Operating expenses (OpEx) are expenses needed to operate your business on an ongoing basis and appear on the profit and loss statement. Capital expenses (CapEx) refer specifically to long-term assets purchased as an investment in your business, the benefits of which will last longer than one year. Capital expenses are reported on the balance sheet, with a percentage of the expenditure recorded on the profit and loss statement as a depreciation expense on a routine (i.e. monthly) basis.
As a business owner, you already know it’s important to carefully monitor your expenses to keep your business accounting in order, manage cash flow, and keep your operations running smoothly overall.
Keeping your expenses down is the easiest way to improve your business’s profitability and ensure you maintain the cash flow necessary to grow your business. But what you might not know is that not all expenses are created equal. Nearly all expenses represent cash flowing out of your business, but that doesn’t mean they all impact your profitability equally.
If this seems confusing, don’t despair. In this article, we’ll look at how different types of expenses impact your profitability and the differences between the two most commonly misunderstood business expenditures: operating expenses vs. capital expenses.
To many business owners, any money spent in the business is an expense. This makes sense from a logical standpoint because all expenditures represent money leaving the business in some form or fashion.
From an accounting standpoint, though, certain expenditures are not immediately recognized as expenses on the business’s financial statements. Some expenditures—like the purchase of assets—are recognized as expenses over a number of years through a process called depreciation.
Most of your expenditures are probably expenses from an accounting standpoint. The expenditures you make for the day-to-day operations of your business are recognized on your profit and loss statement as expenses when they are incurred. These are called operating expenses. But occasionally, your business might incur a capital expenditure—or capital expense—which is outside of the normal operations of your business.
Operating expenses (or OpEx) are—as the name implies—expenses needed to operate your business on an ongoing basis. These expenses happen routinely, either on a set schedule or on a semi-regular basis.
Some examples of operating expenses include:
Basically, anything that goes into the routine operations of your business is considered an operating expense.
Capital expenses really aren’t expenses from an accounting perspective at all. In fact, most accountants prefer the term “capital expenditures” in order to eliminate confusion.
Capital expenditures/expenses (or CapEx) represent an investment made in the business, the benefits of which are expected to last longer than one year. Unlike operating expenses, capital expenses don’t appear on the profit and loss statement. Instead, capital expenses are reported on the balance sheet. Then, on a routine (usually monthly) basis, a percentage of the expenditure is recorded on the profit and loss statement as a depreciation expense.
Some examples of capital expenditures include:
Many accountants use the general term “assets” for capital expenses. But CapEx refers specifically to long-term assets. Current assets—like accounts receivable and inventory—are not considered to be capital expenses.
As you might have guessed, CapEx and OpEx are treated differently for tax purposes. Operating expenses are fully deductible in the year they are incurred. If you are a cash basis taxpayer, you might even be able to prepay some expenses for a future year and take a tax deduction for the expense in the year you make the payment.
In practical terms, if you spend $15,000 on rent over the course of the year, you can claim $15,000 as a deduction on your tax return. This reduces your taxable profit by $15,000, which means you pay less tax.
Capital expenses, on the other hand, might not be fully deductible when they are made. Generally speaking, large expenditures—like the purchase of a building—cannot be deducted all at once. Only the depreciation—or the portion of the asset that is considered to be used in the course of a year—is tax-deductible.
If you purchase a building for $750,000, you cannot claim the entire $750,000 as a deduction on your tax return. At the time of writing, the recovery period—or the amount of time over which an asset must be depreciated—for nonresidential real property is 39 years. In other words, you can claim a deduction of $19,230.77 ($750,000 divided by 39) as a deduction on your tax return.
Both examples given here are simplified for the purposes of this article. The tax code is complex and ever-changing, and every business owner has a different tax situation. Always consult with your tax professional prior to filing your tax return or making decisions that might impact your taxable profit.
From a managerial standpoint, the difference between OpEx and CapEx is a little clearer. On a tax basis, some capital expenditures can be fully expensed in the year they are purchased. For this reason, some accountants will recommend you record these expenditures directly on the profit and loss statement.
From a managerial perspective, all capital expenditures are recorded on the balance sheet, but they are depreciated based on the life of the asset and not a recovery period determined by the IRS (although sometimes the life of the asset and the IRS recovery period are the same).
When you analyze CapEx vs. OpEx from a managerial standpoint, your focus shifts from tax advantages and perspectives to the actual lifetime value of the expenditure, allowing you to make more informed business decisions and to plan for the future more effectively.
Budgeting for operating expenses is usually relatively simple. The most common way to budget for OpEx is to look at your expenses for the previous year, adjust for inflation or additional planned costs, and then form a plan to make sure your income exceeds these expenses so your business makes a profit.
Budgeting for capital expenses can be a bit trickier. Whereas operating expenses occur on a regular basis and are easily planned for by looking at prior years’ expenses, capital expenditures happen much less frequently. This means CapEx can catch you off-guard and wreak havoc on your business’s cash flow and operations.
But it doesn’t have to be this way. You can set aside a portion of your budget—the monthly depreciation amount of the asset is a good place to start—for capital expenditures. This will allow you to replace the asset when it has exceeded its useful life, provided you don’t inadvertently spend the money earmarked in your budget for CapEx on other things.
You can also open a capital expenditures account and physically allocate money to it. This method is especially helpful if your goal is to run your business debt-free or if you don’t always consult your budget before making spending decisions. For asset replacement, you can transfer the depreciation expense amount into your CapEx account each month. When it’s time to replace the asset, you will have most—if not all—of the money saved to purchase the asset outright.
If you plan to acquire a new asset, determine when you want to make the asset purchase. Divide the purchase price of the asset—or the amount you want to apply toward an initial payment if you plan to finance a portion of it—by the number of months between when you will start allocating the funds and the time you plan to make the purchase. As with asset replacement, this will help you ensure you have the cash on hand for either a down payment or the outright purchase of the asset when the time comes.
All expenses aren’t created equal, and the difference between CapEx and OpEx is a perfect example of how different types of expenditures can impact your business’s profitability and tax situation. Now that you know the difference between capital expenses and operating expenses, you might be wondering if one is “better” than the other.
The answer is, it depends on your business and your tax situation.
In many cases, you can gain the benefits of using an asset without actually making a capital expenditure. If you lease or rent assets instead of buying them, the entire expense is considered an operating expense and you can deduct the full amount you pay to use the asset each year. Because of the tax benefits—and because the burden of maintaining or repairing the asset often rests at least partially with the asset owner and not the business using it—many small business owners choose to rent or lease rather than make capital expenditures.
But if you want to build your business’s value, and if you have a plan in place to pay for maintenance on the assets and the taxes on the profits you will show on your profit and loss statement, it might be in your best interest to make the capital expenditures for those assets. Should you choose to sell your business or use the value of it to fund other investments, increasing the overall value of your business will work in your favor.
Just as with the tax treatment of CapEx vs. OpEx, you should discuss the ramifications of choosing one expenditure over the other with your accountant prior to making the expenditure. Your accountant will be able to guide you to the best solution for your business from both a managerial and a tax perspective.
Billie Anne Grigg is a contributing writer for Fundera.
Billie Anne has been a bookkeeper since before the turn of the century. She is a QuickBooks Online ProAdvisor, LivePlan Expert Advisor, FreshBooks Certified Beancounter, and a Mastery Level Certified Profit First Professional. She is also a guide for the Profit First Professionals organization.
Billie Anne started Pocket Protector Bookkeeping in 2012 to provide an excellent virtual bookkeeping and managerial accounting solution for small businesses that cannot yet justify employing a full-time, in-house bookkeeping staff.