Capital budgeting and capital rationing are two important aspects of cost accounting that help businesses make optimal decisions about investing in long-term projects. In this article, you will learn what these concepts mean, why they are relevant, and what are some best practices or tools for applying them in your own context.
Capital budgeting is the process of evaluating and selecting projects that require a large amount of capital outlay and have a long-term impact on the profitability and growth of a business. The purpose of capital budgeting is to maximize the net present value (NPV) of the cash flows generated by the projects, or to achieve other strategic goals, such as increasing market share, enhancing customer satisfaction, or improving environmental performance. Capital budgeting involves estimating the costs and benefits of each project, discounting them to reflect the time value of money, and comparing them with alternative options or criteria.
Capital rationing is the situation where a business has a limited amount of capital available to invest in projects, and therefore has to choose among competing opportunities. Capital rationing can be either internal or external. Internal capital rationing occurs when a business imposes its own constraints on the amount of capital it can allocate to projects, based on factors such as risk, return, or strategic priorities. External capital rationing occurs when a business faces restrictions on the amount of capital it can raise from external sources, such as lenders, investors, or regulators.
Internal capital rationing can cause interdepartmental friction because the project requires additional headcount in the areas of Sales or Marketing. Or increased Commission plans. Employees who were not privy to the plans of the organization or who do not understand the organizational goals may be concerned when they see employee onboarding, but merit increases were not given to employees. It is sometimes misconstrued as partiality towards a specific group. However, the funds spent were included in the budget with success tracked through direct metrics, such as increased Revenue. Unfortunately, roles like those in Accounting tend to be non-revenue-generating, so it is often hard to designate funds to these areas.
Businesses can use various methods and tools to perform capital budgeting analysis and select the best projects. Net present value (NPV) calculates the difference between the present value of the cash inflows and outflows, while internal rate of return (IRR) calculates the discount rate that makes the NPV of a project equal to zero. Payback period measures the number of years it takes for a project to recover its initial investment, while profitability index (PI) calculates the ratio of the present value of the cash inflows to outflows. A positive NPV, higher IRR, shorter payback period, and PI greater than or equal to one all indicate that a project should be accepted as it adds value to the business.
When dealing with capital rationing, businesses can utilize various techniques to prioritize their projects. Ranking projects by NPV, IRR, PI, or payback period involves ordering the projects by their respective values and selecting the highest until the budget is exhausted. This assumes that the projects are independent and divisible. Linear programming formulates a mathematical model to maximize the objective function of the projects, subject to constraints. Integer programming is similar, but restricts decision variables to whole numbers. However, capital rationing can lead to suboptimal decisions and induce managers to manipulate cash flow estimates of their projects. To avoid this, businesses should have a transparent and consistent capital budgeting process and monitor and evaluate project results.
To improve the quality and effectiveness of capital budgeting and capital rationing, a business should align the process with its strategic goals and vision, and involve relevant stakeholders in the identification, evaluation, and selection of projects. Additionally, multiple methods and tools should be used to analyze and compare projects, taking into account both quantitative and qualitative factors. The assumptions, data, and criteria used in the capital budgeting process should also be reviewed and updated regularly. Furthermore, clear and realistic criteria for capital rationing should be established and applied consistently across business units and functions. Finally, a balance must be struck between short-term and long-term results when allocating capital to both maintenance and growth projects. By following these best practices, a business can enhance its decision-making process and optimize its use of capital resources for long-term success.
Interdependency of management goals and focal points requires philosophical considerations, such as: 1. Wisdom, applied, is only as effective as the completeness of situational knowledge. 2. Completeness of knowledge of plans that are financially impactful determines effectiveness of capital strategy. 3. Capital restriction triage will reveal ineffective and/or incomplete communication, and effectiveness of observation regimes. 4. When the potential for failure is the highest, so is the opportunity to learn; seeing frailties unfold is to gain wisdom in real time.