Operating Expense vs. Capital Expense: An Overview
There are a variety of expenses that come with owning and operating a business. These expenses can be separated into different categories. Two of the most common types of expenses are operating expenses and capital expenses.
An operating expense (OpEx) is an expense required for the day-to-day functioning of a business. This means a business incurs an operating expense on a recurring basis. Operating expenses include things like insurance, payroll, and marketing. A capital expense (CapEx), on the other hand, is incurred to create a benefit in the future. They are long-term in nature and are generally used to acquire things like property, equipment, and technology.
Operating and capital expenses are treated quite differently for the purposes of accounting, financial statements, and tax reporting. But a company can sometimes choose whether an expense will be an operating or capital expense, for example, whether a needed asset is leased or bought.
- Expenses are a normal part of running a business.
- Operating expenses occur during the regular course of business
- Examples of operating expenses include general and administrative expenses, research and development, and the cost of goods sold.
- A capital expenditure is incurred when a business uses collateral or takes on debt to buy a new asset or add value of an existing asset.
- Capital expenses include the cost of fixed assets and the acquisition of intangible assets.
Operating expenses are any costs incurred during the course of regular business and are much easier to understand conceptually than capital expenses since they are part of the day-to-day operations. All operating expenses are recorded on a company's income statement as expenses in the period when they were incurred. These include:
- General and administrative expenses, including office supplies, travel, and distribution
- Research and development (R&D)
- Cost of goods sold (COGS)
- Licensing fees
- Property taxes
If equipment is leased instead of purchased, it is typically considered an operating expense. General repairs and maintenance of existing fixed assets such as buildings and equipment are also considered operating expenses unless the improvements will increase the useful life of the asset.
A company may have the choice of incurring an operating or a capital expenditure during the course of running its business. For example, if it needs more storage space to house its data, it can either invest in new data storage devices as a capital expense or lease space in a data center as an operational expense.
Operating expenses and capital expenses are treated quite differently for accounting and tax purposes.
A capital expenditure is incurred when a business spends money, uses collateral, or takes on debt to buy a new asset or to add value to an existing asset with the expectation of receiving benefits for longer than a single tax year. Put simply, it represents an investment in the business.
Examples of capital expenses include the purchase of fixed assets, such as new buildings or business equipment. They also include upgrades to existing facilities and the acquisition of intangible assets, such as patents and other forms of technology.
Capital expenses are recorded as assets on a company's balance sheet rather than as expenses on the income statement. The asset is then depreciated over the total life of the asset, with a period depreciation expense charged to the company's income statement, normally monthly. Accumulated depreciation is recorded on the company's balance sheet as the summation of all depreciation expenses, and it reduces the value of the asset over the life of that asset.
Companies can calculate their gross profit by subtracting the cost of goods sold from their gross receipts. COGS often include the cost of raw materials, factory overhead, labor, and storage costs.
One of the main differences between these two types of expenses is how they're treated for tax purposes. According to the Internal Revenue Service (IRS), companies can only deduct expenses as long as they are ordinary and necessary. It defines ordinary expenses as those that are both common and accepted within a specific industry. A necessary expense is one that is considered appropriate for the business.
Companies are able to fully deduct operating expenses in the same year they are incurred. For instance, it can report the total amount of annual property taxes paid on a plant it owns at the end of the year.
But this same rule doesn't apply to capital expenses. The IRS classifies capital expenses as those related to startup costs, business assets, and any improvements made to a business. The IRS doesn't allow businesses to deduct the total amount spent on an asset, which means they can only deduct capital expenses based on the total amount of depreciation during a given year.
How Are Capital Expenses Different From Operating Expenses?
Capital expenses are any costs that provide future benefits to a business. Operating expenses, on the other hand, are incurred during the regular, day-to-day operations of a business. Both of these expenses are also treated differently for tax purposes. Capital expenses can only be deducted based on the total amount of depreciation each year while operating expenses can be reported only in the year they occur.
Why Are CapEx and OpEx Important to Understand?
CapEx and OpEx are both important figures that companies need to understand in order to run their businesses efficiently and effectively.
CapEx spending allows companies to help maintain their plant, property, and equipment and find ways to improve these assets, whether that's through improving them or by purchasing new ones.
Business leaders can find cost-cutting measures and identify opportunities for increased efficiency if they're fully able to understand OpEx.
How Are Capital and Operating Expenses Calculated?
Capital expenses can be determined by using the information found on a company's financial statements, including its balance sheet. To calculate this figure for the current year, subtract the current year's PP&E from this year's, then add the total amount of depreciation from the current year.
To calculate a company's operating expenses, add up the total amount of assets that are used in its day-to-day operations, including labor, taxes, marketing, utilities, etc.