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Determining Capital Expenditure in budgeting

How do you calculate or determine a reasonable amount for capital spending in fiscal budgeting. I expect there are a variety of ways to come up with an amount such as a percentage of cash flow, a percentage of net or gross profit, annual depreciation, etc. Any thoughts regarding your calculations?

Answers

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

I would discourage "straight out" percentage of anything.

It should be deliberate and based (as much as possible) on strategic plans (what capex will it need to execute). This will entail laying down your plans to include (among others), equipment you will need for production (in case your are in manufacturing) or the number of desks/computers for additional hires. the timing of purchase, etc. Your strategic plans, cashflow and budget should be in sync.

You can also look at historical data on how much capex (replacements) you normally spend in a particular year and you can plug that in.

Although calculating for "straight out" percentages is easy, variances going forward will be significant and will render your initial "percentage" based budget meaningless.

Crystal Wagner
Title: CFO
Company: Werthan, LLC
LinkedIn Profile
(CFO, Werthan, LLC) |

Thank you Emerson. The list from different departments is quite large as you might imagine and it will not be able to be obtained in one year. (yes we are manufacturing) The thought was if we could back into how much we could afford in one year then we could allow each department to re-prioritize their list on their own vs. Finance approving or disapproving. Is this something you would recommend? Thank you.

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

...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.

Anonymous
(CFO) |

@ 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.

Topic Expert
Patrick Dunne
Title: Chief Financial Officer
Company: Milk Source
(Chief Financial Officer, Milk Source) |

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.

Topic Expert
Alan Hart
Title: Consultant
Company: Pacific Shine Group
(Consultant, Pacific Shine Group) |

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.

Topic Expert
David Hughes
Title: Executive VP of Operations
Company: On Target Performance Group
(Executive VP of Operations, On Target Performance Group) |

I will add a related comment to all the previous ones....each capital expenditure should have a cash flow and IRR justification prior to spending the money. Even "replacement" expenditures should have an IRR. Then, two years later, perform a post audit on those projects to see if you achieved the target. This will not only improve the overall process, it will keep people honest on their assumptions.

Ken Mason
Title: Controller
Company: Pascua Yaqui Tribe
LinkedIn Profile
(Controller, Pascua Yaqui Tribe) |

Agreed, and add to that the operational elements (timeline, positions, wages, fringes and operating costs) that will help you determine the impact on the operating budget and understand Total Cost of Ownership.

Crystal Wagner
Title: CFO
Company: Werthan, LLC
LinkedIn Profile
(CFO, Werthan, LLC) |

WOW some very varied opinions. Thank you all for your suggestions. Lots to digest.

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