Capital Expenditures vs. Operating Expenses: An Overview
Capital expenditures are for major purchases that will be used in the future. The life of these purchases extends beyond the current accounting period in which they were purchased. Because these costs can only be recovered over time through depreciation, companies ordinarily budget for CAPEX purchases separately from preparing an operational budget. They tend to also include disinvestment for CAPEX reduction.
Operating expenses represent the other day-to-day expenses necessary to keep the business running. These are short-term costs and are used up in the same accounting period in which they were purchased.
Capital expenditures are the amounts that companies use to purchase major physical goods or services that will be used for more than one year. For example, a company might have capital expenditures to increase or improve its fixed assets.
Fixed assets are treated as noncurrent assets from an accounting standpoint, meaning they won't be consumed in the first year.
Capital expenditures might include:
- Plant and equipment purchases
- Building expansion and improvements
- Hardware purchases, such as computers
- Vehicles to transport goods
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.
The capital expenditure is recorded as an asset on the balance sheet under the section "property, plant & equipment." However, it's also recorded on the cash flow statement under "investing activities," since it's a cash outlay for that accounting period.
Once the asset is being used, it's depreciated over time to spread the cost of the asset over its useful life. In other words, each year, a part of the fixed asset is being used up. Depreciation represents the amount of wear and tear on the fixed asset, and the amount of depreciation for each year can be used as a tax deduction. In general, 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. (Of course, situations vary: A tax advisor can advise on how the IRS calculates depreciation more specifically.)
Capital Expenditures (CAPEX)
Operating expenses are the costs for a company to run its business operations on a daily basis. Examples include:
- Salaries and pension plan contributions
- Any expense considered sales, general, & administrative expenses (SG&A) on the income statement
- Research & development
- Property taxes
- Business travel
As operational expenses make up the bulk of a company's regular costs, management typically looks for ways to reduce operating expenses without causing a critical drop in quality or production output. In contrast to capital expenditures, operating expenses are fully tax-deductible in the year they are made.
It's important to note that 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.
- There are distinct differences between capital expenditures and operating expenses and their respective tax treatments.
- Capital expenditures are for major purchases that will be used in the future.
- Operating expenses represent the other day-to-day expenses necessary to keep the business running.