Capital Budgeting: What It Is and How It Works

Rick Bell | Senior Writer | January 31, 2025

Selecting the construction projects and investments that will yield the greatest benefits for an organization and its customers is rarely straightforward. Capital budgeting, the process of aligning project selection with enterprise goals and available financial and human resources, helps both private and public sector organizations carefully evaluate, prioritize, and optimally allocate resources to capital projects.

This article will discuss the challenges associated with capital budgeting, as well as identify the opportunities that will add the most value for your organization.

What Is Capital Budgeting?

Capital budgeting is the process of selecting the optimal portfolio of projects an organization can deliver within its financial constraints. It identifies and tracks funding sources for large-scale projects, such as public infrastructure, new facility construction, and upgrades to existing facilities and assets.

Capital budgeting processes help ensure that projects meet enterprise goals. In the private sector, those goals might include growth, sustainability, and customer satisfaction. Public sector organizations tend to seek to maximize public benefit, such as a highway project that relieves traffic congestion or improves safety at a dangerous interchange.

Typically, multiple projects are vying for the same pot of money. Effective capital planning teams replace the infamous “loudest person in the room gets all the money” approach with a consistent data-driven prioritization methodology. Organizations can define their criteria and weighting and take advantage of Monte Carlo simulations to predict probable outcomes.

The intended result is to deliver the projects that best align with organizational goals within the time and cost promised. Positive outcomes improve the organization’s reputation and leadership’s confidence in funding future projects and programs.

Key Takeaways

  • Budgeting is an integral part of capital project planning and a predictor of an organization’s long-term success.
  • A formal capital budgeting process increases the likelihood of choosing the right projects and completing them on time and within budget.
  • Some capital budgeting methods can be subjective, a major drawback.
  • Manual processes and spreadsheets generally can’t keep pace with the complexities and dynamics of today’s capital budgeting.
  • The right capital planning/capital effectiveness software can connect finance, planning, and project teams to help ensure consistency and governance, drive efficiency, and provide the data your people need to do their jobs.

Capital Budgeting Explained

Capital budgeting allocates a designated amount of funding that aligns with organizational financial planning, including considerations such as funding for ongoing operations, stock buybacks, dividends, and M&A activity. By incorporating a strategic capital budgeting plan, organizations can more effectively determine and prioritize which projects meet their goals and align with available funding.

A simple example is when an organization states its three goals. They could be, “build this, grow this, and do it safely.” Funding is allocated to the project delivery teams, which now understand how funds are distributed based on enterprise objectives to the right projects that provide the most bang for the buck.

They’ll likely use one or more budgeting methods when prioritizing capital investments. Ranking projects based on criteria set by senior leaders brings objectivity to prioritization and ultimately the decision to approve, defer, or reject projects. Financial analysis provides a valuable indicator of economic performance and feasibility. The potential for risk must also be considered, as it materially affects the likelihood of achieving desired financial outcomes.

How Capital Budgeting Works

Given the myriad organization structures that exist across industries and sectors, managing capital budgeting isn’t one size fits all. Large organizations can afford to have a budgeting committee overseeing capital projects, while smaller organizations generally rely on business line teams to select, execute, and oversee capital projects.

Large or small, public or private, organizations have an annual capital budget process that can be broken down into monthly increments. There’s constant evaluation of what was allocated and spent, followed by budget adjustments based on a variety of factors (weather delays, spikes in the prices of raw materials, labor shortages, and so on), with a corresponding variance analysis and explanation of what went as expected versus what changes were made. That process repeats month to month. Portfolio management is the discipline that connects the project and business planning worlds.

As private sector organizations evaluate investment opportunities, they generally select projects that will maximize revenue and shareholder value. In the public sector, the priority is generally projects that will benefit constituents. Money for new projects or renovations is limited, which is why it’s crucial to analyze and select the right projects to do and the sequence in which to execute them.

steps-in-a-typical-capital-budgeting-process

Methods Used in Capital Budgeting

Capital budgeting methods evaluate cash flows, comparing costs and benefits to provide an indicator of economic feasibility and likely performance. There are three main capital budgeting methods (outlined below), each of which can yield different perspectives. It’s important that your capital planning technology platform has the flexibility to accommodate different methods to provide a full picture of a project’s potential return.

  • Discounted Cash Flow Analysis
    Because a typical capital budget spans multiple quarters and even many years, organizations will use discounted cash flow (DCF) techniques to assess cash flow timing and currency implications. Discounted cash flow also takes into account the inflows and outflows of a project.

    The DCF formula represents the value an investor would be willing to pay for an investment, given a required rate of return on the investment, or the discount rate.

