Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed assets, with a longer-term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.
|Aspect||CAPEX (Capital Expenditure)||OPEX (Operational Expenditure)|
|Definition||– CAPEX represents investments in long-term assets, such as property, equipment, or infrastructure, that provide benefits over an extended period. It includes the purchase and improvement of physical assets.||– OPEX encompasses day-to-day operating expenses required to keep a business running smoothly. These costs are incurred regularly and have a short-term impact. OPEX includes salaries, utilities, and maintenance.|
|Nature||– CAPEX involves substantial, one-time expenditures with a focus on future benefits. These investments often require significant planning and budgeting.||– OPEX consists of recurring, routine expenses necessary for daily operations. These costs are essential to maintain existing assets and support ongoing activities.|
|Accounting||– In accounting, CAPEX is recorded on the balance sheet as an asset and is depreciated over its useful life. This depreciation expense is recorded on the income statement.||– OPEX is recorded directly on the income statement and is deducted from revenue to calculate net income.|
|Tax Treatment||– CAPEX may offer tax benefits as depreciation and amortization expenses can reduce taxable income. Governments may provide incentives for certain capital investments.||– OPEX is generally fully deductible as a business expense in the year it occurs, reducing taxable income in the current tax year.|
|Examples||– Building a new manufacturing facility. – Purchasing heavy machinery for production. – Expanding office space. – Developing proprietary software. – Acquiring vehicles for a delivery fleet.||– Employee salaries and wages. – Utility bills (electricity, water, gas). – Rent for office space. – Office supplies and consumables. – Maintenance and repairs. – Marketing and advertising expenses. – Insurance premiums. – Software subscriptions. – Travel and entertainment costs. – Lease payments for equipment or facilities.|
|Impact on Financial Statements||– CAPEX impacts the balance sheet by increasing assets and can affect the income statement through depreciation expenses over time.||– OPEX directly affects the income statement by reducing profit and cash flow, with no long-term impact on the balance sheet.|
|Timing of Expense||– CAPEX expenses are incurred upfront, often in large sums, before generating future benefits.||– OPEX expenses occur regularly and are distributed throughout the operational period.|
|Strategic Focus||– CAPEX decisions are strategic, aiming to enhance capabilities, expand capacity, or improve competitiveness in the long run.||– OPEX decisions are operational, ensuring the day-to-day functioning of the business and sustaining current operations.|
|Flexibility||– CAPEX investments are less flexible as they are typically long-term commitments, and changes may be costly.||– OPEX expenses offer more flexibility as they can be adjusted relatively quickly to align with changing business needs.|
|Risk||– CAPEX investments carry higher financial risk due to the large sums involved and the uncertainty of future returns.||– OPEX expenses pose less financial risk as they are typically predictable and can be managed more easily.|
|Management||– CAPEX decisions often involve senior management or board approval due to their strategic importance.||– OPEX is typically managed by department heads or operational managers responsible for day-to-day activities.|
|Decision-Making Factors||– CAPEX decisions consider long-term ROI, asset lifespan, and potential competitive advantages.||– OPEX decisions prioritize cost control, efficiency, and immediate impact on profitability.|
|Common Challenges||– CAPEX decisions may lead to overcapitalization, underutilized assets, or miscalculations of future benefits.||– OPEX challenges include cost containment, managing variable expenses, and optimizing operational efficiency.|
CAPEX vs. OPEX
They are the acronyms for Operating Expenditure and Capital Expenditure. For example, imagine you own a real estate firm.
The firm bought an apartment complex with few units. In order for you to rent the apartments, you have to clean and furnish them.
The former activity implies that you call the maid, and pay him/her $100 to have the apartment cleaned.
The latter activity instead implies buying things, such as couches, kitchen stoves, beds, and so on. They will cost you thousands of dollars but will last for a few years.
The Operating Expense is money spent on the day-to-day operations of the business. Capital Expenditure, instead, is money invested in the business from a long-term perspective.
Stop for a second and think. Is the cleaning service OPEX or CAPEX?
The $100 paid to the maid is OPEX.
The money spent on furnishing the apartment, instead, will be defined as CAPEX.
What helps to discriminate between the two are actually three factors:
- Useful Life (More than one accounting cycle).
- Amount Spent (Over $2,500).
