- What CAPEX and capital budgeting are
- Visual map of capital budgeting
- CAPEX vs OPEX and project types
- Steps of capital budgeting
- Investment breakdown
- Worked example: a $600,000 CNC machine
- Capital rationing: when the budget does not cover everything
- Decision and approval criteria
- Common mistakes
- Frequently asked questions
What CAPEX and capital budgeting are
CAPEX (capital expenditure) is spending on long-lived assets such as machines, buildings and systems that deliver benefits for several years. Capital budgeting is the process of planning, evaluating, approving and tracking that spending so money goes only where the return covers the cost of capital.
This article covers the process and decision criteria on the plant side. The evaluation math itself is in NPV, IRR and payback; here it is applied to a complete project.
Visual map of capital budgeting
The map shows the steps from need to approval, the investment breakdown and the result of the $600,000 example.
CAPEX vs OPEX and project types
OPEX is the recurring cost of running the plant (energy, labor, routine maintenance); CAPEX creates or expands an asset. The line matters because CAPEX is depreciated and goes through formal approval. Industrial projects usually fall into four groups:
| Type | Purpose | Example | Main criterion |
|---|---|---|---|
| Expansion | Add capacity | Second filling line | NPV and capacity actually sold |
| Replacement | Keep what exists running | Replacing a press at end of life | Lowest life-cycle cost |
| Modernization | Cut cost or improve quality | Machining center with quick changeover | NPV, IRR and payback |
| Compliance and safety | Meet a regulation or remove a hazard | Machine guarding, fume extraction | Legal obligation; lowest-cost alternative |
For replacement projects, compare alternatives on total cost of ownership, not just purchase price.
Steps of capital budgeting
- Need: describe the problem (bottleneck, cost, risk, regulation) with data, not the solution.
- Alternatives: always include "do nothing" and at least one lower-cost option.
- Investment estimate: add everything needed for the asset to run (see the example below), with contingency.
- Incremental cash flows: savings and added revenue minus added costs and taxes, year by year.
- Evaluation: NPV, IRR, simple and discounted payback, using the company hurdle rate.
- Risk: test pessimistic and optimistic cases; see investment sensitivity analysis.
- Approval: at the authority level matching the amount, within the annual budget or as an extraordinary request.
- Execution and tracking: compare actual spend with budget and deliver the asset on schedule.
- Post-audit: 6 to 12 months after start-up, check whether the expected gains happened.
Investment breakdown
The most common error is approving only the equipment price. The (fictional) example below shows a CNC machine for a modernization project:
| Item | Amount |
|---|---|
| Equipment (purchase price) | $520,000 |
| Installation, foundation and electrical infrastructure | $45,000 |
| Training and start-up | $15,000 |
| Contingency (about 3.3% of the total) | $20,000 |
| Total investment (CAPEX) | $600,000 |
Additional working capital, if any, enters the year-0 cash flow and is recovered at the end. For that effect, see the cash conversion cycle and working capital.
Worked example: a $600,000 CNC machine
The machine cuts machining cost and frees capacity hours, giving net after-tax savings of $190,000 per year for 5 years and a salvage value of $50,000 at the end of year 5. The hurdle rate is 12% per year.
| Year | Cash flow | Present value (12%) | Cumulative cash flow |
|---|---|---|---|
| 0 | −600,000 | −600,000 | −600,000 |
| 1 | 190,000 | 169,643 | −410,000 |
| 2 | 190,000 | 151,467 | −220,000 |
| 3 | 190,000 | 135,238 | −30,000 |
| 4 | 190,000 | 120,748 | 160,000 |
| 5 | 190,000 + 50,000 = 240,000 | 136,182 | 400,000 |
NPV = −600,000 + 169,643 + 151,467 + 135,238 + 120,748 + 136,182 ≈ $113,279
- NPV: $113,279 positive, so the project covers the 12% and still creates value.
- IRR: about 19.1% per year, above the 12% hurdle.
- Simple payback: 3 + 30,000 ÷ 190,000 ≈ 3.2 years.
- Discounted payback: the discounted cumulative flow is still −22,904 at the end of year 4; year 5 adds 136,182, so 4 + 22,904 ÷ 136,182 ≈ 4.2 years.
