Testimony: Mr. Lewis began by discussing the benefits of capital budgets in the private sector. Capital budgets allow businesses to link corporate strategies to capital investments and to increase shareholder value by investing in large-scale capital projects with long-term benefits. Capital budgeting also allows businesses to allocate scarce resources to produce the best opportunities. In addition, the private sector utilizes capital budgets to identify the relationship between capital assets and related maintenance and operating expenses and to establish a benchmark for measuring management's performance.
Mr. Lewis discussed some of the best capital budget practices observed in the private sector. One such practice is the top-down, bottom-up approach in which executives set capital expenditure or performance targets that lower level managers analyze, approve, and implement as a capital budget. Another best practice is the application of activity-based budgeting concepts. This involves identifying capital projects and the budget activities (work) and related resources to complete each capital project. Other best practices include linking capital and operating budgets, completing the capital budget cycle in 30 to 45 days, establishing "hurdle rates" whereby expected results must exceed the weighted average cost of capital, and closely monitoring a project's actual results.
Mr. Lewis concluded by providing a brief overview of the capital budget process in the private sector as exemplified by the utilities industry. Initially, an executive team sets the overall strategic plan for the company with targets for capital spending, "hurdle rates", and key performance measures. Using these guidelines, the strategic business units then develop plans to meet the targets outlined by the executive team. The operating units then develop a three to five year capital budget including information on the activity and resource needs for various projects. The capital budget is then reviewed by the strategic business units and the executive team to ensure that it is consistent with the goals of the organization.
Question from the Commissioners:
Q. How does the private sector define capital expenditures?
A. Typically a capital expenditure is something which generates measurable long-term economic benefits. For example, a utility company would consider a power substation a capital investment because the power it generates will produce a significant return on the company's investment. Capital expenditures of $10,000 or more are typically included in a capital budget, although emphasis is put on projects costing more than $500,000.
Q. Are human capital expenditures such as training
generally included in capital budgets?
A. Human capital expenditures are considered operating expenses and are typically not included in a capital budget. While there are clearly long-term benefits from such investments, it is difficult to measure the true economic benefits.