    DCF analysis will get you to your internal rate of return. Some frown on the IRR because it assumes you can reinvest at the calculated rate, which is unlikely. Regardless, an IRR that’s significantly higher than a company’s weighted average cost of capital (WACC) and/or hurdle rate is an indicator of favorable outcomes. Another output of DCF analysis is net present value, a simple, straightforward measure of project value. The greater the NPV, the more earnings (or financial benefits) exceed investment costs. Additionally, NPV typically uses WACC as its discount rate, making its output more credible.
  • Payback Analysis
    Payback analysis is another tried-and-true method of investment financial analysis. It’s a simple calculation of the amount of time it takes to recoup dollars invested via extracting benefit from the project. Shorter paybacks are better than longer ones and are often mandated if a project is deemed high risk. Many organizations have stated payback targets aligned with their “hurdle rate” or target IRR for investments.
  • Throughput Analysis
    Throughput methods typically analyze revenue and expenses across an entire organization rather than for specific projects. It’s also a method to get more out of existing assets and infrastructure.

    For example, a manufacturer has a plant to make more widgets and a transportation system it wants to use to move those widgets around the country with less fuel. Throughput analysis determines whether the project will improve the company’s overall widget throughput by boosting capacity or reduce expenses.

Important Capital Budgeting Metrics

Selecting the right capital budgeting metrics often is driven by an organization’s leadership and its expectations, by the organization’s regulatory environment (and associated relevant measures), and its risk tolerance. The chosen methods will help eliminate projects that fall short of an organization’s minimum performance thresholds. They also are helpful in comparing competing projects and developing rankings.

  • Payback Period
    Everybody in an organization who is teeing up capital projects will know what the payback must be. The more risk that’s involved, the smaller your payback period will have to be. And if you're trying to do something that hasn't been done before, then you need to clearly demonstrate the ability to get money back quickly.
  • Internal Rate of Return
    The internal rate of return (IRR), or the expected return on a project, finds the discount rate that brings a project’s net present value to zero. In other words, the IRR generates a yield percentage on a project rather than a dollar value. Capital projects with a higher IRR usually are considered the better investment.
  • Net Present Value
    Net present value (NPV) indicates whether a project’s financial benefits will exceed its costs. If NPV is calculated to be less than zero, the investment (cost) required outweighs the benefit and will likely cause the project to be deferred or rejected.

Discover 5 ways to harmonize projects, reduce risk, and boost profits.

Ranked Projects in Capital Budgeting

Most organizations want a list of capital projects ranked in order that align with their objectives and financial allocation. The ability to “rack and stack” projects within a portfolio lets organizations perform “what if” scenario analyses so that they can react to changes in planning inputs quickly, including reallocation to the next project in line as appropriate.

Scenario planning is key. By continually revisiting scenarios and reassessing project forecasts and actuals against plan, planning teams will be more prepared for unexpected events such as natural disasters, supply chain disruptions, and regulatory changes. Selected portfolios of projects and various scenarios should be “memorialized” and accessible in a collaboration platform that provides visibility, flexibility, and consistency.

Capital Budgeting Challenges

Budgeting is a critical process for organizations evaluating their capital spending options, but challenges abound that could lead to mistakes on a grand scale.

  • Estimation and forecasting errors. Even when assembled by skilled professionals, capital project estimates and forecasts are only as good as the data they’re based on and are vulnerable to various unintended biases that can cause errors. For example, availability bias occurs when a forecaster assigns too much weight in a probability distribution For example, availability bias occurs when a forecaster assigns too much weight in a probability distribution to scenarios that have happened before. With desirability bias, forecasters filter out or underplay evidence that doesn’t support the desired outcome.
  • Risk and uncertainty. Capital budgeting decisions are fraught with project-specific and market risks and uncertainties that must be carefully evaluated to allow for the best possible return on investment. Conducting rigorous sensitivity and probability analyses and using techniques such as Monte Carlo simulation help companies mitigate risk and make more informed decisions. However, it’s difficult for forecasters to anticipate adverse weather conditions, supply chain disruptions, and other external factors, so planners should build in some financial flexibility to their budgeting estimates.
  • Capital rationing, or “shuffling the deck.” Organizations are limited in how much financial capital they have available to invest in new construction projects. Capital rationing helps them decide how to allocate those scarce resources. In general, projects are prioritized based on which ones are forecast to generate the highest returns, but that kind of rationing could expose organizations to greater risk by failing to diversity their investment portfolios.
  • Changing regulatory and tax environments. Construction regulations and tax laws, at the local, state, and federal levels, change constantly, adding layers of complexity to the budgeting process. It’s important to stay current, especially on the latest regulations governing worker safety, building codes, and environmental sustainability.
  • Siloed technology solutions. As stated earlier, capital project estimates and forecasts are only as good as the data they’re based on—and that data will be inadequate if pieces of it are locked in siloed applications and spreadsheets. Standardized and integrated planning and budgeting applications help make the capital budgeting process more reliable and accurate.
  • Lack of integration with strategic planning. Project silos aren’t limited to just data and applications. The budgeting process often falls to teams who work in silos, creating a disconnect between strategic and operating plans. An integrated strategic capital budgeting plan can more effectively determine and prioritize the projects that meet organization goals and align with available funding.