- Future Benefits (Will generate revenue).
Indeed, in the first scenario, the maid cleaning expense will have a useful life of a few weeks. Furthermore, it is worth less than $2,500 and it won’t produce any future benefits.
On the other hand, couches and kitchen stoves will have a useful life of few years.
Further, whey will be worth over $2,500 and it will produce future benefits. Of course, there are a few exceptions.
Imagine, the apartment complex your company bought needs to be repainted. Therefore, the painting work is comprised of material (Paint) for $500 and labor (Painter) for $5,000.
The painter’s work meets all the criteria above; thereby it is a Capital Expenditure. What about the material (paint)? Even though the paint does not meet all the three CAPEX requirements.
Although, it can have a useful life of more than one accounting cycle, in our specific case it is not worth more than $2,500. Indeed, there is no way the painter would be able to finalize the work without pain.
Therefore, we will consider the paint as part of the overall work. Thereby, the paint and the labor will be both considered CAPEX. Why is this difference between operating and capital expenditure crucial?
In reporting terms the operating expense will be stated on the Income Statement (Expense Section), the Capital Expenditure instead will be stated on the Balance Sheet (Non-Current Assets Section).
Why is Capital expenditure stated on the Balance Sheet?
Because it will be capitalized. What does it mean? Let me give you a further example. Imagine you bought $20,000 worth of furnishing.
Assuming that the useful life of the items is ten years.
If you were to report the $20K furniture as an expense in the first year your profits would be completely eroded due to the fact that you should report a $20K expense under your income statement.
Instead, since this is a capital expenditure it needs to be spread along with its useful life. In the specific example: ten years.
See the example below:
Difference between Tangible and Intangible Assets
The former are things with a physical entity, while the latter does not have a physical entity. Imagine you own an IT corporation.
What do you need to operate the business? Of course, you need the office, computers and office supplies.
Assuming the corporation produces accounting software. How is your organization generating revenue? Through licensing the software. Therefore, it is crucial to make sure no one will clone it.
How can you avoid cloning?
Through patenting the software. In this example, the patent is an Intangible Asset. The remaining assets: Office building, computers, and supplies are Tangible Assets.
Why is this difference important?
Depreciation & Amortization (D&A).
In the previous example, the IT Corporation needs computers to operate. Assuming 10 computers were bought for $2,000 each, the total Capital Expenditure was $20K.
Furthermore, they won’t last forever. Assuming a useful life of five years we have to figure out: What is the depreciation and How to record the transaction.
First, depreciation is the decreasing value of the asset on a yearly basis. Second, the formula to compute the depreciation rate is (Asset Cost – Residual Value) / Useful Life.
Let’s solve the previous example: the asset cost = $20,000 minus the residual value = $2,000. Divide the result by 5.
This is the formula: ($20K Cost – $2k Residual Value) / 5 years Useful Life) = $18K / 5 = $3,600 per year. In conclusion, your schedule will look like the following:
This method is called straight-line depreciation. Although there are several depreciation methodologies, the straight-line is the most commonly used.
Why do we need to depreciate?
As we saw in step 1, it would be unfair to report the whole asset cost under the Income Statement since it would completely erode Net Income.
It is correct instead to spread the value of the asset over the useful life.
Amortization follows the same process as Depreciation. Keep in mind: that the tangible assets are depreciated; the intangible assets are amortized.
If we go back to the example made a while ago, the IT corporation has at its disposal: tangible assets, such as computers, and intangible assets, such as patents.
Therefore, the former will be subject to depreciation, the latter to amortization.
Amortization and Depreciation are linked to ordinary events in the asset’s life. When, instead, an asset loses value unexpectedly, it will be subject to impairment.
Imagine your real estate company bought a building at $10 million, with a useful life of 5 years.
At the end of year two due to earth quick, the building is badly damaged. Suddenly the fair market value drops to $5 million. The company decides to sell the building.
How do we estimate the impairment?
First, we have to estimate the carrying value of the Building. This is the Cost of the asset minus its accumulated depreciation = $6 million, or $10 million minus $4 million (10 million/5 years = 2 million x 2 years).
The book value of the building at year two is $6 million and the recoverable amount is $5 million, therefore the impairment amount is $1 million.
