Feb 08, 2019
A business’s decision to invest funds into new equipment, property, or software, also known as capital expenditures or ‘capex,’ is one of the most important decisions it will face.
On one hand, there is a clear argument in favor of capex – businesses that invest in better technology and equipment tend to operate more efficiently. Moreover, if these businesses are willing to invest in areas that others are not, they may gain a competitive edge in their market.
On the other hand, capital expenses also present a clear risk. Purchased capital may not deliver on expected results, and a sluggish economy will make it difficult to repay capital purchased with debt. Furthermore, business owners that fail to properly manage their cash flow may find that they’ve spent money needed for operations on long-term purchases and investments.
However, business owners do not need to shy away from major purchases. Instead, they need a rigorous process for ensuring that capital expenses are both effective and financially feasible.
In this post, we’ll walk through a 6-step capex management process that will help your business remain competitive while ensuring you have enough cash to stay afloat.
1. Know the difference between capex and opex
Capital expenditures are not operational expenditures – be sure to remember this, as capex is taxed differently. Business owners that confuse the two may find a much larger tax bill than they bargained for. (See Step 6 for further tax details.)
The difference between capex and opex is:
- Capital expenditures are non-recurring purchases of assets which are expected to provide benefits over a long period of time. Examples of capital expenditures include buildings, vehicles, software, machinery, furniture, and computer equipment.
- Operational expenditures are non-investment expenses related to maintaining a business’s day-to-day operations. Examples of operational expenditures include rent, payroll, transportation, office supplies, employee benefits, marketing expenses, and equipment repair.
While some expenses may seem as though they teeter between both capex and opex, a good rule of thumb is to determine whether an expense is recurring.
For example, a one-time expense for a software overhaul is capex. However, if you purchase the rights to this software on a monthly basis (also known as Software as a Service, or SaaS), this is considered to be opex.
(For a more definitive explanation, be sure to consult with your lawyer or accountant.)
2. Establish long-term objectives for your business
By establishing clear, long-term objectives, you will have a framework to help decide if capex requests are worthy of approval. If capex projects do not further long-term goals, the decision is simple: they do not get funded.
When setting your long-term objectives, think of the position you’d like your business to be at in five to ten years. Short-term plans are still necessary to support your long-term vision, but effective capex will provide a decade’s worth of utility.
Long-term objectives should be S.M.A.R.T. – specific, measurable, achievable, relevant, and time bound. Furthermore, consider categorizing your objectives according to this framework established by small business expert and Purdue University professor, Maria Marshall1:
- Profit: Goals related to increasing profits by a specific percentage
- Growth: Goals which focus on expanding the business, such as through additional employees or markets
- Service: Goals related to improving customer satisfaction or retention
- Social: Goals which focus on social responsibility or giving back to the community
Once you’ve established your long-term goals, be sure to communicate them to all managers. A clear understanding of a business’s objectives will help your team prioritize which capex requests are appropriate for submission.
3. Create a process for approving expense requests
Whether you’re a small business owner or the leader of a 5,000-person team, each capex request must go through an evaluation process. A full evaluation will help you determine if the return on investment – weighed against both the costs and risks – warrants moving forward with the capital expense.
Your process should include:
Cost-benefit analysis (CBA): This is a standard, systematic approach for making business decisions. When performing your CBA:
- Clearly identify the decision: Whether you’re evaluating capex or opex, the question at hand should be simple and clear. Should we purchase new software? Is it feasible to hire another employee? Should we add more vehicles to our fleet?
If your question cannot be answered by a simple yes or no, go back to the drawing board and start again.
Brainstorm all costs and benefits: The cost of a capital expense is much greater than the purchase price alone. There are direct costs, indirect costs, and opportunity costs to consider. For example, if purchasing a major software upgrade, what will be the cost of training employees? Will you hire an IT team to be on-call to answer questions? How much will you lose in worker productivity as you transition to a new platform?
Then, address benefits with the same vigor. Will this capex produce more revenue? Will it allow your employees to save time and effort? Will it cause your customers to bring you more referrals? Take all of this into consideration.
- Assign monetary values: While it may be difficult to predict the value of customer satisfaction or the hours needed to train employees on a new system, assigning monetary values is vital to weighing your benefits and costs.
