Capital rationing is the business practice in corporate finance where businesses will have to choose between different profit-producing projects based upon its capital.
Simply put, capital rationing is the decision-making process of which projects a business should pursue, based upon the resources they have.
As an individual, you have to prioritize and spend your budget wisely between your personal wants and needs.
Similarly, a business must do the same thing, as it may not have the resources to fulfill every possible profit-producing venture.
Soft Capital Rationing
Capital rationing comes in two main formats.
The first format is called soft capital rationing. Every year, major business will have multiple options to choose from, for profit-making ventures.
For example, there is an engineering department at a manufacturing company that produces thousands of patents each year.
The company would have the option to produce each and every one of those patents; however, some might be more profitable than others.
The business will be practicing soft capital rationing by selecting which profit making ventures it will pursue.
The company has appropriate levels of capital to invest in different projects. However, the use of that capital in those projects may not be equal.
When a business has to choose between multiple profit-making ventures and decides the best allocation of capital based upon the best potential, the company is practicing soft capital rationing.
Hard Capital Rationing
The other form of capital rationing is hard capital rationing.
Hard capital rationing is a process where business sets out a budgetary process, declaring the maximum amount of capital it will spend on a particular venture.
In this type of capital rationing a business is actually forming a budget and utilizing that budget as the discretionary reasoning for its capital management.
For example, a business has to choose between three different production facilities.
In this situation, the company decides that, in order to succeed in several other product lines, it can only spend a limited amount of capital for this new facility.
The decision of which new facility to utilize is based upon a hard capital rationing decision.
Thus, hard capital rationing is based upon budgets or resources, while soft capital rationing is based upon deciding between potential of the asset.
Company A has five production facilities, and each facility has 25 engineers who work at the location developing new product ideas.
At facility A, the engineers usually develop 50 potential new product lines, while at the other four facilities, the engineers develop 25 new product lines.
The best decision as to which facilities to keep should the company have to downsize in the future is dependent upon which facility engineers have the most ideas, as well as which ones are the most profitable.
In this example, the decision-making is based upon soft capital rationing.
Even though it does not state how many of those new product lines are profitable when compared to others, the company looks at where the most potential product lines come from in the production process.
In this situation, facility A has the most ideas and thus allocating capital to that facility would be because of soft capital rationing.
Company B, on the other hand, has been allocated $100 million for the development of new products to move into the company sales streams.
The company has three different facilities and each one is capable of producing an equal amount of product each year.
In this situation, the company makes a decision of allocating its capital resources based upon budgetary commitments.
Thus, its capital rationing would be considered hard capital rationing.
Capital Rationing Further Explanations
One final item to consider about capital rationing is why a company would not seek out all potential investment-making products.
The general theory of corporate finance is that a business would be successful anytime it sought to make a profit by selling a product.
Thus, the company could sell 100 widgets make million dollars or it could sell five tidbits and make million dollars.
The profit potential is the same but the allocation of capital to which one is most successful could depend on several different factors. Thus, capital rationing is based upon the rationalization of profit potential when based upon limited resources.
The corporate finance theory does not often take into account limitations as it goes against the basic premise of a business seeking to maximize profits in any way possible.
When a business has to decide what product line to develop and maximize profits based upon that product lines sales that will be practicing capital rationing whether it is hard or soft.
Some may question why the company doesn’t simply issue more stock in order to increase the amount of capital available to the business. In this situation, issuing more stock could dilute the shareholders and cause the business to be less successful when it comes to maximizing shareholder wealth.
Another consideration, which could be considered along the same lines as soft capital rationing, are the constraints of non-monetary resources.
Consider that a company may have a hundred engineers with each one developing 10 new patents per year. Some of the product lines may require those engineers to be allocated in different ways in order to get the production done.
Thus, the company would not be able to allocate enough engineers to its patent development ideas as its limited amount of engineers might have to work on other projects.
In this situation, the company would be constrained because of a non-monetary resource, namely engineers.
Finally, the company may want to practice capital rationing in arts control over exuberance by management. Managers are, after all, human beings and may tend to suspect that their division or product line is more important or more successful to the company’s overall success than a may actually be.
In this case, the company would actually be limiting the expectations of the management teams by restricting the amount of capital allocated to each team’s division.
In this way, the company would be preventing an over exuberance of profit potential in order to keep management’s expectations inside realistic domains.