Investment initiatives typically incur both CAPEX and OPEX. From an economic value perspective, the distinction between Capital Expenditure (CAPEX) and Operational Expenditure (OPEX) is significant only as far as it impacts cash flow. However, from a practical process, accounting system, and accountability perspective, this distinction is important. Increasingly providers are transforming their business models to a services-based concept, and traditional capital purchases (e.g., software, transportation, plant & machinery) are being consumed ‘as a service.’ Accounting standards may require traditional CAPEX to be conservatively accounted as OPEX. Conversely, traditional OPEX may now need to be capitalized in certain cases. In this blog, we will explore the subtleties and best practices related to the effective evaluation, budgeting, and control of both CAPEX and OPEX related to strategic project investments.
Differentiating CAPEX and OPEX
Capital expenditure (CAPEX) is incurred in the acquisition of fixed assets intended to produce a value stream in the future. Operational expenditure (OPEX) is incurred in procurement of goods and services that produce immediate value.
Theoretically, the key differentiator is the timing of future returns, and naturally this is a relative concept. Repairs and maintenance conducted on machinery to extend its useful operating life is OPEX, but replacement of the machine is CAPEX. Both are expenditure incurred today in anticipation of future benefits, so why the distinction?
The practical reality is that the classification of expenditure between CAPEX and OPEX is not based on robust economic impacts, but rather accounting and taxation requirements.
The scale of the expenditure is considered and from a materiality perspective, low-value expenditure is typically classed as OPEX for both accounting and tax purposes, irrespective of its potential useful life. For example, low-value IT equipment is commonly expensed in the period incurred for both accounting and tax purposes.
Accounting concepts require the matching of revenues expenditures into accounting ‘fiscal years,’ and taxation is applied accordingly. Thus, any expenditure likely to produce benefits for less than a year is generally automatically classified as OPEX. For example, software maintenance, whilst providing longer-term benefits, is typically expensed as incurred on an annual basis.
Accounting Policy Compliance
International Accounting Standards require that any ‘asset’ must be valued at the lower of cost or net present value of future benefits. Where the future value expenditure incurred cannot be reliably assessed, prudent accounting practice requires that these investments be ‘written-off’ in the period incurred. For example, prototype research and development costs may well produce significant long-term value, but until a new product has demonstrated commercial feasibility, these costs are conservatively expensed as OPEX.
Conversely, expenditure framed as OPEX such as an equipment lease, may in substance reflect an acquisition of a controllable long-term asset, and accounting standard IAS 16 now requires these leases to be capitalized.
Cash Flow Implications of CAPEX and OPEX
From an economic perspective, the initial cash outflows of CAPEX and OPEX are indistinguishable: goods and services are received from a supplier, who is then compensated in accordance with agreed payment terms.
The only direct cash flow consequence relates to the valuation of the tax shield provided by the expenditure. The tax shield is the net present value of tax offsets related to the expenditure. Where accounting principles and tax regulations require the expenditure to be depreciated over multiple years, the tax shield is worth less than when the full cost is deductible up-front.
Financial Reporting Implications of CAPEX and OPEX
An indirect consequence of the distinction relates to a firm’s funding capacities and cost of capital. Where expenditure is classified as OPEX, and expensed in the accounting period incurred, the reported earnings in the applicable period are reduced. This may affect the ability of the firm to raise fresh capital or require higher interest and dividend payments.
Management Implications of CAPEX and OPEX
Most organizations focus on the income statement – the evaluation of revenues and expenditures in an accounting period to determine operating profit or loss. Management teams are frequently incentivized by shareholders to produce profitable returns with bonuses linked to this short-term operating result. Consequently, most organizations would have an operating plan to measure their annual income and expenses at a business unit and cost centre level. OPEX costs directly impact this short-term result, with a consequence that most managers would prefer investments to be classified as CAPEX, so that future benefits are more aligned to the amortized cost and depreciation.
Alternatively, where incentives are more aligned to firm valuation, treating investments as OPEX will increase the value of the value of the tax shield, and therefore the true economic value of the investment.
Awareness of the moral hazard associated with classification of investment costs as CAPEX and OPEX is the reason most organizations establish strict policy guidelines to ensure consistency in the definition and evaluation of project alternatives.
System Implications of CAPEX and OPEX
Operating expenditure (OPEX) is typically planned at a cost centre (e.g., IT department) and cost element (e.g., consulting fees) per period. Capital expenditure (CAPEX) is ultimately accounted for in a cost centre through depreciation. The depreciation impact of capital expenditure is based on the assessed useful life of the asset.
Actual vs planned OPEX is typically scrutinized closely on a periodic basis and is well serviced by standard system reports.
