Determining Capital Expenditure in budgeting

...and we arrive at the eternal discussion of top-down (business plans to budget) or bottom-up (what we can afford results in our business plan) approach preference to business planning.

From my experience, it is easier to scale back business plans (and the accompanying capex plans) than work up to it. As an exercise, I think it is beneficial for a company to at least see the bigger picture (from a planning standpoint) and then scale back or prioritize plans/initiatives as you see fit. One option for you is to compartmentalize your budget according to INITIATIVES.. When you scrap the initiative, the corresponding revenue, capex and costs goes with it. Resulting in a "what we can afford" scenario.

Also, what you can afford or how you make funds available depends on your view of the Finance function. (ie. I will find ways to fund our plan VS This is what we have and that is it.) Of course with external limitations.

@ Ms. Wagner:

That's not a capital budget. That's a wish list.

Initially, that is fine. But now, it's time to get the department heads together, prioritize that list and show them how far down the list the available funds will take the organization.

I've done top down and bottom up budgeting. I much prefer bottom up. But, that requires a lot more work on my part. It also requires oodles of finesse with managers and higher ups.

Either one can work. But, only if the division VPs and department managers are held accountable. I've experienced that being done by tying bonuses in part, to achieving departmental budgetary goals.

Also, it only works if finance can report back accurate numbers with explained variances. Try that in a sales organization where sales people twist every financial report into some sort of meaningless pretzel as a way of justifying their own selfish, top line interests to avoid any semblance of control.

As a proxy, we use 2%-2.5% of net sales, but only as a starting point. Surprisingly it has been fairly good at giving us a good mix of projects that add new products and those that are just required to replace equipment. We then use a 20% ROI as a hurdle for evaluating projects.

In my experience, a percentage of something else is not the answer unless you have solid experience in your particular business of how capex relates to that “something else”, be it free cash flow, annual depreciation or anything else that can drive the capex number. This can be achieved by using driver based budgeting where your capital budget is “driven” or derived from these other numbers. A well designed planning and budgeting solution can provide you with this capability.

However, using a driver based method usually only works well when budgeting replacement of specific assets, knowing the actual asset life policy and having access to all asset fundamental information in the budgeting software, or when scaling operations and similar, additional assets must be acquired in order to produce budgeted revenues.

A portion of the capital budget will always be driven by your business or strategic plan which will dictate what type of additional assets must be acquired in order to deliver expected results, timing of acquisitions, etc. That is usually more difficult to model using drivers, especially when the business plan calls for new product or service lines where actual historical data is not available.

A well implemented planning and budgeting solution will have a dedicated capital expenditures module where you can use any of the above mentioned methods to selectively budget for individual assets.