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The Capital Budgeting Process

Written by: Richard Frykberg

The capital budgeting process rolls around annually. It’s a time of year many dread, with too many meetings and too many late nights. It’s often associated with stress & frustration as a company plans its priority initiatives for next year.

Project Managers guestimate and Project Sponsors desperately overselling project promises to make the inevitable budget cut. Executives fearful about the choices they make. Back and forth with questions and versions until finally, the final capital budget allocations are confirmed. A big sigh of relief, as the ‘budget’ is reverently committed into the hands of the Capex Controller. Someone to keep track of what was finally agreed. And who will spend the next year reconciling to what is actually done.

But what is the real purpose of all this frenetic activity? And how can modern capital budgeting systems radically transform this legacy process to produce dramatically better outcomes for the organization, and relief for every person involved?

A Typical Capital Budgeting Process

Here we describe the objectives, mechanics, and outcomes of the typical capital budgeting process.

The Purpose of the Capital Budget

The primary objective of the capital budgeting process is to enable Financial Planning and Analysis. Chief Financial Officers are obligated to inform investors of the organization’s expected financial outcomes and ensure solvency. Whilst business-as-usual activities are relatively easy to extrapolate, it is the cost and impact of strategic projects that are harder to assess.

The capital budget seeks to provide certainty as to the financial statement impact of an approved project portfolio. In a steady state environment, this capital reinvestment should at least approximate the annual depreciation of the current capital base. However, to keep growing, an organization will need to invest more capital, more productively. And with an increasing knowledge-based and digitalized economy, the nature of this capital may transition from tangible plant and equipment to more intangible intellectual property and technology assets.

The capital budget is also key to determining an organization’s Treasury and Funding Requirements. Whilst every organization appears to be presented with an almost limitless list of investment possibilities, their funding capacities are invariable constrained. Equity stockholders will continue to invest only where their required rate of return is being achieved. Debt and bondholders will want to ensure that shareholders’ funds are sufficient to cover any variability in operating performance before their funds are exposed. The timing (payback period), net present value and internal return of the proposed project portfolio are essential to the acceptance of the strategic plan by these financial stakeholders.

The capital budget reflects the strategic priorities of the organization. The direction of an organization regarding its product mix, geographic presence, technological innovation, and staff welfare are reflected in the allocation of constrained funding capacity to various functional areas and asset classes. When a project does not make the budget cut, the sponsor can infer that project did not align with the strategic imperatives of management.

In addition to financial stakeholders, organizations increasingly need to consider the demands of the communities and environment within which they operate. Alarmed to the prospect of environmental catastrophe, social pressure and imminent regulation, many organizations are also targeting environment, social and governance objectives. Most private, governmental, and not-for-profit organizations have set net-zero greenhouse gas emissions targets.  Many are strategically targeting United Nations Sustainable Development Goals including gender equality, health and safety, inequality and other environmental protections. To avoid ‘greenwashing’, these promoted strategies need to be actioned by an appropriate allocation of project funding for related initiatives to be included in the capital budget.

The capital budget allows for more effective control and management by exception. Having been included in the budget, a Capital Expenditure Request for a project may benefit from an expedited approval workflow. By contrast, an urgent project proposed during the year that was not included in the budget may require additional levels of approval, and then may be approved only if off-setting savings or project substitutions can be identified.

In addition to the financial, strategic, and control objectives of the capital budget, it provides a critical basis for the programme management office to secure and allocate scarce human resources. In fact, within many organizations, limited business and technical staff are frequently a primary constraint to the project portfolio selection. By agreeing to a ‘manageable’ project portfolio, the likelihood of project success is greatly improved.

The Mechanics of the Capital Budgeting Process

The typical capital budgeting process commences with each area of the organization collecting proposed project initiatives for the following year. These initiatives will be a combination of urgent plant and equipment replacement requests as well as business improvement suggestions. This front-line identification of initiatives may leverage an ideas management tool, but is commonly a fractured collection of verbal submissions, emails and the left-over items from the prior year.

The area manager will typically add these items to a project wish-list together with rough cost estimations. Whilst some initiatives may well be backed by more developed business-cases, it is not uncommon for the area budget submissions to be reduced to the lowest common denominator data set, literally comprising a few columns of a spreadsheet. This projects wish-list is then submitted to a more senior business-unit sponsor.

