Topic Eight: Budgeting and Capital Investment
Nearly everyone budgets to some extent, even though some people may not recognise what they are doing as budgeting. They estimate income, plan expenditures and restrict spending in accordance with the plan. They use estimates of income and expenditures to predict their future financial condition. Whilst such budgets may exist only in the mind of the individual, they are budgets nonetheless.
Program budgeting is method of budgeting that is common among local government authorities and councils although the increasing privatisation of some activities has led to the adoption of private sector budgeting methods.
A common practice across organisations is the use of financial modelling as part of the budget process. Kaye (1994) identifies the modelling process as comprising seven stages:
- Problem definition
- Problem analysis
- Parameter estimation
- Specification of the model
- Encoding the model
- Testing the model
The traditional budgeting process outlined in your prescribed text has been criticised by many commentators. It is inordinately time-consuming for the overall benefits achieved. It involves an excessive number of iterations. It accepts existing expenditure levels as the starting point of 'negotiations' and therefore encourages incremental cost build-ups. It results in arbitrary cost slicing or cost reduction, with everyone taking an equal percentage share of the budget allocation cutback. It is focused primarily on the resource inputs, which tend to be expressed almost exclusively in financial terms.
The evaluation of capital investments can be done using a number of methods. The most common is accounting rate of return, which is based on accounting profit. Other methods such as payback period, internal rate of return (IRR) and net present value (NPV) rely on cash flows. Cash flow analysis is considered
superior to accounting rate of return as accounting profit can be easily manipulated. The three methods that use cash flows are different. Payback tells us how long it takes to get our money back and treats all cash flows as equal. Therefore cash flows received later in the life of an investment are not adjusted for the time value of money. For this reason, payback is considered an inferior method of evaluation compared with the NPV and IRR methods, both of which incorporate the time value of money into their evaluation process and are more widely used. NPV and IRR are referred to as discounted cash flow methods and are based on the equivalent present value of future cash flows expressed in the same time frame.