Planning And Control Of Plant And Equipment Or Capital Assets

Impact Of Capital Expenditures

Capital expenditure planning and control are critical to the long-term financial health of any company operating in the private enterprise system. Generally, expenditures for fixed assets require significant financial resources, decisions are difficult to reverse, and the investment affects financial performance over a long period of time. The statement “Today’s decisions determine tomorrow’s profits” is pertinent to the planning and control of fixed assets. 

Investment in capital assets has other ramifications or possible consequences not found in the typical day-to-day expenditures of a business. First, once funds have been used for the purchase of plant and equipment, it may be a long time before they are recovered. Unwise expenditures of this nature are difficult to retrieve without serious loss to the investor. Needless to say, imprudent long-term commitments can result in bankruptcy or other financial embarrassment.

Second, a substantial increase in capital investment is likely to cause a much higher break even point for the business. Large outlays for plant, machinery, and equipment carry with them higher depreciation charges, heavier insurance costs, greater property taxes, and possibly an expanded maintenance expense. All these tend to raise the sales volume at which the business will begin to earn a profit.

In today’s highly competitive environment, it is mandatory that companies make significant investments in fixed assets to improve productivity and take advantage of the technological gains being experienced in manufacturing equipment. The sophisticated manufacturing and processing techniques available make investment decisions more important; however, the sizable amounts invested allow for greater rewards in increased productivity and higher return on investment. This opportunity carries with it additional risks relative to the increasing costs of a plant and equipment.

These conditions make it imperative that wisdom and prudent judgment be exercised in making investments in capital assets. Management decisions must be made utilizing analytical approaches. There are numerous mathematical techniques to assist in eliminating uneconomic investments and systematically establish priorities. Since these investment decisions have a long-term impact on the business, it requires an intelligent approach to the problem.

 

Controller’s Responsibility 

What part should the controller play in the planning and control of capital commitments and expenditures? The board of directors and the chief executive officer (CEO) usually rely on first-level management to analyze the capital asset requirements and determine, on a priority basis, which investments are in the best long-term interests of the company. The controller has a key role to play in making the determinations. All the functional departments, like sales or manufacturing, will have valid reasons for expansion or cost savings through the purchase of new plant and equipment. In addition, each operating unit will have a real need to increase the capital asset expenditures to meet its goals and objectives. The controller, with the financial knowledge of all company operations, should be able to apply objectivity by making a thorough analysis of the proposed expenditures. In many cases, heavy losses have been incurred because the decision was made with an optimistic outlook but without adequate financial analysis. The responsibility is placed on the controller’s staff to make an objective appraisal of the potential savings and return on investment. The board of directors and the CEO must have a proper evaluation of proposed expenditures if they are to carry out their responsibilities effectively.

After the decisions have been made to make the investments, the controller must establish proper accountability, measure performance, and institute recording and reporting procedures for control.

The following is a list of thirteen functions that relate in some way to the planning and control of fixed assets and that typically come within the purview of the controller :

1.	Establish a practical and satisfactory procedure for the planning and control of fixed assets
2.	Establish suitable standards or guides, also called hurdle rates, as to what constitutes an acceptable minimum rate of return on the types of fixed assets under consideration.
3.	Review all requests for capital expenditures, which are based on economic justification, to verify the probable rate of return.
4.	In the context of the business plans whether short term or long range ascertain that the plant and equipment expenditures required to meet the manufacturing and sales plans (or plans for research and development (R&D) or any other function) are included in such plan, and that the funds are available.
5.	As required, establish controls to assure that capital expenditures are kept within authorized limits.
6.	As requested, or through initiative, review and consider suitable economic alternatives to asset purchases, such as leasing or renting, or buying the manufactured item from others a part of the “make or buy” decision.
7.	Establish an adequate reporting system that advises the proper segment of management on matters related to fixed assets, including:
	-	Maintenance costs by classes of equipment
	-	Idle time of equipment
	-	Relative productivity by types or age of equipment and so forth
	-	Actual costs versus budgeted or estimated costs (as in the construction or purchase of plant and machinery, etc.)
8.	Design and maintain property records, and related physical requirements (numbering, etc.) to accomplish :
	-	Identifying the asset
	-	Describing its location, age, and the like
	-	Tracking transfers
	-	Properly accounting for depreciation, retirement, and sale
9.	Develop and maintain an appropriate depreciation policy for each type of equipment for book and tax purposes, each separate, if advisable.
10.	Develop and maintain the appropriate accounting basis for the assets, including proper reserves.
11.	Ascertain that proper insurance coverage is maintained.
12.	See that asset acquisition and disposition is handled in the most appropriate fashion taxwise.
13.	Ascertain that proper internal control procedures apply to the machinery and equipment or any other fixed asset.