The following journal entry will be recorded on our balance sheet and income statement:
Imagine the opposite scenario. The building increased in fair value instead. At the end of year one, the building is worth $9 million.
Given the carrying value of the building of $8 million, it revaluated by $1 million. We have to record the revaluation on our books:
Capital expenditure examples
Below we will list some examples of where a business may spend money to purchase, upgrade, or extend the life of an asset.
Property, plant, and equipment
Property, plant, and equipment (PP&E) assets are tangible, identifiable, fixed, long-term assets that are predicted to result in an economic return for at least one year, operating cycle, or reporting period.
PP&E is a broad classification with many different asset types.
But in general, purchases of these assets are made with secured debt with repayments made over a number of years.
Here are some of the asset types and some examples for each.
Consider a cement manufacturing company that wants to upgrade the assets at its factory.
In this example, capital expenditure applies to items such as a cement roller press, cement rotary kiln, shaft kiln, and cement vertical mill.
The costs acquired to transport the machinery/equipment to its intended location can also be considered capital expenditure.
The purchase of land is also a capital expenditure in some cases.
When an airport management company wants to expand its operations, it may purchase a tract of land to build a new airport or expand an existing one.
CAPEX also applies when the land is upgraded.
For example, the company that owns a sports stadium may install a new irrigation system or build a new parking lot for fans.
Broadly, vehicles are considered a capital expense when they pick up clients, transport goods, or are otherwise used for business-related purposes.
In the case of a rental company that leases vehicles to individuals and other businesses, the vehicles are considered a capital expense irrespective of whether their purchase was funded by debt or cash.
However, it should be noted that if another business leases vehicles from such a company, it is an operational expense.
Software purchases are complex in that some are CAPEX and others are OPEX.
Owned enterprise software licenses and upgrades are generally considered capital expenditures and can be depreciated provided they meet certain criteria.
If the company is creating software from scratch, some internal research and development or technical design expenses can also be capitalized and depreciated.
Hardware such as computers, servers, and uninterrupted power supply (UPS) systems can be listed as a capital expense provided the company owns them and has total control over their location, disposition, and use.
If a company wants to enable its staff to work remotely, for example, a capital expense may be the laptops it must purchase.
Intellectual property, patents, and licenses
Intangible or non-physical assets such as intellectual property, patents, licenses, and trademarks can also be considered capital expenditures.
One example is a taxi company that needs to purchase a taxi license to operate lawfully.
Another example is the pharmaceutical giant GlaxoSmithKline (GSK).
The company has significant capital expenses related to research, development, and patenting of medicines, vaccines, and other consumer healthcare products.
- CAPEX or capital expenditure represents the money spent by the organization, in what are defined as fixed assets, on the balance sheet.
- The capital expenditure will sit on the balance sheet, and be amortized over the years as amortization expenses under the income statement.
Key Similarities between CAPEX and OPEX:
- Expense Categories: Both CAPEX (Capital Expenditure) and OPEX (Operating Expenditure) are two main categories of expenses incurred by businesses.
- Impact on Financial Statements: Both CAPEX and OPEX affect a company’s financial statements. CAPEX impacts the balance sheet as it represents an investment in long-term assets, and it is amortized or depreciated over time, affecting the income statement. OPEX, on the other hand, directly impacts the income statement as it represents day-to-day operational expenses.
- Necessity for Business Operations: Both types of expenses are essential for running a business smoothly. CAPEX is required to acquire, upgrade, or extend the life of assets necessary for business operations, while OPEX covers ongoing expenses required for daily operations.
Key Differences between CAPEX and OPEX:
- Nature of Expense: The primary difference between CAPEX and OPEX is the nature of the expense. CAPEX refers to investments in long-term assets, such as property, plant, equipment, and intangible assets like patents and licenses. OPEX, on the other hand, includes short-term expenses for day-to-day operational activities like salaries, utilities, rent, and office supplies.
- Accounting Treatment: CAPEX is capitalized on the balance sheet and then gradually expensed over the useful life of the asset through depreciation (for tangible assets) or amortization (for intangible assets). OPEX is directly recorded on the income statement for the period in which the expense is incurred.
- Useful Life and Benefits: Capital expenditures have a longer useful life and provide benefits over multiple accounting periods. In contrast, operating expenditures are typically consumed within the same accounting period and do not result in long-term assets.
