If you want to run a successful business, there are financial terms you should familiarize yourself. I have covered some of them in my previous articles and I would like to briefly explain CapEx (Capital Expenditure) OpEx (Operational Expenditure). Both of them are basic categories of expenses, but they differ in the nature of the expenses and in respective treatment for tax purposes.
Capital expenditures are the amounts that companies use to purchase major physical goods or services that will be used for more than one year. The asset purchased may be a new asset or something that improves the productive life of a previously purchased asset. This might be buying a brand-new furniture, fixture, equipment, plant or a physical building.
CapEx is an expenditure that creates an avenue for revenue generation and value creation
Capital expenditures might include:
Purchase of fixed assets.
Plant, vehicles and equipment purchase or replacements
Restoration of an asset’s value by modernisation and technology upgrades
Building capacity expansion and improvements
Adapting machinery to a different use
Statutory, regulatory and welfare related activities
Capital expenditures are not fully deducted in the accounting period they were incurred. In other words, they are not fully subtracted from the revenue when computing the profits or losses a business has made.
However, intangible assets are amortized over their lifespan while the tangible ones are depreciated over their life cycle. The capital expenditure is recorded as an asset on the balance sheet under the section "property, plant & equipment." However, it's also recorded on the cash flow statement under "investing activities," since it's a cash outlay for that accounting period. Once the asset is being used, it's depreciated over time to spread the cost of the asset over its useful life. In other words: Each year, a part of the fixed asset is being used up. Depreciation represents the amount of wear and tear on the fixed asset, and the amount of depreciation for each year can be used as a tax deduction.
In general, capital expenses are most often depreciated over a five to 10-year period but may be depreciated over more than two decades in the case of real estate. This is an upfront investment with full payment and profit capitalisation is slow and gradual.
Operational expenditure consists of those expenses that a business incurs to run smoothly every single day. They are the costs that a business incurs while in the process of turning its inventory into an end product. Hence, depreciation of fixed assets that are used in the production process is considered OpEx expenditure. OpEx is also known as an operating expenditure, revenue expenditure or an operating expense.
OpEx is in simple, terms, an expenditure incurred to operate the business or systems
Operating expenses are fully deducted in the accounting period they were incurred. As operational expenses make up the bulk of a company's regular costs, management typically looks for ways to reduce operating expenses without causing a critical drop in quality or production output. In contrast to capital expenditures, operating expenses are fully tax-deductible in the year they are made.
In this respect, all expenses incurred to operate the business and systems falls under OpEx. This includes employee wages, repair and maintenance of equipment, rental fees, and utility bills and so on;
Advertising and subscription costs
Legal and attorney fees
Utility costs e.g. energy, water
Property management costs
Property taxation expenses
Repair, maintenance, spare and consumable costs
Rental and lease costs
Salary and wages
Raw materials and supplies
At this point, it is important to mention one of the tricks some companies are using; leasing! If the company has limited cash flow than they might decide to get especially machinery’s by leasing method rather than CapEx. This method financially attractive as they can be able to deduct the total item cost for the year.
The OPEX represent the other day-to-day expenses necessary to keep the business running. These are short-term costs and are used up in the same accounting period in which they were purchased.
Understanding CapEx vs OpEx difference is crucial for any business struggling to optimally utilise finance by making sure that the correct mode is used for various types of expenses. We will now review which one is more preferable and how the companies choose one over the another.
Most of the new, fast growing and capital hunger companies prefers OpEx to CapEx. It allows them to lease their equipment’s rather than buying to be able to deduct its full cash expense for leasing for the same accounting year. This minimises the income tax that is charged on your net income and once you pay your leasing fee, there will be no further financial obligation on your part.
On the other hand, businesses that want to boost its profits and book value can opt to incur a CapEx by purchasing a new machine rather than leasing one. It will have to deduct a small portion of it as an expense in that accounting year. In such a case, the business’ balance sheet would indicate a higher value of assets and net income. Of course, you will be able to save very little on tax.
CapEx entails huge investments in goods that are placed on the balance sheet and are then depreciated over the life of the asset. On the other hand, operating expenditures appear on the P&L account. They relate to costs incurred on a continuous basis.
How we can read this in the hotel business?
Many hotel management agreements have a CapEx formula. As an example, for full-service luxury, it is 5 per cent of gross revenue. As gross revenue rises, the amount put into CapEx reserves increases. Also, most brands keep changing brand standards which increases the cost.
Hotels that looks new and fresh always outperform in their marketplace comparing to the hotel that does not spend money on their establishment. It could change depending on soft and full refurbishment, however, as a guidance, hotels required to refurbish their guest rooms, lobbies and F&B areas in every five to seven years (I have shared this information in details in one of my previous articles). Guest rooms are too expensive to refurbish and as it takes time, you need to take these rooms out of inventory during this process. This means, while you spend an excessive amount of money, you will also lose your main income for a period. Technology change with a fast pace that it is nearly impossible to keep up and depending on the size of the property, providing the same service to all guest rooms requires a huge investment.
Due to the above, there is a big change in focus from hotel rooms to lobbies on CapEx. No one wants to spend money and time in hotel rooms, instead, lobbies are being designed with a level of energy and entertainment. As a result, we start seeing colourful, inviting, energetic new tech lobbies in most hotels.
Internet bandwidth is another area that hotels are willing to spend more money as a value creator. We can add fitness centres, Food and Beverage outlets adjacent to and in the lobby with improved breakfast experiences are also key CapEx focus areas in today’s hostel business.
To be able to accomplish the full CapEx refurbishment programme in today’s technologic world requires seven to nine per cent of Gross revenue CapEx allocation (reserve) which is too high for management companies. Therefore, they prefer to allocate two to three per cent annual OpEx spending to deliver above mentioned quick wins while keeping their establishment attractive to their customers. They keep two to three per cent maximum for CapEx reserve to make sure that they can comply with contractual obligations. This mix usage allows them to advantage on OpEx tax benefits.
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I hope you find this article useful. Please feel free to contact us to get advice, assess your property and help to optimise the usage of the hotel's physical and human assets to achieve superior standards of service and deliver maximum value to owners and investors within agreed profit objectives.
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