While the controller and staff have certain accounting, evaluation, auditing, and reporting requirements to meet, it should be understood that the line executives have the major responsibility for the acquisition, maintenance, and protection of the fixed assets.

Capital Budgeting Process

Having mentioned the responsibilities related to fixed assets that are typically assigned to the controller, we devote the principal part of this chapter to the capital budgeting process. Most of the accounting and reporting duties are known to the average controller, but more involvement in the budget procedure needs to be encouraged. Given the relative inflexibility that exists once capital commitments are made, it is desirable that the CEO and other high functional executives be provided a suitable framework and basis for selecting the essential or economically justified projects from among the many proposals even though their intuitive judgment may be a key factor. And when the undertaking begins, the expenditures must be held within the authorized limits. Moreover, for the larger projects at least, management is entitled, once the asset begins to operate, to be periodically informed how the actual economics compare with the anticipated earnings or savings.

The sequential steps in a well-conceived capital budgeting process are outlined below. It should be understood that these steps are not all performed by the controller, but rather by the appropriate line executive. (In separate sections, some of the more analytical facets are explored.)

1.	For the planning period of the short term budget, which may be a year or two, determine the outer limit or a permissible range for capital commitments or expenditures for the company as a whole, and for each major division or function. This is desirable so that the cognizant executive has some guidance as to how much he can spend in the planning period. (There must be a starting point, and this is as good a one as any.) Depending on the circumstances, this may be an iterative procedure.
2.	Through the appropriate organizational channels, encourage the presentation of worthy capital investment projects. For major projects, the target rate of return should be provided, and any other useful guidelines should be furnished (corporate objectives, plans for expansion, etc.).
3.	When the proposals are received (and presumably there are many) make a preliminary screening to eliminate those that do not support the strategic plan, or that are obviously not economically or politically supportable.
4.	After this preliminary screening :
	a.	Classify all projects as to urgency of need.
	b.	Also, calculate the supposed economic benefits. Those performing this task must be given guidance as to (1) the method of determining the rate of return and (2) the underlying data required to support the proposal.
5.	When the data on proposed projects are submitted for top management approval, the financial staff should review and check the material as to :
	a.	Adequacy and validity of nontechnical data
	b.	Rate of return and the related calculations
	c.	Compatibility with
		i.	Other capital budget criteria
		ii.	Financial resources available
		iii.	Financial constraints of the total or divisional budget and so forth
6.	When the proposals have been reviewed and analyzed, and approved by top management, the data must be presented to the board of directors and approval secured in principle.
7.	When the time approaches for starting a major project, the specific authorization should be reviewed and approved by the appropriate members of management. This process may require a recheck of underlying data to be sure no fundamentals have changed.
8.	As a control device, when a project has started, periodic reports should be prepared to indicate costs incurred to date, and estimated cost to complete among other information deemed critical.
9.	At stipulated times, and for a stated period, after a major project has been completed, a post audit should be made comparing actual and estimated cash flow.

As can be deduced, the role of the controller and staff as to capital budgeting relates to the financial planning, the establishment and monitoring of the capital budgeting procedure, the economic analyses, and the control reports during and after completion.

Establishing The Limit Of The Capital Budget

A common beginning point in the annual planning process is to set a maximum amount that may be spent on capital expenditures. There will be occasions when the “normal” limit is set aside because of an unusual investment opportunity or other extraordinary circumstances. Normally, however, top management will set a capital budget amount, based on its judgment and considering such factors as :

-	Estimated internal cash generation (net income plus depreciation and changes in receivables and inventory investment, etc.)
-	Availability and cost of external funds
-	Present capital structure of the company (too much debt, etc.)
-	Strategic plans and corporate goals and objectives
-	Stage of the business cycle
-	Near  and medium-term growth prospects of the company and the industry
-	Present and anticipated inflation rates
-	Expected rate of return on capital projects as compared with cost of capital or other hurdle rates
-	Age and condition of present plant and equipment
-	New technological developments and need to remain competitive
-	Anticipated competitor actions
-	Relative investment in plant and equipment as compared to industry or selected competitors

At different times, each of these factors will seem more compelling than others. As an additional rule of thumb for “normal” capital expenditures, some managements determine the limit based on the (a) amount of depreciation, plus (b) one third of the net income. The remaining two thirds of net income are used equally: one half for dividend payout to shareholders, and the other half for working capital.

