Capital budgeting is the process of reviewing requests to purchase fixed assets. There are a number of methods available for doing so; most are based on the concept of changes in cash flows related to the specific asset in question. Using these methods does not necessarily result in the correct investments. Instead, an analysis based on incremental changes in throughput is the best approach. Using this method may result in a decline in the total amount of fixed assets purchased, since it will reveal instances where a prospective investment will not yield an increase in throughput.
Traditional Capital Budgeting
The standard approach to capital budgeting is that management is presented with an unrelated group of requests for investments in fixed assets, to which they apply the following decision process:
- Compile the discounted cash flows related to each project.
- Adjust the discounted cash flows based on the perceived risk of each project.
- Rank the projects based on the amount of positive cash flows to be garnered from each one.
- Authorize the projects for investment from the top of the list to the bottom, until available funds run out.
This process has a number of problems, which include:
- Managers can be overly optimistic in their cash flow estimates, in order to ensure that their projects are accepted.
- The proposals do not describe the impact of an investment on the bottleneck operation within the company.
- The proposals are considered individually, and not in terms of how they impact the entire system of production. Thus, the emphasis is only on the localized improvement of specific work centers.
Throughput Capital Budgeting
Basing the capital budgeting decision process on throughput eliminates the preceding set of issues. Instead of cash flow analysis for each separate project, the emphasis should be on improving the amount of total throughput generated by the company. Throughput is revenues minus all variable costs. Increasing throughput usually requires that the capacity of the bottleneck operation be enhanced in some manner.
If a capital proposal does not improve throughput, then it must instead do one of the following:
- Reduce the basic operating expenses of the business
- Fulfill a legal requirement
- Mitigate a risk
- Increase the ability of a workstation upstream from the bottleneck operation to rapidly produce goods, thereby ensuring that a sufficient buffer of inventory is maintained in front of the bottleneck
If a proposal does not meet any of these criteria, then it should be rejected.
There may be cases where management is considering direct investments in the company's bottleneck operation. This is not a minor decision, because bottlenecks have that status for a reason - they are very expensive. The decision to make such a large investment may depend on the perceived level of long-term demand. If the amount of demand is uncertain, the massive step cost incurred by investing more cash in a bottleneck may result in a long-term decline in profitability.