The fundamental purpose of budgeting is to assist management to carry out its basic functions of Planning, Coordinating and Controlling operations, effectively.
It is very important that Management, from the top down, must participate in the establishment of goals, and in making plans, in harmony with other Departments. Adequate historical accounting data is required to put down in figures what is necessary for satisfactory results and Plans for the most economical use of recourses.
There must be a formal Management structure to support a responsibility accounting budget. A responsibility accounting process means that each executive is accountable for achieving the budget, as part of the overall corporate development plan. The responsibility budget needs a budgetary planning and control system. To do their jobs effectively, people needs facts. Supplying the facts for control is an important budgeting function.
Follow –ups on capital expenditures includes checks on the spending itself and comparison of how near the estimates of the cost and returns were to actual. If there are wide variances, then a revised capital budget may be necessary to provide additional resource appropriation.
The basic objective of any investment is that in return for paying out a given amount of cash today, a larger amount will be received back over a period of time. This larger amount should not only repay the original outlay, but also provide a minimum annual rate of return on the outlay. To obtain a true picture of the investment, all cash outlays and inflows must be taken into account.
Having calculated the rate of return for a project, it must then be decided whether the project is financially acceptable or not.
Cost of Capital: The minimum acceptable return from any project is the rate of interest which the company is paying for the capital invested in the firm. i.e., the cost of capital.
Opportunity cost: All projects must compete with the return that the company could earn by investing its available finance outside the business. The risk and uncertainty attached to outside investments must also be taken into account.
Alternatives projects: Where the company is in a capital-rationing situation, alternatives projects will have to be ranked. These will compete with each other for the limited supply of finance available.
Capital Project Analysis Techniques for its Feasibility
Paybacks: The payback method calculates the length of time taken by the projects net cash inflows to equal the initial investment. If the payback period is less than that demanded for this type of project, then the project is acceptable.
Accounting Rate of Return (ARR): In this method, the accounting rate of return of a project is calculated as a net profit percentage on capital employed after charging depreciation. The accounting rate of return can be determined for each year of the project, but is usually calculated as an average over the life of the project.