From an accounting standpoint, there are two types of budgets: operating and capital. From a facility management viewpoint, budgets are likely to be categorized by program: for example, maintenance, operations, space build-out, environmental, and security. One of the continuing budget challenges for most facility management and property management organizations is taking the time to define and set rules for annual (or semi-annual) versus capital expenditures. The facility manager should have the capability to manage and track each program in both operating and capital budgets.
Operating Budgets
When informal conversation in a company turns to the budget, the term usually refers to the operating budget. Facility managers are more likely to have control of the operating budget rather than the capital budget. The operating budget is also far more likely to be the subject of intense scrutiny and cost-cutting efforts. You can expect a closer examination of line items, disproportionate to dollar value, than you would experience with capital budgets.
Portions of the yearly operating budget for an entire company are allocated to each corporate department for its day-to-day operating requirements. The total allocation for the facility management department is subdivided into portions allocated to personnel costs (staff salaries and benefits) and such non-personnel costs as rent, electric bills, minor repairs, and so on. Most organizations use a large portion of their revenue-generated cash flow to cover costs anticipated in the yearly operating budget.
A certain portion of the cash flow of the organization is spent each month on running the daily operations of the company. At the end of the fiscal year, any income not used to pay operating expenses is considered retained earnings and becomes a capital asset shown on the corporate balance sheet.
Operating budgets can be both short-term (one year or less) and mid-term (between one and two years). Operating budgets represent out-of-pocket costs, which organizations prefer to avoid if possible.
Capital Budgets
The parameters of a capital budget have evolved as the country, and therefore its businesses, have shifted from producing things to producing and managing information. Huge corporations evolved that now do nothing but deal with information. The whole idea of capital expenditures correspondingly shifted. Major capital expenditures now take the form of computers, printers, scanners, plotters, and the like. This differs greatly from huge printing presses, major new assembly lines, or new production equipment for manufacturing concerns that were much more common in past decades.
Compared to operating budgets, capital budgets may seem rather static: they involve fewer cost types, less scrutiny, and longer terms. Things ought to happen more slowly, but they don’t. If interest rates rise, investment capital for real estate-related and facilities-related projects almost always becomes scarce. Capital budget plans may also be disrupted when the government raises the discount (prime) rate to control inflationary growth.
Implications of Capital Spending for Operating Budgets and of Operations Costs on Capital Budgets
Capital budgets are sensitive to how operating budgets are managed. For example, preventive maintenance, if funded and practiced, will have a very beneficial long-term impact on capital projects by extending the useful life of capital assets. Most preventive maintenance programs can provide reasonable predictions of how long mechanical HVAC equipment will last, enabling you to make some sober predictions about planned equipment replacement, which is almost always a capital expense.
There is one caveat, however: your company will realize these savings only if it remains in the facility or uses the equipment long enough to reap the benefits. For this reason, such financial arguments rarely make sense for leased space unless the lease is a long-term triple-net lease.
Capital projects and investments usually require maintenance, care, and operation after they are purchased or built. It is very important to examine capital expenditures for the ongoing effects they will have on the operating budget. The most commonly used tool to identify such costs is LCC (life cycle cost) analysis, which accounts for all costs associated with an item over its expected life, including purchase, operation, maintenance, and disposal. In many cases, large capital investments are approved on the basis of LCC claims that they will reduce operating costs.
If such predictions turn out to be inaccurate or overstated, the facility management department will bear slightly higher ongoing operating costs—higher maintenance or housekeeping for each such project, for each year. Unless you can research life cycle cost analyses for these projects and compare predicted figures with actual results, you may have a difficult time proving why your costs keep increasing.
Capital Budgeting Process
The decision to invest in the workplace is usually made in the context of the company’s strategic plan and capital budget development process.
The first step in the process, in many companies, is for management to set the size of the total capital pool for a particular time period. This pool is determined largely by the company’s financial position, required investments, other investment opportunities and priorities, and the anticipated revenue for any given period. Total capital investment is usually a small proportion of the yearly revenue stream.
The second step is the allocation of the capital budget among various projects competing for corporate funds. The key is determining how the corporation chooses or rejects projects and how it ranks those it decides to fund. Generally, decisions are made according to what will best support the strategic business plan. If the facility manager cannot demonstrate support of this plan, there will be little or no capital investment unless outside forces, such as government regulations, require it. Under these circumstances, it is difficult to move ahead with new facilities projects.
One approach is to establish a priority system for facilities projects. For example, mandatory projects to satisfy government requirements and replacement of certain equipment usually take priority, followed by discretionary investments. The distinction between mandatory and discretionary is not always clear and may depend on the nature of the business strategy. A more detailed breakdown of these categories, in general order of priority, might look like this:
- Requirements to meet legal compliance and personal safety
- Requirements to protect corporate financial integrity
- Completion of ongoing projects
- Maintenance or replacement of worn-out equipment
- Modernization of work processes
- New capacity with high expected ROI
- New capacity with average expected ROI
- Other projects
Budget Planning Periods
In contrast to operating budget time frames, capital budget time frames are always multiyear, typically spanning between two and ten years. (Governments are more likely to use longer time frames.) Because time frames are long, the time value of money becomes a significant factor in capital planning, particularly if capital funds are borrowed or acquired through equity participation such as stock issues. Therefore, getting accurate cost estimates on long-range projects is both difficult and critical. You may find it helpful to consult with corporate financial planners on what long-range planning assumptions are being used by other corporate departments in their capital requests.
Aside from applying present value and discounting techniques to individual capital projects, applying present value to the entire capital budget over several years, through the course of multiple projects, will change it substantially. The differences between present-day and discounted dollars will be most evident in the future of the capital budget plan, when the diminished value of the dollar will have its greatest impact. These factors are very important to corporate financial planners who must issue bonds or debentures or take on a mortgage to raise capital funds for projects.
Summary
This How-to article provides some very general guidelines on how to separate operating and capital expenses; general because the industry hard-and-fast rules don’t exist. In an ideal world, a standard would be set as to what is funded as maintenance, repair, major repair (above a certain dollar level), alteration, minor construction, major construction, and replacement, with each category then being either allocated to the annual budget or capitalized. But the reality is that no cookie-cutter definition is going to suit every organization. This standardization being absent, you as a facility manager can do yourself and your organization a favor by defining some clear rules and following them consistently. Doing so can have dramatic fiscal impacts, and will ensure that in budgeting (and during audits), you are comparing apples to apples.
This article is based primarily on content from BOMI’s course Fundamentals of Facilities Management, but was supplemented by expert feedback BOMI received regarding our forthcoming release of Asset Management.