Around the globe, CxOs like you are recognizing the importance of investing in intelligent automation to improve productivity and optimize operations. But, deciding to embark on a digital transformation journey is only the first step for your organization. What comes next?
Before diving into enterprise-wide digitization, you must define your software procurement strategy as one of two approaches, capital expenditure (Capex) or operational expenditure (Opex).
A Brief Introduction to Capex and Opex
Any established business goes through multiple transactions at every touch point, both as income and expenditure. To maintain a comprehensive financial record of the company, keeping track of all these expenses is crucial.
There are many ways through which a company’s financial record can be accounted for; the two most prominent of these methods are Capex and Opex.
Capital Expenditures, or Capex, are the major purchases made by the company for large assets that add value to the company’s plans. Operating Expenses, or Opex, on the other hand, are the relatively minor expenditure that a company incurs daily.
Why is it Important to Differentiate Expenditure as Capex or Opex?
If you think about it, both Capex and Opex are types of expenditure incurred by a company. But what’s the need to create such a stark distinction between the two?
The Capex vs. Opex discussion is popular because distinguishing the two is a significant decision a business must take during its financial projections. One might argue that since they deal with expenditure, they share many similarities.
While that is true, we need to establish that there are particular distinctions between the two that a company cannot ignore.
One such essential difference between the two is their accounting treatment. The different ways of reporting an expenditure to play a vital role in any company’s plans. Certain factors like accounting principles, tax implications, and other financial considerations must be considered while determining how to treat a company’s expenditure on paper.
If you treat an expense as a capital expense, it will have different implications than if you would treat it as an operating expense. It will also dictate how external parties and concerns will perceive the company’s financial position.
Apart from accountants, the company’s management may also approach these expenses differently. Capex, for instance, is the more expensive alternative of the two. It would require quite a bit of time to reap actual rewards, time that many executives don’t have on their tenure. Opex, on the other hand, is cheaper, more flexible, and more rewarding in the short term.
A real-time example of how these financial terms can be leveraged strategically to further a company’s position is the treatment of Information Technology in modern industries.
Earlier, all expenses related to the IT sector were treated as Capex. Purchasing software and hardware, a robust infrastructure, internet connections, and so on were long-term investments that reaped benefits over longer periods.
With the arrival of cloud solutions, investing in large servers, devices, and related software is no longer a priority. It is more beneficial to consider the cost of hiring cloud-based services as an operating expense to meet the company’s flexible IT standards.
What is Capital Expenditure?
We know that there are significant differences between Capex and Opex, especially in what they imply for a company’s financial plans. Now, it’s time to pay closer attention to such differences. Let’s go back to the basics and clear one crucial query – what are Capex and Opex?
As mentioned earlier, Capex refers to expenditures that generate benefits in the future. These expenses include substantial assets such as land, machinery, and IT systems. For example, purchasing a new building may not grow your profit margins in the short run, but the investment will return significant value to your business over time.
What is Operational Expenditure?
Now let’s move on to the next part – what is Opex?
Opex is comprised of the expenses a business incurs in its day-to-day operations. Its effects can be measured within a short timeframe. Examples of operating expenses include wages, utilities, rent, and maintenance of buildings. Other operational expenditure examples are business travel, interest, accounting fees, etc.
Capex generates potential value in the future based on costs incurred by a business on its working capital. In contrast, the Opex model incurs costs on current operational terms with no scope for future value addition.
Accounting Treatment of Capex and Opex
It is often difficult to conclude the age-old capital expenditure vs. operating expense debate. But you can decide on one if you know which will better reflect the interest of your company’s accounts.
There are significant differences between how an accountant treats long-term capital investments and short-term expenses for daily operations. These differences will dictate the company’s compliance with governmental standards, tax laws, etc.
One of the most crucial differences is that an accountant can only partially deduct capital expenditure in the same accounting year during which the expenditure was incurred. Instead, the expenditure is “depreciated,” so the expenses are spread throughout the asset’s lifespan. After each accounting period, the value of the asset drops.
For example, if you purchase a piece of equipment for $100,000, the value of the machinery will start depreciating at a fixed rate every year, say 10%. So, at the end of each year, $10,000 will be recorded in the company’s financial statement as the depreciated expense. On the other hand, accountants treat operating expenses as “immediate expenses,” and they don’t have any helpful life.
Another crucial difference in their accounting treatment is where they are recorded. Capex, for example, will be recorded on the Balance Sheet under the section “property, plant, and equipment” to reflect the company’s long-term investments. On the other hand, operating expenses will be recorded on the “income statement” of the company.
You can guess the capital expense vs. operating expense debate is beginning to take shape. While they are both responsible for reducing a company’s overall income, they do so very differently.
Capital expenditure is depreciated over a long period – the asset’s useful life. Operating expense, on the other, is recorded as an expense immediately. The most fundamental difference between Capex and Opex lies in their tax implications. Operating expenses are tax-deductible for the relevant accounting period. Capital expenditures, on the other hand, are not tax-deductible. The implications and consequences of treating an expense as Capex and Opex are essential for a company’s financial plans and positioning. Proper planning regarding the same is vital.