The sponsor collates the capital project budget requests from their individual areas of responsibility and assess the total requested investment required. Based on prior years, and guidance by the board, the sponsor will typically challenge areas submitting extraordinary budget requests and may request a review and reduction of cost by that area. A further round of spreadsheet submissions is then received, reviewed, and the process continues iteratively until the sponsor believes that the annual budget requests are reasonable in total, and likely to be approved.

The capital projects controller, program management officer, financial controller or equivalent central administration office will then receive the proposed budgets from each sponsor and collate them for the capital committee. The capital committee will examine high value strategic initiatives in some detail, and typically require presentations to be made by the managers responsible. The combined balance of the funding requested will again be assessed on reasonableness based on the allocation of funding between sustenance, growth, environmental, safety, and compliance categorizations. Individual projects and sponsor’s cumulative submissions will likely be returned for trimming and re-submission.

Sponsors will meet repeatedly with their area managers, responsible project managers and technical experts and negotiate re-costing and reprioritization of listed initiatives for ‘final’ submission.

Ultimately, the capex committee will present the endorsed annual capital budget to the board for approval. After much relief, cheering, and bewilderment by some as to where the budget line was drawn between which projects ‘made it’ and which didn’t, the capital budget is ‘locked-in’ for the another year’s execution.

Actioning the Capital Budget

The custodianship of this all-important ‘capital budget’ is entrusted to the central capex controller. They, and they alone, are responsible for tracking which projects are ‘in’ and which are ‘out’. They become a critical cog in the release of funds to projects for the remainder of the year, as they keep meticulous track of the allocation of project budgets. Because whilst a project may be approved in the ‘capital budget’ it is typically not until the Capital Expenditure Request (or Authorization for Expenditure) is approved that procurement can occur. This is because the information required by executives to approve actual expenditure is more detailed from both a cost and business-case perspective than will have been provided in the capital budget wish-list.

Key Problems Faced in the Capital Budgeting Process

With an increasingly turbulent business environment organizations must become more agile, more flexible. With the speed in which technology is moving transitioning to digital solutions will be key in reducing the challenges faced by many organizations.

Annual Budgeting Cycles Are Too Rigid

A key challenge is the annual cycle in which the capital budgeting process is conducted. This annual frequency is dictated by financial reporting and taxation requirements and practical convention. And annual planning may well be the optimal frequency for planning of seasonal industries like agriculture. Or for the scheduling of shutdown and overhaul projects during an organization’s ‘quiet time’. For other project initiatives, however, this is a completely artificial planning frequency constraint, that may be too soon or too late.

Annual planning is too late for urgent initiatives. Despite an organization’s best efforts at crystal balling the future, urgent unplanned initiatives will always materialize. Existing capital plant and equipment may require unscheduled replacement. Competitors may make unanticipated moves that require a response. Breakthrough technologies may arrive. The operating environment may dramatically change due to climate disaster, pandemic, or war. Or perhaps all three together, as in 2022.

Annual planning may be too soon for the confident submission of a budget request. Frantic last-minute submissions may be seriously ill-considered or inaccurately costed. Accordingly, they may frustratingly ‘miss’ the budgeting cycle for another year. Or, potentially even worse, they could be approved for the wrong amount or without sufficient justification with devastating consequences.

Spreadsheets Are Holding Companies Back

Current capital budgeting processes are characterized by a spreadsheet. Populated neatly with the lowest common denominator level of information. Spreadsheets are ubiquitous and easy to use. They are also challenging to version manage and control. Rather than focussing on individual initiatives, the logical ‘unit of work’ is the entire spreadsheet. This must be saved and versioned and emailed with every resubmission. And somebody else must collate and control the ‘master-list’. Online spreadsheets are not the solution either as confidentiality, editability and an audit trail of adjustments are difficult to enforce.

Spreadsheets thus become isolated silos of critical business data. Without manual consolidation they are difficult to aggregate for analysis. The data classifications and quality are difficult to enforce. Calculation formulae are error prone. Consequently, downstream system integration is impractical to automate. Spreadsheets thus rely heavily on manual administration and inevitably require the re-keying of data into execution systems.

A main goal of the capital budget is to control and manage by exception. Every Capital Expenditure Request (or Authorization for Expenditure) includes the question: “Was this initiative budgeted”. When the capital budget is locked-away in a spreadsheet, the only person who can reliably validate the initiator’s assertion in this regard is the Capex Controller. The key inefficiency is that this valuable role gets so tied-up in the administration of project approvals, that they invest less time in the more value-added development of reliable business cases.

Project Selection Requires Unbiased Scoring and Ranking Matrix

Ultimately, the most important goal of the capital budgeting process is to assist an organization in selecting the optimal projects to deliver its strategic objectives within funding, resourcing, and risk-management constraints.

