It is important for management to comprehend
capital budgets for numerous of reasons. Some of the obvious reasons for
management to comprehend capital budgets simply rely on the framework of cost
control which would consist of preventive and detection correction. This is
performed through the use of cost variance analysis which consists of a sound
system of standard setting, or budgeting, with a related system of cost
accounting. Through the use of cost
accounting it supplies two informational needs that are essential for the
welfare of an organization. First, it supplies data essential for product or
service costing. Secondly, it provides information for managerial cost control
activity.
Cost control is what management uses to
first recognize there is a problem, then determine what the problem or cause
is, and finally a resolution in correcting the problem. This is relevant to
financial management because as long as there is an unresolved problem the
greater the cost will be to the organization. Therefore, to express the total
cost incurred from an unresolved out-of-control situation by an organization is
the efficiency cost. An organization may choose to express or represent the
formula as the following: Efficiency
cost =T x R x P (Cleverely, Cleverely, & Song p. 381).
The T was said to account for the total
of time units that the problem remained uncorrected. The R is for the loss or
cost per time unit, and while the P is said to stand for the probability that
the problem occurrence is correctable. This is what ultimately leads management
to the preventive approach whereby, management attempts to minimize the
efficiency cost by trying to eliminate or minimizing the probability that a
problem will have a chance to occur. This is said to be used by many
organizations however, smaller organizations use this approach the most. Next
there is the detection-correction this focuses on minimizing the time that a
problem remains uncorrected. This method is said to be related directly to
effectiveness of variance analysis. This should result in a reduction of both
the recognition of problem phase and the determination of cause phase.
However, for management to detect the
out-of-control cost they use two theories which consist of the classical
statistical theory and the decision theory. The classical statistical theory
basically uses a control chart to monitor a physical process of comparing
output observation with predetermined tolerance limits. This enables the
financial manager to forecast outcomes. For example, if the actual observation
falls between predetermined upper and lower control limits on the chart, the
process is assumed to be in control. Even though a control chart can signal
when a situation is likely out of control it cannot directly evaluate whether
an investigation is warranted. Then there is the decision theory which provides
a framework for directly integrating the probability of the system being out of
control and the costs and benefits of investigation into a definite decision
rule. This theory uses the payoff table which uses the objective to minimize
the actual cost for a given situation and in order to accomplish this;
estimates of the probabilities for the two states, in control and out of
control are required. There are various types of cost variances which consists
of the following price variances, efficiency variances, volume variances,
utilization variance, enrollment variances, cost-related variances, utilization
variance just to name a few.
Capital budgeting
is meant to focus on an individual investment project throughout its life,
recognizing the time value of money. Ultimately, the life of a project is said
to be often longer than a year. However through
accrual accounting the financial manager can focus on
a particular accounting period, often a year, with an emphasis on income
determination.
Methods and Samples
There are five stages related to capital
budgeting and are as follows:
1. There
must be an identification stage this determines which types of capital
investments are available to accomplish organization objectives and strategies.
2. Secondly,
the information-acquisition stage is to gather data from all parts of the value
chain (investor, stakeholders, etc.) in order to evaluate alternative capital
investments.
3. Thirdly,
there is the forecasting stage that
will project the future cash flows attributable to the various capital
projects.
4. Next,
there is the evaluation stage where capital budgeting methods are used to choose
the best alternative for the organization.
5. Finally,
financing, implementation and control this actually get the project on the way
and monitors their performance.
Discounted
cash-flow method calculates the expected cash inflows and outflows of a project
as if they occurred at a single point in time so that they can be aggregated
(added, subtracted, etc.) in an appropriate way. This enables comparison with cash flows from
other projects that might occur over different time periods.
Only quantitative
outcomes are formally analyzed in capital budgeting decisions. There are many effects of capital budgeting
decisions, which make it difficult to quantify in financial terms. However,
there are nonfinancial or qualitative factors (for example, the number of a
laundry versus the number of patients actually occupying beds or employee education)
are important to consider in making capital budgeting decisions.
Sensitivity
analysis can be incorporated into DCF (discounted cash flow) analysis by
examining how the DCF of each project changes with changes in the inputs used. This
could include changes that occur in revenue assumptions, cost assumptions, tax
rate assumptions, and discount rates.
The payback method
measures the time it will take to recoup, in the form of expected future net
cash inflows from present endeavors, which refers to the net initial investment
in a project. The payback method is said to be simple and easy to understand.
It is a useful method when screening many proposals and particularly when
predicted cash flows in later years are highly uncertain and the financial
manager is explaining it to stakeholders. Nevertheless, the main weaknesses of
the payback method is said to be that the neglect of the time value of money
and of the cash flows after the payback period.
The accrual
accounting rate-of-return which is known as (AARR) method simply divides an
accrual accounting measure of average annual income of a project by an accrual
accounting measure of investment. As with any other method there are strengths
and weakness. The strengths of the accrual accounting rate of return method are
that it is simple, easy to understand, and considers profitability making easy
for everyone. Its weaknesses are that it ignores the time value of money which
is imperative for forecasting and does not consider the cash flows for a
project.
