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.
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
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.
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.
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.
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.
Discover 5 ways to harmonize projects, reduce risk, and boost profits.
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.
Budgeting is a critical process for organizations evaluating their capital spending options, but challenges abound that could lead to mistakes on a grand scale.
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.
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.
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.