Where the selection of budgeted initiatives is light on reliable comparative data, and heavy on representation, the higher the likelihood for pre-disposition and pet-projects being approved. An organization that relies too heavily on the instinct and prejudices of the incumbent management team is likely to be less nimble and successful than its more analytical competitors.

Capital budget wish-list submissions that are too-light on detail are subject to ‘gaming-of-the-system’. Everyone learns that annual budget submissions are trimmed. Consequently, it is ubiquitous practice to pad budget requests, so the ‘right’ amount is left-over after any budget cuts. If everyone else is padding theirs, then so must you.

When it comes to budget trimming, both sponsors and area managers are human too. They don’t like disappointing passionate initiators, who are so vocally pressing their case for the inclusion of their project ideas. There is thus a moral hazard for both sponsors and area managers to reduce budget amounts, rather than cut the number of projects approved. This can be a critical cause of project failure: attempting to do too many projects, with insufficient human and capital resources.

The very common approach of comparing capital budgets year-on-year encourages sub-optimal submissions. Potentially high-value ‘tall-poppy’ projects are cut-early in anticipation of their ‘unlikely to be approved’ expectation, even though it is these radical initiatives that may deliver transformational outcomes.

Because the capital budgeting exercise is expected to be completed in a defined period, not all initiatives are consistently analyzed. The problem is that current processes revert to the lowest common denominator list of attributes, sometimes as naïve as project titles and costs, dispensing with the additional information that may have been available for projects at a more advanced stage of analysis. The actual project details are retained by the initiators in a variety of free-form documents, which are presented only once their initiatives are challenged.

The lack of consistently prepared project definitions in accessible formats makes the decision makers job harder. It makes for extended iterations of reviews and causes delays. Ultimately, and potentially catastrophically, this may lead to a sub-optimal project portfolio selection.

Probity Needs a Reliable Audit Trail

When decisions are made, executives are held accountable not only for the outcomes, but also the probity of their decision process. Most organizations are enhancing their governance systems to be able to demonstrate to all stakeholders the reasonable basis for those decisions. These stakeholders include not only an organization’s shareholders represented by activist investors, but also governments, regulators and the communities in which they operate. Any scent of impropriety in the allocation of funding to major projects quickly attracts media attention and can easily unravel an organization’s good reputation.

For this reason, it is essential to be able to trace the provenance of a project all the way through the project delivery lifecycle from idea to asset. And a key step along the way is inclusion of the project in the capital budget. This step of the overall process should be seamlessly integrated in this overall process flow and not treated as a stand-alone annual activity. Unfortunately, with current capital budgeting processes based on spreadsheets, emails, presentations and verbal representations, it is exceedingly difficult for an executive to present the necessary audit trail and justification for their decisions.

To provide a reliable audit trail it is imperative that the access to the underlying data is effectively authorized and restricted. Strategic initiatives often contain commercially sensitive information, and an organization should take active steps to ensure their confidentiality and security. This sensitive data includes both the budgeted list of items as well as the supporting documents. Unfortunately, it is not uncommon to have the documents placed onto file-shares that are too broadly accessible.

Carry Forward Projects Should be Assessed

In addition to new projects that are up for consideration as part of the capital budget, special attention must be given to carry-forward project commitments from the prior year. Particularly post-pandemic, war and the energy crisis, labour shortages and supply chain disruptions have been significant, resulting in many projects rolling-forward from one year to the next. Whilst the presumption is that these carry-forward projects are pre-committed and therefore are automatically deducted from the pool of available capital, this is not necessarily the optimal strategy. As every economist advises, sunk costs are irrelevant to the assessment of future investment opportunities. Typically, the costs left on a project reduces and the purported benefits remain valid, and so the continuation of the project is justifiable. However, if costs are increasing or benefits are reducing, the continued funding of these projects should be carefully reassessed considering the alternative investment opportunities.

With current capital budgeting systems, the current state of in-progress projects is sourced separately and is not truly known until the end of the financial year. This is why the capital budgeting process ends up being so rushed – sponsors are trying to combine new initiatives with running projects at a single point in time leveraging data from disparate sources.

Project Substitution Are Hard to Track

Because budgeted project lists are prepared annually based on inconsistent data, they are seldom accurate or complete. Indeed, the percentage of projects that are actually executed is typically around 60% of what was budgeted. This doesn’t mean that capital budgets are under-spent (this happens a lot less frequently!) but rather that organizations end-up doing more urgent things than they planned to do. To gain approval for these more urgent projects, sponsors are normally required to identify substitutions, because the organization is constrained by the original budget capacity.

