Operating Costs versus Capital Costs | The Budgeting Process


When budgeting, you must consider if an expense is a capital or operating expense item. Capital items represent an asset (similar to furniture or equipment) whose total value you report on the balance sheet and then depreciate (i.e. expense) incrementally over the useful life of the asset. A capital expenditure is typically for something that has a useful life of several years and the cost exceeds a threshold, like a server. An expense item is something whose value is absorbed by the business within a single fiscal period and cost is below the threshold (e.g., paper used for printing or a printer cable.) The finance department assigns to IT capital equipment an estimated life (typically between three to seven years) and depreciates the asset over that time frame once the asset has been put into use. For example, a $50,000 capital asset with a useful life of five years would have a $10,000 depreciation expense each year. The purpose is to align the expense of the asset with its useful life. Some capital items also may be eligible for research and development or investment tax credits.
Write-off unused assets

"We reviewed the numbers, starting with the largest areas, such as depreciation. We reviewed every asset and looked at what we could write-off, eliminate, or consolidate. We wrote off $4M of asset value, or $1M in annual savings. This is an example of something that typically doesn't get reviewed in good times."
—Greg Hayhurst
Tennant Company

Capital items are usually budgeted separately from operating expenses with typically more flexibility and variability than the operating budget, which depends on the company's financial position. Moving items to the capital budget provides relief in the annual operating budget. Similarly, moving items to the expense column allows for purchases in a capital-constrained environment.
It is important to understand what items are capital and what items are expenses. Generally Accepted Accounting Principles (GAAP) dictates whether an item is capital or an expense. Within this framework, each company adopts its own specific categorization policies. For example, one company treated project management costs within a capital project as an expense, except if it was bundled within a fixed-fee consulting bid. For purchased off-the-shelf software, the company treated systems development time and systems integration costs as capital assets. Often, companies offset any planning, operational, and implementation costs for internally developed custom software, but it varies by company policy.
Typically, after implementation, as you depreciate hardware over the equipment's useful life, the depreciation expense impacts the IT budget. Similarly, amortized software costs appear on the IT operational budget. The finance department usually calculates these costs for the annual IT operational budget. Further, it is important to understand how you should treat assets because you need to account for the cost when you no longer treat assets as capital items. Likewise, if an IT capital asset is prematurely retired, or you fail to put it into production, then the company must immediately write-off (or write down) the remaining value of that asset. Depending on the size of the company, you often need to explain financial write-offs in board meetings and financial statements, which is one of the reasons failed projects are so financially disruptive.

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