What are capital and revenue expenditures? Well, if you’re a business owner then you have probably been using both, whether or not you’ve been aware of it. Spending money is rarely an enjoyable aspect of daily business life, but understanding the distinction between capital and revenue expenditures can help you forecast a budget and better understand how you invest in assets. Below I break down both expenditures and explain the most crucial details. If you need to raise some capital first, enlist in this finance boot camp for entrepreneurs.
Capital Expenditure 101
In the briefest words, capital expenditures are those that produce an advantage in the long-term. It is not incorrect to think of capital expenditures as investments, but it is also not most accurate way of looking at them.
- The “If”
Capital expenditures are not something you use every day. They are primarily the costs sustained on large or significant assets. It is important to note that they can also be costs used to upgrade or maintain these assets if – and only if – these costs directly increase or positively affect the profitability of the existing assets. Being a beginner is no excuse to be uninformed; learn everything you need to know about financial modeling for startups with this course designed by startup expert Chris Benjamin.
- Earning Capacity
Broad examples of capital expenditures are buildings and equipment, although real estate is not generally considered a capital expenditure. Regardless of what the capital expenditure is, the way we judge the value or even usefulness of the expenditure is by measuring the extent to which increases the company’s earning capacity.
- The Balance Sheet
When it comes to entering capital expenditures on the balance sheet, they are not entered as assets or current assets; they are non-current assets, due to their long-term nature. Further, the value of non-current assets is the difference between the expenditure and the earning power of the asset over its lifetime. A number of factors play into this equation, such as depreciation, tangential benefits, additional/related capital expenditures, etc.
Examples Of Capital Expenditure
1. Imagine a company that manufactures pencils. Let’s say that it owns two machines that cut wood into pencil shapes. If the company purchases a third machine that, presumably, increases production by 50%, then this would be a capital expenditure. The machine may have a ten-year life cycle, in which case it would be expensed over this period of time as discussed above.
This same company can have capital expenditures even without buying new equipment. Let’s imagine a new, more efficient saw or boring device has been invented. The company might be able to purchase these, install them on their pre-existing machine, and either produce more pencils or waste less material. In either circumstance, the expenditure increased their capacity for revenue and is therefore of the capital variety. However you spend your money, learn how to grow your business with this course on reducing expenses.
2. For our second example, let’s say the same company decided to build a new office building. First of all, the building itself is a capital expenditure, as it will house new/more employees and presumably be designed to increase sales, marketing, etc.
But an empty building doesn’t do the company much good, does it? It may seem obvious, but all the things purchased for the inside of the building are probably capital expenditures, as well. These would include computers (good for three-five years), furniture (three-ten years), the patents or copy rights of any ideas/products that are produced in the building, etc. All of these things increase the building’s/company’s capacity for revenue over a long period of time.
Revenue Expenditure 101
If capital expenditures are those that produce an advantage in the long-term, then revenue expenditures would be . . . ? Not what you think, actually (that is, if you think they give you an advantage in the short-term). While they are, in fact, short-term expenditures, they are not so much aimed at producing an advantage as they are at maintaining the advantage that already exists.
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- Boring But Essential
Revenue expenditures might not sound as exciting as capital expenditures (the former maintains profits while the other, presumably, increases them), but they are essential to every business. Most revenue expenditures are sustained regularly, sometimes even at fixed intervals (if equipment parts are only good for six months, for example).
- The Balance Sheet
Whereas capital expenditures are spread out over multiple accounting periods, revenue expenditures are expensed in the period in which they were sustained. There is really no need to calculate any hidden value in revenue expenditures as they do not exist for that purpose. Again, revenue expenditures are designed to maintain productivity and are not investments or assets that are designed at increasing revenue or profitability in any direct or intentional manner. Thus, they must be recorded as such.
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Examples Of Revenue Expenditure
1. Revenue expenditures can get tricky. For example, consider the pencil company we used in our examples of capital expenditures. Let’s say the new machine that we purchased (a capital expenditure) suffered a broken part. Naturally, the company will replace the part, but the part can, technically, be either a capital or revenue expenditure.
If the part simply fixes the machine and returns it to its normal degree of function, then it is a revenue expenditure. It is a short-term, non-profit-increasing expenditure. Check out this article on the objectives of financial management for advice on creating a sustainable business model.
If, however, the part either makes the machine more efficient or if it makes the machine last longer, then it is a capital expenditure. For example, if the machine was originally good for ten years and the new part does not affect the longevity of the machine, then it’s a revenue expenditure; but if the new part is more substantial and now the machine is good for fifteen years, then it is a capital expenditure.
2. Now let’s look at a couple other scenarios. The pencil company needs transportation so that it can distribute its product. If it were to purchase a fleet of trucks, these would be capital investments. But the fuel, general maintenance and even wages paid to the drivers could all be revenue expenditures.
You can even consider monthly or even yearly charges to be revenue expenditures. Utilities (electricity, gas, water, phone, internet, etc.) are all revenue expenditures. These do not directly increase the earning potential of the business, but it would be borderline impossible to run a successful business without them.
Other examples include renewal expenses (leases can fall under both categories, depending on duration and the purpose for signing the lease) and virtually all other repair/maintenance costs. Needless to say, you need money before you can spend it (or at least, that’s the smart way to go about it). Learn how to raise the right kinds of capital with this course that covers the nuts and bolts of startup fundraising.
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