Chapter 13 Capital

Expenditure
Asset to Be Bought, Sold, and Discarded
 CAPITAL EXPENDITURES

► Should be consistent with company’s long-term plan.

► They may be for generating earnings by providing additional revenue or reducing cost;
such as when the purchase of more efficient equipment and machinery results in lowei
maintenance expenditures.
► They should generate an adequate return; therefore, a desired return on investment
(ROI) should be set.
► Capital expenditures include replacing machinery to economize on costs, expanding
production to increase volume, marketing a new product, improving the quality of products
or services, and manufacturing under proposed contracts.
► Capital expenditures may be incurred because of growth, increased sales, increased
production, changes in production methods, changes in style, cost reduction, efficiency and
effectiveness, productivity, improvement in product quality, new business, normal
replacement, preventive maintenance, and counteracting competition.
 CAPITAL EXPENDITURES

► The capital expenditure budget depends on such factors as:

► Future potential ROI, sales, profitability, productivity and efficiency, capacity utilization,
► Payback period (how many years it takes to get the initial investment back),
► Timing of needed capital expenditures,
► Risk, technological obsolescence, diversification, safety concerns,
► Financial position (including cash flow, tax benefits, and other government incentives),
► Market share, new product development, maintenance and repair requirements, problei
areas, replacement options, nature of industry,
► Economic conditions, political factors, and laws and regulations (e.g.,pollution
requirements, restrictive uses on assets)
 CAPITAL EXPENDITURES

► There are uncertain benefits for capital expenditures because of the significant cash
outlay and long time period involved. In fact, if for some reason a capital expenditure fails, a
significant loss is likely.
► The manager should prepare the capital expenditure budget needed for his or her
responsibility unit after consulting with engineering and technical staff. A capital asset cannot
be bought unless it has been included in the capital budget.
► Capital assets include equipment, furniture, machinery, storage facilities, distribution
facilities, and computers.
► Capital expenditures should be approved only after detailed study and justification; after
that, continual monitoring and control are recommended.
► The manager should set up a priority listing of capital projects based on earnings or
strategic importance. The planning should take into account the peculiar characteristics and
nature of the industry and company
 CAPITAL EXPENDITURES

► The timing of capital expenditures depends on available alternatives, startup time, and
funds. The manager must identify which capital expenditures are not essential, which can
be delayed for a reasonable time, and which are urgently needed.
► Some capital expenditures result in profit reductions, such as outlays that are required by
law, that improve research and development, and that enhance employee morale. Some
capital expenditures are required by government, such as for employee safety an to
conform to building codes.
This chapter discusses the budget process, authorization of capital budgets, capital budget
forms and reports (including special reports), budget revisions, analysis and evaluation of
capital expenditures, and controls.
 BUDGET PROCESS
For budgeting, capital expenditures may be classified as normal or special.
► Normal expenditures are routine, less costly, and made to maintain current operations.
example is a minor replacement of machinery.
► Special capital expenditures are unusual, costly, and made for a specific purpose, such as the
purchase of a new machine to manufacture a product for a special job of a one-time nature.
► The four steps in the capital expenditure budgetary process are:
1. Approving the project
2. Approving the estimate
3. Authorizing the project
4. Following up
► Capital expenditure policy should take into account: Desired rate of return; Cost impact; of
existing assets; Expected capacity of the item; Asset life; Growth potential; Employee
availability; Competition; Stage of the business cycle; Legal liability exposure; Regulatory
requirements
AUTHORIZATION OF CAPITAL BUDGET

If capital expenditures exceed authorized limits, special approval by top

management is required.
A project not meeting expectations or that is no longer appropriate, given
current circumstances, may be canceled. It is better to cancel a project if the
cost-benefit relationship indicates that the project is no longer viable.
The amount authorized should be compared periodically to actual costs
incurred. In addition, commitments must be recorded and monitored because
ultimately the total appropriated amount may be exceeded.
The estimated cost to complete also should be noted, along with any expected
overruns or underruns
CAPITAL BUDGET FORMS

► Request forms should be completed and approved for capital expenditures. A

commitment record contains the purchase orders issued, and an appropriation
form provides information on the benefits to be obtained from the proposed
project and the expected cost savings. The authorization sets forth the type and
scope of the project.
CAPITAL BUDGET FORMS
► An appropriation request form is filled out in detail by the manager of the
responsibility unit, providing justification to support the capital proposal and
thoroughly appraising the proposed capital project.
► A proposal form for capital expenditures may include the title of the project, the
project’s objectives, a description of the project, the proposed budget, analysis and
evaluation, supporting documentation and calculations, justification,
and time estimates.
CAPITAL BUDGET

► The capital asset budget includes beginning balance, additions, deletions,

depreciation, construction in progress, and ending balance.

The budget format should include category, class, project title, project
number, project life, capital costs, and return on investment. The budget
should contain a provision for explanatory comments.

► Extraordinary repairs are usually included in the capital expenditure

budget, but ordinary repairs are included in the expense budget. The
production budget may require capital additions.
BUDGET REVISIONS
Capital budgets should be revised when errors are found or circumstances change.
Revisions would be required for changes in cost estimates, unexpected
developments in the economy, design changes, technological developments, action
by competitors, change in divisional or departmental objectives, and casualty
losses.
SPECIAL PROJECTS
► Special capital expenditures involve non-routine, large cash outlays for major specific
projects. An example is the purchase of new machinery to meet customer demand.
Optional projects include equipment replacement, capital expansion, modified
techniques, and new ventures. Capital expenditures should be consistent with the
►
manager’s desired return on investment.
SPECIAL PROJECTS

ANALYSIS OF CAPITAL PROJECTS

► The manager should compare the expected profit to actual profit for each capital
project There should be an evaluation of the difference between budgeted and actual
capital expenditures, along with justification.
► Some questions to be answered by managers include: Are specialized equipment and
machinery required? If capacity is expanded, what impact will it have on warehouse space?

CONTROL OVER CAPITAL EXPENDITURES

► The manager should control individual projects from beginning to end. Capital
expenditure outlays should be documented by supplier.
► Contractor price quotations should be reviewed for reasonableness, and competitive
comparisons should be made. Contractors may be changed when cost savings arise, quality
problems exist, or delivery dates are not being met.