initiatives, even if individually the substitute projects may appear more beneficial. This is because capital projects are seldom isolated and have an impact on both upstream and downstream plans and activities.

Practically, the impact on related projects and activities is seldom fully factored into the evaluation of alternative project selections. It is important, therefore, to maintain a portfolio perspective to ensure cohesive alignment of initiatives as opposed to incremental, case-by-case evaluation and approval.

For example, if an upgrade of the paint shop is switched out at the last minute for a nominally more valuable replacement of an ageing production line, any related activity predicated on the paint-shop upgrade (such as new system implementations, staff training, consumable purchases, preparation of updated marketing sheets) may be wasted.

Under Performance

For many organizations, capital budgets are not fully utilized, leading to stunted growth and lower profitability.

CapEx underspend is due primarily to project delays and sandbagging of expenditure forecasts. As a consequence, capital is not redirected to alternative initiatives, and the capital capacity is wasted.

For example, if budgeted projects are not started or completed as budgeted, the associated revenue growth or cost savings will not be realized.

Aligning Capital Budgeting and Project Execution

So, how can one balance the dual objectives of portfolio optimization agility and planning certainty?

Project Proposal Quality

The differences between budgeted project portfolio selection and actual portfolio execution can be minimized by effectively selecting the most valuable projects in the first instance, in the budgeting process.

If the wishlist of project proposals evaluated in the budgeting cycle is too flimsy and ill-conceived, it is highly unlikely that the most important projects will be correctly identified and costed. Conversely, investing excessive effort in developing detailed business cases at the budgeting stage may be wasted if it is unlikely for many of the initiatives to progress.

An effective budgeting process should ensure that an appropriate level of analysis is performed at the proposal stage to fairly evaluate and rank projects. This will help ensure that an optimal portfolio selection is performed up-front and reduce the volume of unbudgeted project substitutions later on.

Project Scoring and Ranking

Whilst all critical aspects of a project should be considered at the proposal stage, these may be more qualitatively expressed in the proposal stage, and cost estimates suitably ranged based on previous experience.

An effective scoring model for capital projects should include cost, benefit, risk, and strategic alignment dimensions.

At the proposal stage, cost estimates may vary widely, particularly for initiatives which the organization is inexperienced in delivering. To facilitate evaluation, the planning accuracy should be considered and an appropriate contingency factor applied.

Benefit assessments at the proposal stage should be tailored to the nature of the project.

• For example, simple capital replacement initiatives may be assessed more on risk mitigation benefits, and savings initiative may be assessed on relative savings potential.

Project risk should be assessed from both the perspectives of inaction (and corresponding opportunity costs) and implementation.

• For example, the risk of inaction is effectively the urgency of the project and can be effectively assessed via a heatmap analysis of likelihood and consequence of inaction.

Implementation risk of all projects should be explicitly considered to ensure alignment with the anticipated project benefits. Implementation risk is expressed as the confidence of successful project delivery.

• For example, an initiative will attract a high confidence score if it involves familiar technology, clearly defined scope, and a reliable business partner.

Strategic alignment is arguably the most important scoring dimension of all. Every initiative should be aligned to one or more strategic objectives of the benefiting area. Projects that are most aligned should naturally rank highest when prioritizing capital allocation.

• For example, when considering growth and capacity investments, the initiative that is most aligned with the organization’s strategic priorities should rank highest.

An individual project score is normally a function of its cost, benefit, risk, and strategic alignment assessment. By effectively scoring and ranking projects in this way in the budgeting cycle, the volume of substitutions later-on is significantly reduced.

Budget Control by Investment Reason

When performing the capital distributions, it is beneficial to classify the nature of the investments being budgeted. Typically, CapEx investments are categorized as replacement, savings, growth, and compliance projects. Compliance investments may include safety, environmental and regulatory projects.

The key distinction between these categories of investment is how they are scored and ranked. Whilst replacement initiatives are largely focused on urgency and cost, savings initiatives are more financial benefit focused. Growth initiatives are generally weighed more towards strategic outcomes. Compliance initiatives have their own metrics (e.g., for greenhouse gas abatement) and some regulatory initiatives will need no justification at all as they are mandatory.

Strategically, organizations will generally want to ensure that the capital investment in replacement initiatives is capped, so that funding is available for growth. By maintaining an investment reason classification against all initiatives, it is easier to ensure that any necessary substitutions are of the same type to avoid strategically important growth initiatives being substituted by urgent capital replacement projects.

For example, when unbudgeted replacement initiatives are approved, executives will want to ensure that any substituted projects were also replacements to avoid an unanticipated change in the capital allocation mix to the detriment of future success.

Global Assumptions and Financial Recalculations

To achieve fairness and consistency of project selection, and reliability of project outcomes, the capital budgeting process should make consistent use of global assumptions.

Key assumptions that affect all initiatives include interest rates, exchange rates, and discount (cost of capital) rates. Other global assumption may relate to internal labor rates, market growth rates or selling prices.

All financial analyses should reference these common planning parameters. When conducting scenario planning, this planning parameters may be varied accordingly. When global parameters are adjusted, all impacted projects financially should be consistently recalculated, the project re-evaluated and reprioritized accordingly.