In considering the company investment in plant and equipment versus the industry, these two ratios may provide some guidance :

1.	Ratio of fixed assets to net worth. This ratio, when compared with those of competitors, indicates how much of the net worth is used to finance plant and equipment vs. working capital.
2.	Turnover of plant and equipment. The ratio of net sales to plant and equipment, when compared to industry data, to specific companies, or to published ratios such as those issued by Dun & Bradstreet, shows whether too much is invested in fixed assets for the sales volume being achieved.

Information Supporting Capital Expenditure Proposals 

An important element in a sound capital budgeting procedure is securing adequate and accurate information about the proposal. In this connection, the reason for the expenditure is a relevant factor in just what data are needed

In a sense, a capital expenditure may call for a replacement decision, that is, an existing piece of equipment is to be replaced. For such a decision the information necessary would include :

-	The investment and installation cost of the new piece of equipment
-	The salvage value of the old machinery
-	The economic life of the new equipment
-	The operating cost of the new item over its life

Presumably, the economic decision would relate directly to the lower cost of production with the new piece of equipment, and possibly the opportunity to produce a greater quantity of output. 

In contrast, consider an expansion type of decision. Assume a company wants to produce a new product to be sold in a new market. Then, not only must the economic data on the acquisition and operation of the new equipment be available, but also marketing information is required, such as estimates of :

-	The market potential for the new product
-	The probable sales quantity and value of the output for X years
-	The marketing or distribution cost

Such a capital investment obviously will involve more risk than a replacement decision. One other comment may be germane to securing good ideas and adequate information about new capital items. First, those who would use the equipment and are knowledgeable should be consulted. Too often management does not listen to this valuable source of information. Secondly, management should encourage the flow of ideas about capital expenditures, especially new processes and perhaps new products. It is far better to have too many good ideas than not enough. Ideas should be sought from many elements of the organization and compared. What is most desirable is a balanced agenda, rather than a limiting of ideas to  any one department or single source.

As is discussed later, economic data on proposals normally should include all relevant cash flow information cash outgo the complete installation costs and operating expense, and cash inflow the expected net sales revenues less related marketing expense, and so on. Any relevant economic data should be made available, such as tax data, inflation outlook, economic life of the project, other equipment needed, capacity data, cost information, and salvage value.

Here is an expanded list of the reasons that capital expenditures are made, all of which have a bearing on input data :

-	To enable continued operation of the business
-	To meet pollution control requirements
-	To meet safety needs
-	To reduce manufacturing or marketing (distribution) costs through more efficient use of labor, material, or overhead
-	To improve the quality of the product
-	To meet product delivery requirements
-	To increase sales volume of existing or new products
-	To diversify operations
-	To expand overseas and so forth

Methods Of Evaluating Projects

In an effort to invest funds wisely in capital projects, companies have developed several evaluation techniques. It is these expenditures that provide the foundation for the firm’s growth, efficiency, and competitive strength. Because most companies do not have sufficient funds to undertake all projects, some means must be found to evaluate the alternate courses of action. Such decisions are not merely the application of a formula. The evaluation of quantitative information must be blended with good judgment, and perhaps good fortune, to produce that aggregate wisdom in capital expenditures that will largely determine the company’s future earning power.

As will be seen, some entities have rather simple procedures while some of the more capital intensive managements feel a need for more sophisticated methods. Those companies using the more analytical tools find these three elements essential :

1.	An estimate of the expected capital outlay, as well as the amount and timing of the estimated future benefits the cash flow
2.	A technique for relating the expected future benefits to a measure of cost perhaps the cost of capital, or other “hurdle rates”
3.	A means of evaluating the risk which relates to (a) the probability of attaining the estimated rate of return, and (b) a sense of how changes in the assumptions can affect the calculated return