The problem with current capital budgeting processes, is that the reconciliation of what was actually approved for expenditure, and what was budgeted, is managed off-line by a central person. As more and more project substitutions occur, the harder it becomes to keep track of these budget reassignments and remaining budget availability.

In addition to budgets being reallocated to new projects, it can also happen that allocated budgets are not fully consumed. Managers are required to ensure that on project completion, or ideally earlier by way of forecasting, superfluous budget allocations and contingencies can be reversed, and more effectively re-deployed. When the budget is maintained offline in a silo, it is harder to facilitate these budget transfers and returns.

Supplement Tracking Is Difficult

Sometimes, despite all the unused budgets being returned to the investment program and reallocated as substitutions, there remains the need to complete critical ‘unbudgeted’ projects. These unbudgeted, unsubstituted, projects are approved through an extended workflow and result in the capital budget being increased accordingly. With stand-alone budget repositories, tracking of these approved budget supplements is a manual and inefficient process.

Solving Capital Budgeting Process Challenges with Digital Transformation

Modern capital budgeting solutions address these challenges and apply the power of technology to address the challenges of capital budgeting cycles.

A Single Data Source for the Capital Budget

At the heart of digital transformation is the idea of centralized data. The goal is to ensure that all necessary data can be effectively collected, stored, and protected. The promise of digital transformation is that this data can then be exploited to deliver project portfolio outcomes exceeding that which is achievable by traditional manual methods and systems. Over time, relevant and reliable data inputs and outcomes can be analyzed using machine learning to more effectively identify patterns and produce optimal strategies. But it all starts with a coherent, seamless and standardized data flow from the idea through to the asset and post-investment review.

Engage Stakeholders on a Single Platform

A key benefit to users of capital budgeting solutions is the ability to collaborate in real-time at a granular project initiative level. As opposed to sequential emailing of spreadsheets, all participants including the initiator, area manager, sponsor and portfolio manager have a consistent and simultaneous view of the item under discussion. Functional experts can be engaged to provide technical inputs and endorsement. Supporting documents can be directly accessed.

Digital collaboration and approval, enable full parallelization of the workflow process. All relevant stakeholders can be reliably engaged based on initiative classifications and values. Ultimately, a fully workflow-enabled solution ensures compliance with an organization’s delegation of authority and other control processes.

Improve Data Quality with Smart Digital Forms

From an end-user perspective, effective digitalization can also significantly simplify their user-experience. Like traditional paper forms, spreadsheets don’t support context aware completion: all columns are typically available for all items. With modern digital forms, however, the required data to be input can be highly tailored to the nature of the request. As would be expected, high value, strategic initiatives should require more detailed analysis and justification than simple like-for-like asset replacements.

Furthermore, by providing data entry look-ups and validations, it is not only easier to complete forms, but the quality and validity of the data can be controlled at source. This saves on requests needing to be returned due to incomplete sections or data errors.

And from an overall productivity and traceability perspective, a key benefit of an integrated and seamless flow from idea to asset is that data is only every required to be captured once. Like layers of an onion, the initial concept is enhanced and extended as it passes through various stages of planning, approval, and execution.

Standardize Processes and Data

The larger the enterprise, the more initiatives are likely to be in-progress at any one time. For both equity and effectiveness of decision making, it is essential to implement a degree of standardization to achieve comparability.

With a capital budgeting solution, the primary classification of an initiative is the investment reason. These investment reasons vary by organization but tend to include sustenance, growth, compliance, safety, and environment reasons. Like the evaluation of financial portfolio investments, where it makes no sense to compare international equities to domestic bonds, the rationale for the investment will typically drive the relevant data to be collected to enable effective assessment of choices within an investment reason category. For example, whilst the primary driver of prioritization of asset replacement initiatives may be the risk of failure of the current equipment, the prioritization of greenhouse gas abatement initiatives may be related to the CO2 emissions reduction per dollar.

Over time, various areas and departments within an organization may evolve their own unique tools and processes. Introduction of a new capital budgeting system provides an opportunity to drive cohesion and best-practices by standardizing the process and data for everyone.

Objectively Score Each Initiative

From a capital budgeting perspective, the most obvious deliverable of a digitally transformed process is an improvement in the project portfolio selection. This relies on an effective initiative ranking mechanism and this will be based on a standardized scoring model based on the investment reason. The scoring system should be pervasive, starting with the idea, refined for budgeting purposes in the investment proposal, detailed in the business case, reassessed throughout execution (especially on the release of supplementary funding requests), and ultimately reviewed on completion.

