Operating Vs. Capital Budget

To many of us, the annual operating and capital budget development process is viewed with trepidation and confusion. But they are really just plans: one for the immediate future and one for the long term. While the short-term operating budget may affect how much we can wine and dine a client, the capital plan may determine whether we can meet our long-term career goals.

A budget details a financial plan. Companies break down the plan into two types: an operating plan and a capital plan. The operating budget focuses on the day-to-day running of the company and it usually covers a one-year period. Throughout the year managers continually review the plan and measure any deviation from expected revenues and expenses as changes will affect the annual operating profit. Capital budgets focus on internal investment strategy and are usually long-term, although they may be updated annually. A typical capital budget will extend over five or 10 years.

Managers develop an operating budget by first estimating sales revenue. Market trends and pricing decisions facilitate this forecast tempered with the capacity of the company to deliver the product or service. While a growing industry may demand almost unlimited product, plant capacities may limit production. Expense budgets follow and cover costs such as labor, raw materials, utilities, overhead, sales, marketing and research and development. Budgets are often zero-based, meaning the cost estimates are based on detailed forecasts by expense type rather than simply estimating costs based on history. Operating budgets are developed by month and may differ significantly based on timing of outlays such as the purchase of raw materials. Operating budgets are monitored at least monthly with any variance closely analyzed.

Capital budgets are developed for two main reasons: expansion and replacement. Successful companies continually evaluate market conditions and analyze opportunities. They may decide to expand by entering other geographic areas or may add new products to their offering. Both of these expansion decisions require the addition of plant and equipment. Facilities also become worn out and machinery eventually needs to be replaced or updated. The financial plan developed to meet these two needs is called a capital budget. It is an investment in the future.

While operating budgets determine short-term viability, capital budgets look to the future. Most capital budgets are determined by top executives and each investment is carefully analyzed. Managers scrutinize each investment proposal, which may involve a decision to borrow money that will have no immediate investment return. Net present value methods determine whether an investment made in current dollars will pay off with future profits. An example is an airline that makes an investment in a multimillion dollar aircraft. Analysis will predict whether the cost of the aircraft is justified based on its future ability to generate revenue and add to company profitability.