Don’t be afraid to consult industry experts and additional business stakeholders as you determine appropriate monetary values.
Compare the benefits and costs: In other words, do the benefits outweigh the costs? If so, how long will it take for the capex to pay for itself? Calculate the upfront costs, then add the ongoing benefits while subtracting the ongoing costs. For example: a 3-D printer for the office may cost $3,000 upfront, but perhaps the net savings are $500 a year.
- Risk analysis: Every capital expense has its risks. Will this capex force you to hire additional employees? Will a sluggish economy make it difficult to repay? Use this time to consider all feasible possibilities while presenting solutions for managing them.
- Alternative solutions: There are typically multiple solutions to a problem. Take the time to brainstorm all alternatives and present the consequences for pursuing them. For example, one alternative may be to continue “as-is” – what would be the incurred costs of doing so?
- Metrics for success: Your job as a capex manager isn’t done once the capital is purchased. Your team will need to monitor the effectiveness of the capital to ensure it’s delivering on the benefits outlined in the cost-benefit analysis. Use this time to outline these metrics and establish a process for determining if the capital is reaching its goals.
Once you’ve outlined the capex evaluation process, require all managers to submit a formal capex request prior to the new fiscal year.
4. Prioritize, prioritize, prioritize
Because most businesses have a finite pool of funds, it is unlikely that you will approve all capex requests that cross your desk. With this in mind, it is important that you establish an objective system for prioritization.
One simple process is the ICE scoring framework. ICE is an acronym for:
- Impact: How much impact do you expect this capital to deliver?
- Confidence: How confident are you that this capital will meet your metrics for success?
- Ease: How much time, effort and money will be spent to get this capital in working order?
Use your best judgment to grade all criteria on a scale of 1-10 for each capex request. (10 is the best possible score, while 1 is the worst).
Then, present the ICE score as an average of all numbers. For example, if a proposed vehicle fleet has an Impact score of 5, a Confidence score of 9, and an Ease score of 8, the ICE score is 7.33.
Finally, rank your capex requests according to the scores and prioritize according to what your budget will allow.
5. Budget ruthlessly
A proper budget will ensure you have the necessary funds to move forward with capex projects while keeping enough cash to support operations. As you set your budget for the year ahead, you will need to decide whether to allocate current funds to purchase capital or add debt to your balance sheet.
Use this time to determine how your capex will affect opex. For example, if you are purchasing a new vehicle fleet, be prepared to also spend money on gas and maintenance. (These ongoing opex costs should already be outlined in your cost-benefit analysis).
You will also want to determine if it’s financially feasible to continue with capex or, instead, shift to opex. As production tools continue to rapidly evolve, it may make sense to lease equipment or software rather than purchase it outright.
Finally, don’t be afraid to negotiate prices. Let vendors offer bids to compete for your business, always ask for discounts, and regularly review your vendors to ensure you’re getting the best offer.
6. Don’t forget about taxes
Unlike operational expenses, you will not be able to immediately write off your capex. Instead, the IRS allows an annual allowance for depreciation, or the regular wear and tear or obsolescence of the purchased capital.
Most businesses calculate depreciation using the Modified Accelerated Cost Recovery System (MACRS), which allows businesses to deduct more depreciation within the early stages of a capital’s lifetime. Section 179 of the U.S. Internal Revenue Code also allows certain types of capital to be deducted as expenses.
Before moving forward with executing capital expenditures, be sure to consult with your CPA to determine if the tax implications are feasible.
Although there is a lot of heavy lifting involved with respect to evaluating capital expenses, the final payoff will be worth your effort. By doing your due diligence, you will allow your business to stay afloat while looking forward to new growth opportunities.
Remember – you always have help beside you. Never hesitate to consult your CPA, business stakeholders, and other industry experts as you continue to evaluate projects.
No matter the size of your business, or where you are going, our business banking products offer solutions to help get you there. Explore your options on our Small Business Banking website.
- Vanden Bos, Peter, “How to Set Business Goals,” Inc., June 29, 2010, https://www.inc.com/guides/2010/06/setting-business-goals.html.
6 Steps for Effective Capital Expense (CapEx) Management
This blog post was published by Axos Editorial Team on February 8, 2019 and last updated on February 8, 2019.
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