By deriving a quantitative, data-driven, and objective score for each option of each initiative, the organization can quickly discard poor options and initiatives, expedite ‘no-brainers’, and focus management attention on the grey areas.

Producing a quantitative score that can be used for ranking does not require that the inputs are necessarily quantitative. Indeed, at an early stage in the evaluation of an idea, the scoring is most likely to be based on qualitative assessments. These qualitative assessments may include risk assessments, degree of benefit assessments, and alignment perceptions. As the initiative progresses through its life cycle, the initial qualitative assessments may be replaced with more quantitative metrics such as Net Present Value and payback period.

An effective scoring model requires, that based on the investment reason and the lifecycle stage, an appropriate scoring matrix can be applied for each of the relevant dimensions of urgency, benefit, implementation risk and strategic alignment. Each of these scores can then be appropriately weighted to produce a single ‘overall score’ to reflect the organizational value of each initiative relative to all others of that same investment reason class.

Automate Portfolio Planning

With an agreed score, the capital budget can be readily optimized by selecting the portfolio of initiatives that maximises the overall score given human and funding constraints. This portfolio can be automatically calculated and proposed, and manually refined at the boundary as required. Once dependency relationships between initiatives are identified, the value of the automated portfolio selection is increased, as eye-balling and picking the optimal portfolio manually (especially in a committee meeting) is incredibly hard.

An automated portfolio planning approach can further assist the organization’s planners by plotting an ‘efficient frontier’ of possible outcomes. This helps identify what additional value could be achieved by a marginal increase in the funding envelope.

Integrate with Financial System

With high quality data maintained in a centralized system, the opportunities for core system integration are increased. Once an initiative moves into the execution phase, the system should automatically create projects and budget allocations in the underlying financial system.

Real-Time Analytics For Faster Decision Making

A key opportunity for digital transformation of the capital budgeting process is the accessibility of centralized data for real-time analytical purposes. Without having to wait for resubmission of an entire new spreadsheet version, capex controllers can immediately evaluate proposed initiatives by Benefiting Area, Investment Reason, Asset Class, Score, and other important classifications.

Benefits of Digitally Transforming the Capital Budgeting Process

The business benefits gained from digital transformation is setting companies apart from their competitors. It enables them to move faster and more accurately giving them an edge in the market.

Efficiencies of Live Integrated Data

Non-value adding manual rekeying, collation and follow-up of capital budget submissions can be eliminated by providing a continuous flow of an initiative from idea to asset, including the capital budgeting process. With a standardized, validated, and secure repository of proposed project initiatives, real-time analytics and system integration can be enabled. These efficiency gains save time, save effort, and save money.

Effective Process Outcomes

By capturing all the relevant data, applying a rigorous and objective scoring model to the evaluation of alternative initiatives, and automating the portfolio selection process, the overall effectiveness of the capital budgeting process will be enhanced. Ultimately this will help an organization achieve strategic objectives sooner, at the lowest possible cost and risk.

Ability to be More Agile

Digital transformation of the capital budgeting process will effectively eliminate the word ‘annual’.  On-going submission of investment proposals, and more efficient and effective review, prioritization and approval of these submissions will allow the project portfolio to be continuously optimized to your strategy considering changing environmental circumstances, whilst respecting the need for certainty around funding and resourcing demand.

Adopt an Effective Capital Budgeting Solution

Completely change the game with a radical transformation of the capital budgeting process from locking in the ‘annual wish-list’ to maintaining an active ‘planned strategic project portfolio’. Don’t wait until the eleventh month to fall-about and submit your best-guess cost of projects to be started sometime in the next thirteen months.

Rather, adopt capital budgeting software to radically transform your capital budgeting process. Enable your entire organization to continuously identify improvement opportunities. Apply a simple and effective scoring of these initiatives. Focus on the most urgent, beneficial, low-risk and strategically aligned initiatives. Track each initiative from idea to asset as it moves progressively through the various stage gates of approval, and very seldom go backwards.

The benefits to be derived are dramatic: deliver on your strategy sooner and most cost effectively. Allow your organization to prosper by deploying scarce capital and human resources more effectively. And delight all stakeholders including Project Managers, Sponsors, Administrators, and Senior Executives with a solution that is more efficient and easier to use, and more responsive to an ever-changing operating environment.