March 18th, 2019 • capex management
When it comes to financial analysis and accounting, capital expenditure and operational expenditure are some of the most commonly confused terms. They’re both business expenses and, sometimes, the line between the two is blurred.
For example, the purchase of a photocopier would be CapEx but the purchase of toner and paper are OpEx.
CapEx and OpEx are treated differently from an income tax standpoint and businesses prefer one to the other based on various reasons. There’s a clear distinction between the two–they can’t be used interchangeably. Since the tax treatment of CapEx and OpEx are different, it’s important to know what both these expenses mean.
Operational expenditure (or OpEx) is the money a business spends on a regular, ongoing basis to run its daily operations. Since operating expenses make up the bulk of the day-to-day expenses, businesses try to minimize these costs with careful planning and management.
Operating expenses do not have future benefits usually.
Capital Expenditure (or CapEx) refers to the funds used by a business to acquire, maintain, and upgrade fixed assets. These might include plant, property, and equipment (PP&E) like buildings, machinery, and office infrastructure.
These are usually long-term assets that have a useful life or a productive purpose lasting longer than one accounting period.
When a business incurs expenses to generate profit in the future, it’s most likely that they are capital expenses. The asset purchases may either be new ones, or assets that improve the productive life of a previously existing asset.
|Funds used by a business to acquire, maintain and upgrade fixed assets||The money a business spends on a regular, ongoing basis to run its daily operations.|
|CapEx Examples: Buildings, equipments, vehicles, patents||OpEx Examples: Office, rent, utilities, salaries|
|Tax can be deducted through depreciation every year||Can be fully deducted during the incurred accounting period|
Capital expenditures are not fully deducted in the accounting period they were incurred in, but rather depreciated to spread the cost over the useful life of the asset. Every year, a part of the asset is “used up”.
Capital expenses are recorded as assets on the Balance Sheet under the “property, plant & equipment” section. On the cash flow statement, it’s recorded under “investing activities”. In the case of the Income Statement, the costs are charged to the expense account as depreciation.
For example, your company purchases machinery worth $40,000 and the life of the asset is ten years. As the machine ages, its value starts depreciating by 10 percent a year. At the end of each accounting year, $4,000 (the reduced value) is reflected by the depreciation expense in the financial statement.
Just like tangible assets are depreciated over time, intangible assets and intellectual properties are amortized over their life cycle.
Utilities, rent, salaries, and other business expenses are listed under the “Operational Expenses” section in the Income Statement. When thinking about CapEx vs OpEx, operating expenses are tax-deductible for the accounting period they were incurred in, while capital purchases are not.
Traditionally, IT investments would be considered CapEx, so businesses can take advantage of amortizing these expenses over a period of time. The software is proprietary, and often tailor-made for organizations. After the advent of the cloud era, companies have switched IT expenses to OpEx.
Most SaaS tools are subscription-based; companies pay these costs on a monthly or annual basis making these expenses extend beyond the current year. Plus, these expenses cannot be considered assets.
Choosing between CapEx and OpEx can impact the purchasing decisions of an organization to a great extent. For example, businesses can choose to lease properties and equipment instead of buying them. This enables them to fully deduct the cash expense when calculating taxes for the current year.
There are some cases when it makes more sense to go for CapEx. Purchasing and owning capital assets can boost the financial strength of any business. Apart from the high initial cost, you don’t continue paying for it.
Even though capital expenses aren’t immediately tax deductible, capital assets can provide future tax benefits over a period of time. As the equipment ages, its value is depreciated over the life of the asset. The depreciation expense can be claimed back at the end of every accounting year.
While it means little savings on tax, it indicates a higher profit and asset value on the Balance Sheet that can be reported to the stakeholders
However, capital expenses can’t be undone without the business incurring heavy losses. If your business anticipates quick growth or technological changes, OpEx would naturally be a better choice. Further, here are some reasons businesses opt for OpEx:
If you are trying to determine CapEx vs OpEx, it isn’t always an “either-or” situation. Businesses need to decide what model each expense would fall into, fully knowing the trade-offs. You need to deliberate upon the budget, financial goals, availability of funds, and tax benefits before you make a decision.