Capital Budgeting Best Practices

Capital spending often represents a significant percentage of an organization’s overall budget, so it’s important to continually revisit the portfolio and fine tune the process. Capital budgeting best practices help build certainty, accuracy, and predictability. Uniform processes can also support project-to-project comparisons and lead to lessons learned. Several best practices are outlined below.

  1. Use a rolling forecast. Instead of sticking to a static annual budget that can become obsolete quickly, consider creating rolling forecast that continuously updates the plan and budget estimates.
  2. Use consistent ROI models. Models that measure ROI—most often calculated by dividing an investment’s net profit or loss by its initial cost—should be based on robust, accurate data and applied uniformly throughout the organization, helping ensure that all projects are evaluated on the same criteria. That leads to objective and comparable results.
  3. Implement zero-based budgeting. Zero-based capital budgeting starts from square one every budgeting cycle, no matter what was spent during the previous cycle. It requires that every dollar requested be explained and justified. Zero-based budgeting promotes a culture of cost management and accountability by identifying overspending and reallocating those resources toward more strategic, higher-growth uses.
  4. Know where every project is in the approval process. Think of this as preventive maintenance. Keeping a close eye on capital project costs and the budget, project performance, and the team executing it helps ensure that the project gets delivered on time and meets the budget. Regular reviews also confirm the project is progressing in an orderly manner that allows for adjustments.
  5. Make decisions based on actual cash flows. By comparing the expected and actual cash flows of each capital project, the budgeting process helps determine where those resources are best allocated to boost profitability and maximize value.
  6. Use discounted cash flow (DCF) analysis. Discounted cash flow (DCF) analyses, which estimate the value of an investment based on the cash flows it’s expected to generate, can provide organizations with a reasonable projection of whether a proposed investment is worthwhile. Its projections can be adjusted to provide different results for different what-if scenarios.

Maximize Capital Budgets with Oracle Capital Program Management

If you’ve endured the pain of budgeting in spreadsheets managed by different departments in various formats, why continue to toil in “Excel hell?” The right software can help make capital budgeting simpler and more accurate, consistent, and reliable.

Oracle Primavera Cloud Portfolio and Capital Planning is a comprehensive planning, budgeting, and project portfolio management solution purpose built for construction. It’s based on more than a decade of capital planning expertise, yet accessible to new users and veterans alike. In Oracle solutions, all data is centralized, immediately updated by project, lets all stakeholders collaborate, and gives management relevant information in real time. Oracle Primavera Cloud Portfolio and Capital Planning also provides significant value for organization-wide decision-making processes.

Organizations often make important capital budgeting decisions with inadequate information, inconsistent processes, and a lack of standard systems. Establishing a reliable process that objectively ranks projects based on organizational goals prioritizes the projects that deserve approval. While a ranking system isn’t foolproof, a formal capital budgeting approach based on best practices increases the likelihood of selecting the capital projects that increase shareholder value and revenue, or in the public sector, deliver the greatest benefits to constituents.

Capital Budgeting FAQs

What is meant by capital budgeting?
Capital budgeting helps organizations identify the set of projects for which they have sufficient money and how to best allocate funds across those projects.

What are the three methods of capital budgeting?
The three most commonly used evaluation methods in capital budgeting are the payback period, the net present value, and an evaluation of the internal rate of return.

What are examples of capital budgeting?
One example of capital budgeting is when a private company decides how to allocate and reallocate funds across construction of a manufacturing plant, renovation of an office building, and retooling of an R&D facility. Another example is when a public entity allocates taxpayer dollars to build a sewage plant or add a lane to a highway.

What is a problem with capital budgeting?
One problem with capital budgeting is inconsistent and manual processes, which often lead to mistakes, inaccuracies, and suboptimal selection of projects.

Learn how with smart applications, construction industry leaders can improve efficiency by combining experience and expertise with quantitative and qualitative insights.

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