Gold, B. 1976. The Shaky Foundations of Capital Budgeting. California Management Review (Winter):
Summary by Brook Robinson
Master of Accountancy Program
University of South Florida, Fall 2001
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first part of capital budgeting, after creating the estimates for the
construction of the plant, is to consider the possibility of changes in
estimates. It is highly probable that the initial estimates will need to be
adapted for changes in prices, scheduling impediment due to lack of materials or
equipment, and labor problems. Another
problem that could prove difficult and detrimental is if new technology or other
innovations are not implemented correctly, or in an efficient manner. Problems such as these would cause the estimates to be way off target,
which would give investors a false number and potentially lead to an incorrect
revenues is another part of capital budgeting that requires heavy
forecasts. Revenue estimates, in turn, rely on estimates of the output period,
the expected pattern of prices and the estimated life of the building. The pattern of output depends on the total output of the industry, the
projected products market share, and the projected output of the given entity. The pattern of prices depends on the production costs; the supply and demand of
the product; the chance of setting a premium price because of the products
uniqueness and the general price level changes, all of which are estimates. The estimated productive life of the building depends on the probability
that the building will become obsolete because of changes in product
requirements; the chance that a new building would be needed for reasons such as
pollution or the possibility that the location of the building needs to be
relocated due to vendor changes. These are most of the variables that need to be
considered just for the revenue estimates.
final factor involved in the capital budgeting process deals with the
costs of production and other factors that affect revenue.
The estimated cost of production entails estimated changes of variable
costs, fixed costs, distribution costs and tax rates. Estimated variable costs must also take into account the additional input
requirements due to an increase in efficiency; the estimated change in input
requirements due to changes in competition, suppliers or governmental
regulations; and other estimated input adjustments.
The estimated fixed costs have to account for the predicted changes of
time patterns related to the production costs.
order to be able to decide on whether or not to embark on an investment project,
there needs to be accuracy involved in the determination of the estimates and
forecasts. As stated above, one
estimate depends on yet many other estimates, but it has to be done in order to
get the full picture of the project. Investors depend on these estimates to be reasonably
accurate. The article states that
the investment requirements, part one of capital budgeting, is more likely to be
accurate than the projection of revenues and costs, parts two and three.
Another difficulty arising from estimates is the acceptable margin of
error. By how much can the true
numbers deviate from the projections and still be meaningful?
Unfortunately, those are questions that are hard to answer, if not
Although investors are often times skeptical about capital budgeting, it does provide useful insight into the decision making process. The use of estimates in capital budgeting is inevitable because investors are trying to predict the future. The important part of the budgeting techniques is to have the margin of error fall within a range that allows the estimates to be useful for making decisions. In determining the usefulness of capital budgeting, the article concludes by making three hypothesis: entities donít have much of a choice about taking on new projects, but itís a question of when they will do such; long run estimates are not accurate enough for top management to capitalize on an opportunity; and finally the belief that although mistakes are bound to occur, itís most important to catch the errors as early as possible in order to keep the costs as low as possible.