Equipment is a tangible assets that your organization invests in to enhance its productivity. Typical equipment includes computers, photocopying and printing machines, trucks, and other machinery used for manufacturing processes. They are non-current assets, and as a business owner, you need to do proper planning before investing in them to avoid compromising the liquidity of your business.
So, what are some of the costs you should consider before purchasing equipment? The two costs associated with equipment are capital and equipment expenses. So, what is the difference between these two? This article discusses them in depth to help you understand their effect on the profitability and liquidity of the business. Please read through to get a grasp of these concepts.
Capital expense of equipment refers to all costs of acquiring or upgrading a piece of equipment. For example, the capital expense for manufacturing equipment includes the cost of purchasing the equipment, any attachments and modifications, accessories, and auxiliary items required to make it operational. Some of the auxiliary charges include taxes, duty, insurance, shipping, and installation costs.
Usually, there are two capital expenditure forms. These are expenses of maintaining the present operation levels within an organization and expenses that enable future increase and growth. Capital expenses are either tangible or intangible, with both variants taken as assets because it is possible to sell them when needed.
Choices on the amount to go into capital expenditure are usually among the essential decisions organizations need to make. They are critical because:
Capital expenditure decisions have effects that are often experienced in the future. For example, the current manufacturing or production activities primarily result from past capital expenditures. Likewise, the current capital expenditure decisions will significantly influence future company activities.
Decisions on capital expenditure determine the direction the organization will take. Long-term strategic goals and the company's budgeting process must also be in place before capital expenditure authorization.
Usually, reversing capital expenditure is challenging without the organization incurring losses. In addition, many capital equipment forms are tailored to meet company needs and requirements. As a result, the used capital equipment market is typically relatively poor.
Capital expenditure is typically costly for organizations in the industries of telecom, production, manufacturing, oil exploration, and utilities. On the other hand, physical assets and capital investments such as equipment, property, or buildings present the chance of offering advantages in the future. However, they will require a significant initial monetary investment. Furthermore, capital costs usually increase as technology advances.
Capital expenditure initially increases in organizations' asset accounts. Nonetheless, upon capital assets starting to get in service, depreciation sets in, and there is a value reduction throughout their entire lifetime.
Before getting to what an equipment expense is, you must first understand what an operating expense is.
Operating expenses are expenses that a business might incur during its normal operations. It is usually abbreviated as OPEX and includes equipment, rent, inventory costs, payroll, marketing, step costs, insurance, and funds set aside for development and research.
The IRS (Internal Revenue Service) permits businesses to abstract operating expenses where the business operation aims to make profits. Contrastingly, non-operating expenses are expenses incurred by businesses that have no relation to the business's core operations. Now we focus on equipment expenses as one of the operating expenses. But before that;
Capital expenses, abbreviated as CAPEX, are the investment purchases made by a business. CAPEX includes costs incurred in upgrading and acquiring tangible or intangible assets. Tangible assets in a business range from factory equipment, real estate, office furniture, and computers. Copyrights, intellectual property, trademarks, and patents are Intangible items
The Internal Revenue Service takes capital expenses to be different from operating expenses. Per the IRS, operating expenses need to be ordinary, necessary (appropriate and helpful in the business field), and (accepted and shared in the business field). Generally, a business is permitted to disregard operating expenses for the year during which the expenses were incurred; otherwise, the business must capitalize on capital costs/expenses.
For instance, if a business expenditure on payroll is $100,000, it could disregard the entire year's expense. However, if the business uses $100,000 to purchase a vehicle or a piece of extensive factory equipment, it will need to capitalize or write off the expense over time. There are IRS guidelines on how a business must capitalize its assets, and different asset types are categorized into different classes.
Equipment expenses on the other hand refer to all costs associated with operating and maintaining equipment. Ideally, you start incurring these costs once your equipment becomes operational. Some of the equipment expenses for a printer or a photocopier include the the cost of replacing ream papers, ink, power, replacement of high-wear parts, and cleaning and repair.
So, what is the difference between equipment expenses and capital expenses? As discussed, capital expenses refer to all costs associated with acquiring and installation of equipment whereas equipment expenses refer to costs associated with the operation of office equipment. Capital costs are typically one-time costs that end once the equipment has been purchased or upgraded. On the other hand, equipment expenses are recurring and are dependent on the frequency of use of the equipment.
The balance sheet records capital expenses as the cost of acquiring or upgrading office equipment as a non-current asset. Operational expenses include things like operator costs and fuel costs.
Repair and maintenance costs refer to costs incurred in repairing and replacing worn-out parts of equipment. The costs incurred to bring equipment to its initial condition are tagged equipment expenses. The repair and maintenance account will keep track of all expenses for paying technicians and buying replacement parts. The income statement records them as an expense. A good example of repair and maintenance that will fall under expense is the cost you incur in replacing a broken-down engine to restore the operation of a machine.
So, when does repair and maintenance cost become a capital expenditure? Repair and maintenance done to upgrade the equipment in capacity and operational life makes the charges capitalized. A good example is when your company replaces the random access memory of its computer. This is to increase the processing power of the machines or when it upgrades to new software versions. The company includes the cost of these items in its non-current assets.
Capital expenses of equipment fall under the non-current assets of a company. This means the benefits associated with these items take longer than one year and are hard to convert into cash. Your company will spend a lot of revenue on capital expenses of equipment which will affect the liquidity of the company. However, because of the increased productivity and efficiency associated with capital equipment, your company will enjoy increased profits.
It is advisable to plan and do proper analysis before incurring capital expenses. This is to avoid compromising the day-to-day operation of your organization. Considering its effect on your cash flow and debt ratios, you want to ensure that it does not affect the minimum liquidity required to pay workers, rent, and suppliers. Also, consider upgrading existing equipment, buying used equipment, or leasing to minimize the risks associated with capital expenses.
While equipment expenses do not involve huge finances as capital expenditure if proper care is not taken it can take a toll on the company's profitability. First, you want to ensure that the work used for the equipment justifies the operation cost. Utilize the machinery for its intended purpose, and maintain it regularly. This lowers pricey repair expenses.
Training your workers on efficient use of the equipment helps minimize wastage. It also reduces the poor use of machines leading to the increased operating cost of the equipment. A good record of the equipment expenses allows you to come up with ingenious ways of cutting the operating costs linked with particular equipment.
Sometimes it is wise to rent or lease equipment to avoid associated risks such as huge initial costs and disuse. This is so if you are a small business owner with limited financial ability. So, where does renting and leasing fall under? Are they capitalized or charged as expenses?
When you rent a copier, you make a one-time payment, Thus, you will charge the cost incurred in renting it plus any associated operation costs as equipment expenses. Also, when you lease equipment you commit yourself to payments, thus you will charge the premiums as equipment expenses.