Managing Your Operating And Capital Expenses
Business expenses are the ordinary costs incurred by a business in order for it to operate, with ordinary cost being one that is common in your trade or business. A key concern of a Small Business Owner is to carefully monitor the expenses of the business, keep its accounting in order, manage its cash flow, and ensure the smooth running of its operations.
In striving to achieve these goals, the Small Business Owner must know what constitutes an expense item, the types of expense items, the differences between expense items and how each expense item impacts on the profitability of the business. How does the Small Business Owner come to grips with the two major groups of business expenses, namely, operating expenses and capital expenses, and be able to understand how they differ and how they affect the profitability of the business?
Operating expenses, often abbreviated as OpEx, are expenses necessary for the on-going operation of the business. These routine expenses happen on a set schedule or on a semi-regular basis, and appear on the profit and loss statement. Examples of operating expenses are:
- Office supplies.
- Repairs and Maintenance.
- Professional fees
Capital expenses, sometimes called CapEx, are long-term assets acquired by the business, as investments that will last longer than one year. Unlike operating expenses that appear on the profit and loss statement, capital expenses are reported on the balance sheet, with a percentage of such expenses being recorded as routine monthly depreciation expenses on the profit and loss statement. Examples of capital expenses include:
- Purchase of buildings.
- Purchase of vehicles.
- Purchase of equipment.
- Acquisition of patents.
- Acquisition of other tangible assets.
What is the difference between operating expenses and capital expenses? In the ordinary sense, the Small Business Owner considers all monies spent in the business as expenses, because the monies leave the business. In accounting terms, however, some expenses are not immediately recognised as such while others are recognised as expenses over a number of years through depreciation.
In essence, the expenses made for the day-to-day operations of the business are recorded when they are incurred and are called operating expenses. When the business incurs a capital expense outside its normal operations, which happens occasionally, such expenses are called capital expenses.
As the foregoing suggest, operating expenses and capital expenses are treated differently for tax purposes. While operating expenses are deductible in the year they are made, and the business can take a tax deduction for the expense in the year it makes the expense, capital expenses may not be fully tax-deductible in the year they are made. For example, the purchase of land or building may not be deducted at once in the year of purchase, and only the portion of the asset used in the course of the year may be tax-deductible as depreciation, based on the life of the asset.
More important than the tax advantage, the Small Business Owner must use analysis of operating and capital expenses to improve budgeting for the business.
Budgeting for operating expenses usually begin with looking at the expenses of the business for the preceding year, adjusting for inflation and/or new costs, and creating a plan with the income of the business exceeding its expenses, thereby resulting in a profitable enterprise. However, capital expenses are less frequent and unlikely to be repeated yearly. Except for unforeseen capital expenses that catch the business off-guard, with potential to destabilise the cash flow and operations of the business, the Small Business Owner must allocate portion(s) of the budget, based on the monthly depreciation amount of the asset(s) being provided for, for capital expenses. This is to enable the business to replace its assets when it is time to do so.
If the business plans to acquire a new asset, a capital item, it should determine when it wants to make the purchase, divide the cost of the asset by the number of months between when it will start allocating the funds and when it plans to make the purchase, and provide funds for it accordingly. This will ensure that the business has the money to purchase the asset when it is needed.
Given the differences between operating expenses and capital expenses, and how each of them impacts the tax situation and profitability of the business, what can a Small Business Owner do with this understanding? It helps for the Small Business Owner to discuss the implications of choice of expenses with a hired or part-time Accountant, who will advise on the best solution for the business from a managerial and tax perspective. The Accountant will help to answer questions like:
- How can the business gain the benefits of using an asset without making a capital expenditure?
- When should the business lease or rent an asset instead of buying it, thereby making it an operating expense to be fully deducted in the tax year?
- When is it in the best interest of the business to make the purchase of an asset a capital expense to boost the value of the business?
The Small Business Owner who makes informed decisions on the operating and capital expenses of the business will be equipped to manage the expenses, maintain the needed cash flow and improve the profitability of the business.