Present values are rounded; the exact sum is $113,278.82. At a 20% rate the NPV is already about −$11,700: the project's safety margin lies between 12% and 19%.
Capital rationing: when the budget does not cover everything
If four projects compete for $1,000,000, NPV alone is not enough. Rank by profitability index (NPV ÷ investment) and pick the combination with the highest total NPV within the limit:
| Project | Investment | NPV (12%) | NPV ÷ investment | IRR |
|---|---|---|---|---|
| A (CNC) | 600,000 | 113,279 | 0.189 | 19.1% |
| B | 300,000 | 60,478 | 0.202 | 19.9% |
| C | 450,000 | 18,621 | 0.041 | 13.7% |
| D | 250,000 | −33,713 | −0.135 | 6.4% |
Project D destroys value and drops out. A + B uses $900,000 for a total NPV of $173,757; B + C uses $750,000 for $79,099. A + B is the best feasible combination, and the remaining $100,000 waits for the next cycle. For indivisible projects, test combinations rather than just ranking.
Decision and approval criteria
- NPV ≥ 0 at the hurdle rate, the central criterion.
- IRR above the cost of capital as confirmation, never alone to compare projects of different scale.
- Maximum payback set by company policy, as a liquidity and risk filter.
- Return and value created: compare with the unit's ROI and EVA.
- Approval levels: the larger the amount, the higher the sign-off; align with the annual production budget.
Common mistakes
- Ignoring installation and start-up costs: the real investment exceeds the equipment price.
- Optimistic benefits: savings that depend on changing processes with no plan to do so.
- Forgetting taxes and depreciation: the relevant cash flow is net, not accounting profit.
- Leaving out the do-nothing alternative: with no baseline, every project looks good.
- Relying on payback alone: it ignores what happens after capital is recovered and the time value of money.
- Skipping the post-audit: without checking results, future estimates stay uncalibrated.
Frequently asked questions
What does CAPEX mean?
Capital expenditure: spending on long-lived assets such as machines, buildings and systems that deliver benefits for several years and are depreciated.
What is the difference between CAPEX and OPEX?
CAPEX creates or expands an asset and is depreciated; OPEX is the recurring cost of operating, such as energy, labor and routine maintenance.
What goes into a project investment?
Equipment, installation, infrastructure, training, start-up, contingency and, if any, additional working capital. In the example, $600,000 in total.
Which criterion should approve a project?
NPV at the hurdle rate is the central criterion. IRR, payback and profitability index support it. In the example, NPV of $113,279 and IRR of 19.1%.
How do I decide when the budget is smaller than the sum of projects?
Drop projects with negative NPV, rank by NPV ÷ investment and test combinations within the limit. In the example, A + B ($900,000) gives the highest NPV.
What is a post-audit for?
It compares actual results with the forecast 6 to 12 months after start-up and improves the estimates of future projects.
Sources
- Richard Brealey, Stewart Myers and Franklin Allen. Principles of Corporate Finance. McGraw-Hill.
- Stephen Ross, Randolph Westerfield and Jeffrey Jaffe. Corporate Finance. McGraw-Hill.
- Lawrence Gitman. Principles of Managerial Finance. Pearson.
- Project Management Institute. A Guide to the Project Management Body of Knowledge (PMBOK Guide). PMI.
Keep studying: trusted sources and links
- Sebrae: gestão, custos e finanças para empresas (in Portuguese)
- CFC: Conselho Federal de Contabilidade (in Portuguese)
- Wikipedia: Capital budgeting
- Wikipedia: Quality audit
Save this address: Manufatura Enxuta is your school for lean manufacturing. Come back whenever you need to study, with a complete article, a visual map and trusted sources. Follow one of the learning paths or check the A–Z glossary.
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About the author
Lean Manufacturing & Behavioral Management Specialist
Over 20 years in the automotive and metalworking industries (GM and Dana), Lean Manufacturing practitioner since 2006. SENAI instructor and mentor in Brazil’s Brasil Mais Produtivo program, delivering consulting, training and audits for 50+ companies, combining quality, productivity and people development.