Capital expenditure (CAPEX) is planned by project and investment reason (e.g., replacement). This capital budget is often not directly reflected within the management accounting system. Sustenance capital expenditure is relatively predictable and in a steady-state environment, proportionate to annual depreciation. However, investments in growth, strategic, and compliance projects may vary substantially based on a firms’ current operating environment. Most organizations will therefore go through an annual capital budgeting process to identify the wishlist of capital investments and prioritize these according to resource and capital constraints to establish an optimal portfolio of projects to undertake during a fiscal year. This ‘capital budget’ is often simply maintained in a spreadsheet.
So, whilst the capital component of projects is planned in the capital budget, and other operational expenditure is planned at a cost centre level, where are the OPEX components of a capital projects portfolio planned? It is this intersection of the OPEX component of a CAPEX project portfolio that needs careful system consideration to avoid being missed or duplicated:
Workflow Process Implications of CAPEX and OPEX
Because of the materiality and long-term commitment, CAPEX projects normally require extensive Authorization for Expenditure (AFE) or Capital Expenditure Request (CER) approval. The length of this approval chain is based on value, and commonly investment reason, asset class, and whether or not the project was included in the annual capital budget.
Operational expenditure is normally addressed through the procurement process, based on purchase requisition or purchase order approval release strategies.
The delegation of authority levels defined by an organization for CAPEX and OPEX expenditure are often different, and implemented in different tools, or manually enforced. Whilst OPEX approvals lead directly to a commitment with a vendor, CAPEX approval typically authorizes a budget allocation to the project, with supplier contracts and purchase orders subject to a second approval.
These policy and process variations create further complexity in the approval process of projects combining both CAPEX and OPEX components.
Best Practice for Evaluation of Initiatives with CAPEX and OPEX
The key principle in the evaluation of investment initiatives is to consider all related costs, including both CAPEX and OPEX components. From an economic perspective, the distinction is in any event subtle, and primarily related to the valuation of the tax shield. Financial analyses should be based on templates that provide simple guidance to sponsors as to the appropriate classification and inter-dependency of cost components. Internal processes should be established to review business case submissions to validate this classification and try and achieve consistency, but the most critical point is that ALL costs are included for a holistic assessment of each initiative.
Some organizations treat initial prototype and design stages as OPEX until final sanction is granted, at which point these costs may be capitalized. Whilst from an accounting perspective, this conservative valuation approach is to treat expenditure as OPEX until long-term value is established, the conservative economic valuation approach for projects is to assume that the costs are capital in nature, and that the tax shield will only apply in future periods.
Because of the potential variability of taxation regimes (for example accelerated write-offs offered to organization during the pandemic), some organizations forgo the consideration of taxation when considering the Net Present Value of investments. Whilst this is a convenient simplification, this can unduly benefit certain types of investments (e.g., buildings) by ignoring the tax shield benefits associated with investments providing an accelerated tax write-off (e.g., plant and equipment).
Best Practice for Budgeting of Initiatives with CAPEX and OPEX
Whilst ‘business-as-usual’ OPEX is most effectively planned and budgeted within a cost centre, CAPEX costs together with related OPEX components should be budgeted within the capital budget. Because the operating environment is seldom static, all organizations should aspire to bring greater agility into their capital project portfolio management processes to achieve an optimal strategic outcome on limited human and financial resources. This capital budget should clearly identify CAPEX and OPEX cost components and provided a comprehensive forecast of future cashflows including the tax shield.
Projects should be structured to support the segregation of CAPEX and OPEX components. This allows for explicit budget allocation, and the effective accounting for capital work in progress and ultimate settlement to fixed assets.
Best Practice for Control of Initiatives with CAPEX and OPEX
Responsibility accounting and reporting systems should be enhanced to provide area managers with effective analysis of the capital project budgets, commitments and forecasts. In addition to ongoing effective management of their project portfolio cost, sponsors should be able to monitor the impact on future revenue flows or cost savings from delays or changes to their investment portfolio.
Seamlessly Manage CAPEX and OPEX
Most significant projects have both CAPEX and OPEX components. The distinction is subtle but important for seamless evaluation, budgeting, and control.
Your Capital Budgeting process should accommodate both, and delegation and control policies should be based on the substance of the commitment, and not the form of procurement or accounting rules.
Stratex Online incorporates classification and distinction of both CAPEX and OPEX from initial idea through to final asset. In the financial analysis of Business Cases, tax shields are automatically calculated based on tax regimes. Workflows are based on gross-commitments, and projects are structured for effective control of capital costs and asset accounting. Comprehensive reporting based on a single source of truth helps ensure that capital project portfolios are continuously monitored and optimized to achieve your strategic goals and maximize your return on investment of both CAPEX and OPEX.