Capex vs. Opex – The Right Fit for You
You won’t always have the choice to classify a certain expenditure as “Capex” or “Opex.” What is considered a capital expenditure by law cannot be changed. For instance, if you buy a building as your company’s workspace, accountants must treat it as capital expenditure.
But there are some areas of investment where you can determine the kind of expenditure you are making based on your company’s strategy. For instance, you can instead rent a workspace, which will be recorded as an operating expense.
Here are some other examples through which you can change a capital expenditure into an operating expense:
- Stop purchasing the hardware and software required to run an IT infrastructure and invest in cloud-based services.
- Move away from in-house, dedicated servers and opt for shared hosting plans instead.
- Stop investing in edge servers and look for third-party service providers in different geographical locations.
Based on your organization’s unique goals, you must decide between making a large, one-time capital investment and committing to a recurring expense. For instance, to select the appropriate IT procurement model for your business needs, consider the following questions:
- What is your IT department’s policy regarding Capex and Opex?
- Which approach is more likely to be approved, based on your company’s culture?
- What can your organization afford at the moment?
- Once you have answered these questions, you must analyze the pros and cons of Capex and Opex as you decide.
The benefits of capital expenditure and operational expenses can be handy for different organizations. It’s the company’s job to decide which model would work well for them based on the benefits they want in their system.
Pros of Capex:
- The developments made by capital expenditure increase production quality and facilities.
- The expenses incurred in Capex are useful for maintaining steady profits over long periods.
- The overall operational efficiency of the business improves due to the investments made under capital expenditures.
- Increased autonomy and control, especially since equipment ownership, like servers, allows for greater IT agility.
- If the total cost of ownership (TCO) is worked out for more than five years, then Capex is a clear favorite since Capex purchases are amortized, further reducing the cost.
- A higher value of assets on the balance sheet
- Higher net income to report to investors
Cons of Capex:
- Despite the advantages, capital expenses require approval from several layers of management, resulting in a lengthier procurement process. Additionally, all costs must be paid upfront, along with purchasing several supporting capabilities, such as a power supply, insurance, and maintenance.
- The Capex model requires higher cost upfront.
- Capital expenditure, contrary to popular belief, is not a one-off expenditure. After buying an asset, the expenditure becomes operational for maintenance, upkeep, repairs, etc.
- The long-term value of any capital expenditure is not definable and is, therefore, risky.
Pros of Opex:
- All the Opex purchases made in a single assessment year are deductible in terms of tax returns.
- Can be leased or purchased from a hosting company and paid on a monthly or quarterly basis
- Purchases can be claimed in the current tax year, which allows for more cash in hand
- Low monthly costs can allow for easier budget approval
- Backups, operating system upgrades, and maintenance can be performed by the provider every month (per the contract)
Cons of Capex:
- Opex has its limitations, including fluctuating monthly payments.
- Dependency on a third party to facilitate and monitor your IT performance and deliverables.
The Choice is Yours
Deciding between a Capex or Opex procurement model requires careful consideration of the benefits and challenges related to both options, especially concerning your vision. Both avenues can enable you to automate processes, achieve your goals, and transform your business—there is no right choice, only the best fit for your organization.
Why do Banks Need Automation?
As the business landscape continues to become competitive, corporate leaders are trying to find ways to put their companies on the front foot. One such method, the global consensus has it, is to rely on automation and robotics.
With the arrival of automation in the industry, the banking sector has witnessed significant automation in its business processes. Though the implementation of automation in banking activities is imminent, many are still trying to figure out an economical way to do so.
The introduction of automation in banking can reduce or even eliminate human errors and make the entire process less time-consuming. It will maximize profits and save a lot of money the bank spends on fulfilling its staffing needs.
Increasing Accessibility of Banking Automation
Earlier, only the capital expenditure financial model was applicable when making large purchases, such as installing automation in banking systems. While larger companies could leverage their capital and employ robots and automation in their infrastructure, smaller organizations could not do so.
Further, Capex only made sense if the investment was made for specific automated systems, which would compensate for the high upfront payments by amortizing everything in the long run and working with high volumes of tasks.
Nowadays, banking automation is more accessible due to the Opex model. Such automation and AI-driven technologies can now be hired through third-party service providers. Smaller companies can use this model because of the elimination of high risks and bulky upfront payments. All the initial costs involved in CapEx are converted into smaller, volume-dependent payment cycles in the OpEx model.
So, in the case of banking automation, CapEx makes sense if you are an industry giant. However, if you are running a smaller organization with little capital to spare, the OpEx financial model would be better to take you to a better place.
Finishing Up
The strategic use of Capex and Opex financial models can prove to be a massive boon for any company. It’s up to the leaders and executives of the organization to study the potential effects of Capex and Opex on their financial planning and implement their decisions wisely.