For example, higher interest rates will have a material effect on the cost of capital and the net present value (NPV) of future benefits that may result in some capital projects being deferred.

Single Source of Truth

A key principle in capital allocation is that investments should always be viewed from a portfolio perspective. The question should not just be “is this a good investment of time and money,” but rather “is this the best investment, given a range of alternatives.”

In many legacy environments, maintaining visibility of the entire project portfolio is hampered by the project control mechanisms in place. Commonly, the backlog of projects is distributed amongst multiple spreadsheets in various locations.

By keeping track of the evolution of a project from the initial ideation stage, all the way through the capital budgeting, business case approval and project execution phase, decision makers can have greater confidence that they are making the best possible portfolio decisions.

For example, executives will not want to approve a good project today, if they know there is an even better proposal in the works they could otherwise approve tomorrow.

Collaboration and Approval Workflows

Obtaining the best capital project outcomes is a collaborative effort that requires the input and experience of all relevant stakeholders.

During the capital budgeting process, it may be necessary to engage technical experts, business unit managers, project managers, finance specialists and procurement officers to ensure that initiatives are well thought through, all viable options have been considered, and that candidate projects represent the best approach to identified challenges and opportunities.

Engaging with all parties in an open and collaborative manner early in the budgeting process closes the gap between the budgeted project portfolio and project execution by ensuring alignment between participants sooner than later.

For example, by including a central procurement officer in the portfolio planning process, it may help identify that a key supplier is overloaded with work in another area, and that a proposed project should be deferred.

Risk and Contingency

By their nature, all capital projects carry a degree of inherent risk, as they relate to an uncertain future. For an approximate investment today, organizations are hoping for an approximate return tomorrow.

Whilst the future may be unpredictable, this inherent risk can be mitigated. Every project should be assessed for sensitivity to key input assumptions. By conducting scenario-based sensitivity analyses, the range of likely outcomes can be assessed.

The ranges will impact on both cost and benefit projections. Presenting approvers with a confidence interval of project outcomes is much more realistic than presenting a single point estimate. The range of potential outcomes may indicate a potential loss as well as potential super-returns.

Based on an organization’s risk tolerance, an appropriate amount of cost contingency can then be provided. Because of the portfolio effect, this contingency reserve can be pooled and optimized, as it is unlikely that all projects will go well or badly, and the offsetting effects will to some degree offset each other.

Keeping track of contingency reserves and releasing these only as required is important to avoid every project being allocated and consuming its full contingency reserve allocation.

For example, by estimating worst, best and most likely expenditure and returns will help decision makers compare the relative variability of individual projects and retain an appropriate amount of pooled contingency reserve.

Artificial Intelligence

Artificial intelligence (machine learning) is well suited to pattern recognition and can help organizations more effectively identify the features of projects that lead to successful project outcomes.

To enable machine learning, organizations need a robust and reliable data source. Consistent classification and evaluated outcomes of past projects is necessary for machine learning algorithms to identify the likelihood of success of future projects.

Actual project experience will also help forecast capital expenditures, as patterns of over-expenditure and project delays expose themselves.

Informed by this objective evidence, executives will be empowered to make optimal budgeted project portfolio selections and monitor project execution to successful completion.

For example, from the historical analysis of similar projects, an AI-powered CapEx planning solution can help determine appropriate budget and schedule contingency provisions for future projects to guide portfolio selection.

Budget Versions

Capital budgeting need not only be done once a year. Digitalizing and automating the budgeting process and workflows will enable budgeted capital project portfolios to be reassessed more frequently.

Budget version comparisons at a project level will help management keep track of movements and ensure that operational impacts are effectively communicated to all stakeholders.

For example, an organization may elect to redetermine its budgeted project portfolio on a quarterly basis, refining the project selections in light of the prevailing operating environment, whilst remaining within capital and resourcing constraints.

Closing the Gap between Capital Budgeting and Capital Expenditure

Project substitutions are a natural part of capital expenditure optimization, and your project portfolio control mechanisms should facilitate this agility. But your governance framework should ensure that important strategic initiatives aren’t impacted.

The causes of these differences include both planning errors and changes in the internal and external environment.

By implementing an effective project portfolio planning and budgeting solution, you can minimize the number of unplanned and unbudgeted projects that get executed. This is achieved by applying rigorous project evaluation, scoring and ranking methodology, and collaborating broadly, to ensure that the most strategically aligned, highest value, lowest risk projects are executed first.

In a dynamic operating environment, some degree of project substitution will always be necessary. This process can be managed through budget versions, or ad-hoc substitution requests, but in all cases executive management should have visibility of any expedited or deferred initiatives. By classification of projects by investment reason, continued investment in both replacement and strategic initiatives can be assured.

Artificial Intelligence and Machine Learning promise enhanced insights into capital project sensitivity analysis, portfolio optimization and expenditure forecasting but require access to consistent, accessible, and reliable historical data.

Spreadsheet-based processes are a common cause of the capital budgeting gap. Transitioning to specialized capital budgeting software will help you plan better and execute with greater confidence to maximize your return on invested capital.