- Threshold for Recognition: CAPEX is usually recognized if the expenditure meets specific criteria, such as having a cost above a certain threshold (e.g., $2,500) and generating future economic benefits. OPEX, on the other hand, is recognized as expenses as and when they are incurred, without any threshold or requirement for future benefits.
- Reporting on Financial Statements: On the financial statements, CAPEX is reported as part of non-current assets on the balance sheet, while the associated depreciation or amortization is reported on the income statement as an expense. OPEX is reported directly as expenses on the income statement, contributing to the calculation of net income.
- Technology & Software:
- Purchasing a server for hosting a company website (CAPEX).
- Monthly subscription fee for cloud storage services (OPEX).
- Developing custom software for internal use (CAPEX).
- Paying for yearly antivirus software licenses (OPEX).
- Real Estate & Infrastructure:
- Buying a new office building (CAPEX).
- Monthly office rent (OPEX).
- Installing a new elevator in an existing building (CAPEX).
- Routine maintenance of the office HVAC system (OPEX).
- Manufacturing & Production:
- Acquiring a new assembly line robot (CAPEX).
- Electricity bill for running the factory (OPEX).
- Building a new manufacturing plant (CAPEX).
- Raw materials used in daily production (OPEX).
- Vehicles & Transportation:
- Purchasing a delivery truck for a retail business (CAPEX).
- Fuel expenses for company cars (OPEX).
- Upgrading an airline’s fleet with new airplanes (CAPEX).
- Routine aircraft maintenance checks (OPEX).
- Research & Development:
- Setting up a new research lab with equipment (CAPEX).
- Salaries of research scientists (OPEX).
- Investment in a multi-year project to develop a new product (CAPEX).
- Costs of daily experiments and trials (OPEX).
- Retail & Sales:
- Buying new Point of Sale (POS) systems for a chain of stores (CAPEX).
- Daily expenses for store cleaning and maintenance (OPEX).
- Renovation and expansion of a shop (CAPEX).
- Inventory purchased for resale in a boutique (OPEX).
- Marketing & Advertising:
- Building a large, permanent billboard in a prime location (CAPEX).
- Monthly payments for digital ad campaigns (OPEX).
- Creating a one-time, high-quality promotional video (CAPEX).
- Regular print of flyers and brochures for distribution (OPEX).
- Hospitality & Tourism:
- Constructing a new wing in a hotel (CAPEX).
- Daily costs of cleaning and room service (OPEX).
- Investing in a new resort property (CAPEX).
- Expenses for staff training and workshops (OPEX).
- Capital Expenditure (CAPEX) refers to funds spent on acquiring or upgrading fixed assets.
- CAPEX includes costs like buying land, machinery, or intangible assets like patents.
- Operating Expenditure (OPEX) covers daily operational expenses such as salaries and rent.
- CAPEX results in long-term assets, whereas OPEX expenses are for short-term operational needs.
- In accounting, CAPEX is capitalized and amortized over time, while OPEX is directly expensed.
- Examples of CAPEX: Buying an office building, investing in a new software system.
- Examples of OPEX: Monthly electricity bills, employee salaries, marketing costs.
- CAPEX affects both the balance sheet (asset value) and income statement (depreciation), while OPEX only impacts the income statement.
- Key criteria for CAPEX include a useful life of more than one accounting cycle, an amount spent over a threshold (e.g., $2,500), and the ability to generate future revenue.
- Tangible assets like machinery get depreciated, while intangible assets like patents get amortized.
- Deciding between CAPEX and OPEX can impact a company’s financial statements, tax position, and cash flows.
Connected Financial Concepts
Connected Video Lectures
- Business Frameworks
- Business Analysis Framework
- Cash Flow Statement In A Nutshell
- How To Read A Balance Sheet Like An Expert
- Income Statement In A Nutshell
- What is a Moat?
- Gross Margin In A Nutshell
- Profit Margin In A Nutshell
- What is a Financial Ratio
- Types of Business Models You Need to Know
- The Complete Guide To Business Development
- Business Strategy Examples
- What Is Market Segmentation? the Ultimate Guide to Market Segmentation
- Marketing Strategy: Definition, Types, And Examples