I’ve met a shocking number of SMB owners who don’t understand the difference between CapEx and OpEx. While this distinction may seem minor and somewhat nitpicky to write an entire post about, it’s critical to get right.

Blurring the lines between the two can not only lead to tax headaches but also cash flow issues, while additionally painting a confusing picture for investors.

So my goal with this week’s post is to clear up the confusion with a quick, tactical guide—spelled out in plain English.

But before I dive into the meat of it, I need you to keep in mind the following.

The question is not which to spend more on. Rather, the goal is to know what each means and how to optimize both for your business. 

Everything You Need to Know About CapEx

What it is

CapEx, or capital expenditures, have a useful life >1 year and pertain to the purchase of long-term assets. CapEx includes the cost of fixed assets, such as a new building or machinery, as well as intangible assets like intellectual property.

The most common types of CapEx will vary across industries, but it’s important to note that capital expenditures also include funds for business expansion, updating old equipment, and extending the life of existing assets—both physical and intangible. A great example of this would be purchasing a software upgrade.

Accounting treatment

CapEx is treated as an asset and reported on the balance sheet under PP&E. It also appears in the investing activities section of the cash flow statement. The asset is then expensed as depreciation over the course of its useful life.

Why you need it

Capital expenditures build your asset base, help generate long-term sales and income growth, and increase the competitiveness of your business.

While these expenses can’t be deducted from income for tax purposes like OpEx can, depreciation of CapEx over time yields a higher asset value on the balance sheet, which leads to higher valuations over time.

So if your business is looking to increase its earnings and attract investors, CapEx is a great way to do this. It also allows for better efficiency in capital allocation over the long term relative to OpEx.

Drawbacks

For its many strategic advantages, CapEx also comes with considerable upfront costs, long-term commitment—often including financing—, and no guaranteed ROI. At the same time, poor investment decisions can be difficult to reverse without absorbing massive losses.

Examples

Examples of CapEx include purchasing a new vehicle, buying a new building or machinery, and acquiring land.

Everything You Need to Know About OpEx

What it is

Operating expenses, or OpEx, are the expenses incurred as part of the day-to-day management of your business. Unlike CapEx, these expenses stand to benefit the business for <1 year.

That said, operating expenses do NOT apply to any costs directly related to the production of goods or services.

Accounting treatment

OpEx is treated as an expense reported fully on the P&L for the period in which it’s incurred. Unlike CapEx, these expenses can be fully deducted from taxes provided that they’re ordinary and customary costs for your industry.

Why you need it

Aside from sustaining business operations, operating expenses also offer greater flexibility than capital expenditures. Similarly, poorly managed OpEx is much easier to reverse than poor CapEx decisions.

Accounting rules also allow for a degree of flexibility around the use of assets here. For example, the choice to lease rather than purchase an asset would classify that transaction as OpEx rather than CapEx. Aside from tax deductions, going this route can be especially attractive for firms limited in cash flow.

Overall, if a company is looking to conserve its capital and maximize flexibility, incurring OpEx over CapEx typically makes more sense.

Drawbacks

Although OpEx offers greater flexibility than CapEx, it still involves recurring costs that require more hands-on management to stay on top of. These outlays also tend to increase year to year due to inflation.

Examples

Examples of OpEx include rent payments, utilities, employee salaries, interest paid on debt, R&D costs, property taxes, accounting and legal fees, SG&A, and business travel.

Putting It All Together

Here are your top takeaways from this week’s post.

1. CapEx pertains to the purchase of long-term assets with a useful life of over 1 year. OpEx includes the day-to-day costs incurred to maintain business operations.

2. CapEx is reported on the balance sheet as an asset. It’s also expensed as depreciation over time. OpEx is expensed entirely on the P&L for the period in which it’s incurred.

3. CapEx builds your asset base and fuels long-term growth in the business, but it comes at a significant upfront cost without a guaranteed return.

4. Incurring OpEx over CapEx offers more flexibility and is fully tax deductible for the period in question. Poor OpEx decisions are also much easier to reverse than inappropriate capital expenditures.

5. Every business needs both CapEx and OpEx. The optimal split will vary based on industry, business model, amount of cash on hand, risk tolerance, and other factors.

Hungry for More?

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‘Til Next Time,

Connor