Performance enhancement is the result of doing many, many things right.

Effective budgeting to provide for capital requirements and to control operating costs are critical parts of the effort to increase busines value over time. The annual process of developing operating and capital budgets should be viewed as an opportunity to test and adjust strategies and tactics. Ultimately, management of any enterprise is about effectiveness and efficiency. Budgeting is a process which should address both effectiveness and efficiency. The capital budgeting process will always have three elements that ultimately effect operating results.

All expenditure of capital fall into three capital budget groups are:

(1) Revenue enhancement
(2) Maintenance of present capacity
(3) Change to the operating process

Operating budget considerations must then analyze the strategies chosen in the capital budgeting process and strive to constantly increase efficiency. When the limits are reached in efficiency development, a change in the way the work is done must be considered. The point of departure then drives or prompts future capital budget considerations.

Effectiveness is doing the right things.  While Efficiency is doing things right.

Operating and capital budgeting requires the determination of what are the right things to do (Effectiveness) and how to do what is planned in the right way. (Efficiency.) To accomplish these dual management goals requires integrated planning of all budgets. The business planning and budgeting process and procedures should provide this opportunity to review the chosen business strategies and the departmental operating tactics.

Economic vs. Accounting Depreciation

For each capital or operation expenditure there are two critical management determinations: The first is the "driver" and "function" of the item or expenditure. (Revenue enhancement, maintenance of capacity; change in the operation process.) The second is the economic life of the new asset. Obviously, any item with an economic life of one year or less should be expensed, while items with anticipated economic life of greater than one year should be capitalized to properly account for multi-year benefits. Account and reporting standards will control the "depreciable life for accounting purposes." (There is some flexibility accorded these "accounting determinations.") Management should not rely directly on the "accounting life" of assets for planning purposes. The "useful" or "economic life" of the asset must be the planning driver. In addition, the "function" should be a major determinate of whether an expenditure should be considered a repair/maintenance expense or a capital expenditure. If the expenditure specific is required only to maintain the operating integrate of an item and not to extend the life of the item, it may be correctly considered a repair expense. However, within either definition of "asset life", consistency of the estimate of either "economic" or "account" life of an asset is important. Such an approach should result initially in a plan to create an annual expected replacement expenditure. The date of original acquisition should be used to prompt planning, but the review process should not rely solely on the age of equipment to develop plans.

Return on Investment (ROI)

Historically, capital budgeting in most closely-held busineses has not been fully disciplined by analysis of the return-on-investment (ROI). In some environments it may seem difficult to apply standard investment measurement methods. Although ROI analysis may be difficult conceptually to use in replacement analysis, this is not the case with major projects. All projects, which drive strategic operating changes, must be thoroughly analyzed. Such projects should not be approved unless they will provide a return equal to the cost of capital plus a risk factor which reflects any uncertainty in the anticipated revenue stream and operating costs.

Comparison analysis on all replacement planning should be instituted. The mathematics associated with this analysis should be carefully understood. Analysis often does not have to provide for consideration of mid-year present value applications or other refinements to enhance the process. An alternative method would be to employ the simpler "payback period method" for all investments below a threshold investment amount. Initially an investment threshold can be adapted and rechecked over time to assess the benefits of detailed analysis. Replacement, maintenance, repairs and actions to simply maintain facilities or other assets required to continue operations will always appear difficult to analyze. However, in all investment decisions there are alternatives or substitutions. The necessity for management to consider and study alternative approach or substitute products should be driven by an "investment" approach to capital budgeting. In many cases alternative or substitute may not be readily evident. It is the thinking process employed to discover optional ways to reach the same objective that will help optimize investment decisions. A situation as simple as finding out that a new piece of equipment with cost saving features will be available in 6 or 12 months. Thus a delay in the purchase decision may provide cumulative advantages. A consistent management orientation that causes all "investments" to be reviewed and tested and retested will deliver these desired benefits.

The general questions are:

1. Is this the best way to solve this problem?
2. What alternatives were considered?
3. Are there any benefits or impacts from delaying this decision?

Operating Budget Approach/Cross - over

Budget planning, monitoring, and controlling for all Income Statement expenses is critical to overall management activity. The planning process provides an opportunity to reconsider capital investments to reduce operational expenses. The development of trend information is critical to prompt activities of this nature. A review of the income statement for the business will show the relative size and importance of wages, salaries, benefits, and taxes. Often these items comprise a significant percentage of total operating costs. Staff planning for the anticipated operating levels should include an interactive analysis to prompt management thinking about "How the work is done" as well as ways to comply with key system needs and drivers. If wage and related expenses increase faster than the increase in unit revenue over a period of years, structural-staffing changes may be required. This focus on effectiveness and the resulting situation analysis may indicate a need for a greater level of capital spending. Managers will need to interactively assess long-term capital costs and annual operating costs. The business owner must be in a position to study, plan, and fund required operational changes to meet critcal challenges. The repairs and maintenance budget is the complement to the capital budget. Increased repairs may slow or reduce capital expenditures. The classification of these expenses is always a point for discussion. (Although all operating budgets can be improved by adopting a dynamic budgeting approach, this is less important for the repair and maintenance budget.)

Multi-year Planning Model

Typically a multi-year cash flow planning model should be developed to permit iteration with various scenarios. The model should be simple to integrate by making changes in major activity driven budget assumptions, and should take fully into account all system constraints. Such a model should be used to provide an early indication that strategic or operation changes should be considered. Both capital budgeting and operational budgeting plans should be developed only after a full assessment of the existing business strategies and assumptions. Use and continuous improvement of such a model is especially important in an environment which has a high degree of change and/or increasing competition. Strategic changes and optimizing of capital budgets should provide the business owner with the opportunity to maintain the company's competitive advantages and resulting performance. It is important to make assessments and to make changes early. If funds are spent for operations in a sub-par structure, those funds are gone and cannot be applied to an investment that can optimize the operating environment. Both the capital budgeting and operating budgeting process can be used to create an environment with lower risks.

Summary

Capital budgeting is not a stand-alone process. To effectively make investment decisions, capital budgeting must be integrated with operational budgeting and testing of strategic plans and operating tactics. In this way capital budget can be optimized and can drive the annual planning process. The opportunity is available for management to make changes to enhance organizational performance. To accomplish this, a multi-year interactive planning model, effective grouping of capital assets for review and control, and effective grouping of operating accounts to improve monthly budget reports should be the minimum tools employed by a business owner. Disciplined use of "Payback" or "Return on Investment" analysis should assure optimization of the operational impact of all investments. Dynamic (flexible) budgeting can be implemented, when indicated, to improve the utility of management reports. In addition, trend analysis, which provides for period-to-period comparisons, should be developed and used to provide additional impetus for timely decision making and planning.