Capital expenditures (CAPEX) and operating expenses (OPEX) represent two basic categories of business expenses. They differ in the nature of the expenses and in their respective treatments for tax purposes.
Capital expenditures are the funds that a business uses to purchase major physical goods or services to expand the company’s abilities to generate profits. These purchases can include hardware (such as printers or computers), vehicles to transport goods, or the purchase or construction of a new building. The type of industry a company is involved in largely determines the nature of its capital expenditures. The asset purchased may be a new asset or something that improves the productive life of a previously purchased asset. If the asset’s useful life extends more than a year, then the company must capitalize the expense, using depreciation to spread the cost of the asset over its designated useful life as determined by tax regulations. Capital expenses are most often depreciated over a five- to 10-year period but may be depreciated over more than two decades in the case of real estate.
An operating expense results from the ongoing costs a company pays to run its basic business. In contrast to capital expenditures, operating expenses are fully tax-deductible in the year they are made. As operational expenses make up the bulk of a company’s regular costs, management examines ways to lower operating expenses without causing a critical drop in quality or production output. Sometimes an item that would ordinarily be obtained through capital expenditure can have its cost assigned to operating expenses if a company chooses to lease the item rather than purchase it. This can be a financially attractive option if the company has limited cash flow and wants to be able to deduct the total item cost for the year.
Because capital expenditures are major purchases, and their costs can only be recovered over time through depreciation, companies ordinarily budget for these purchases separately from preparing an operational budget.
How should a company budget for capital expenditures?
The process of budgeting for capital expenditures is essential for a business to operate and grow from a sound financial position. Capital expenditures are expenses a business makes to generate financial benefits over a period of years. Thus, a capital expense is the cost of assets that have usefulness and can help a company create profits for a period longer than the current tax year. This distinguishes them from operational expenditures, expenses for assets that are purchased and consumed, or used up, all within the same tax year. For example, printer paper is an operational expense; the printer itself is a capital expense. Capital expenditures are much higher than operational expenses, covering the purchase of buildings, equipment and company vehicles, although they may also include items such as money spent to purchase other firms or on research and development. Operational expenses are just what their name signifies, the expenses required for the company to operate from week-to-week or month-to-month.
Because capital expenditures represent substantial investments of cash, designed to show a return on the capital investment over a period of years, it is important for companies to carefully plan for them. Nearly all companies budget separately for capital expenditures. Having a separate budget from operational expenses makes it simpler for companies to calculate the respective tax issues. For operational expenses, deductions apply to the current tax year, but deductions for capital expenditures are spread out over a space of years and figured as depreciation.
The procedures for the preparation of a capital expenditures budget obviously vary from one company to another depending on such factors as the nature of the company’s business and the size of the company. In large firms, the first step in capital budgeting may be individual departments within the company submitting requests for things the department needs that fall under the heading of capital expenditures. In the end, however, capital expenditures are inevitably determined by upper management and owners. For one thing, the decisions involve very large expenditures, and it is management that must make the evaluation as to whether the investment in assets is worth the cost. Capital expenses almost always impact operational expenses as purchased items need to be maintained, and the “big picture” needs to be considered. Management must make the call on whether capital expenditures come directly from company funds or if they must be financed. Leasing is an option as well, one that becomes appealing if a company is purchasing assets such as computers or other technology equipment, items that can quickly become obsolete.
Budgeting for capital expenditures is critical future planning. In deciding on a certain capital expenditure, a company’s management makes a statement about its view of the company’s current financial condition and its prospects for future growth. It is also giving indications regarding what direction(s) it plans to move in the years ahead. Capital expenditure budgets are commonly constructed to cover periods of five to 10 years, and therefore can serve as major indicators regarding a company’s “five year plan” or long-term goals.