Before the advent of cloud services, companies generally had to either purchase their IT infrastructure assets – a capital expenditure (CapEx), or lease them – an operational expense (OpEx). However, with the adoption of Infrastructure as a Service (IaaS) and Software as a Service (SaaS) models, organizations have been able to shift more of their IT spending towards operational expenses (OpEx). In this blog, we’re going to take a look at why OpEx holds the advantage over CapEx when it comes to IT budgeting.
But first, let’s get a basic understanding of the differences between CapEx and OpEx since this is essential for anyone involved in financial decision making. CapEx and OpEx are treated very differently as far as accounting and taxation for the business are concerned.
What Does CapEx Mean?
CapEx, or capital expenditure, refers to one-time upfront costs incurred for assets that will be used in the future. A capital purchase shows up in the company balance sheet and depreciates in value over its lifetime. The business expects to derive value from the asset for a period of time longer than a single tax year.
Since the upfront cost could be substantial, budgeting for CapEx involves setting some money aside for these types of purchases. It usually also means that a more stringent process is required to be followed to get approvals on these purchases.
When it comes to taxation, CapEx deductions must be amortized over the lifetime of the asset.
What Does OpEx Mean?
OpEx refers to the day-to-day operational expenses that support the business. These typically include general and administrative expenses, employee wages, research and development, cost of goods sold (COGS), maintenance, repair costs, leases, etc.
Unlike CapEx, OpEx has no or low upfront costs and allows companies to spread their expenses over a period of time. Operational expenses are included in the income statement of the company for the period during which they are incurred. For tax purposes, OpEx purchases made in a single tax year can be fully deducted. There will be no amortization of these expenses since these items are fully consumed in the tax year.
CapEx and OpEx in IT
In IT, CapEx corresponds to the costs incurred for the purchase of infrastructure, such as hardware (e.g. servers) and equipment, that generally have a lifespan of two to 10 years, depending on the depreciation value. With a CapEx budget item, the business incurs the expense in the present and expects to generate profit in the future.
OpEx in IT includes costs for SaaS licenses, IaaS subscriptions, contract-based services, internet and utilities. Since OpEx corresponds to current costs, no future benefit to the business is accounted for in an OpEx model.
What IT Expenses Are Included in CapEx?
A few IT expenses that are included in CapEx are:
- IT infrastructure, which includes hardware and software asset purchase costs. In the case of software, this would apply to the traditional perpetual license model where you make a big upfront payment and you “own” the software forever.
- Asset upgrading costs, such as adding to the memory in the server.
- Patents, trademarks, copyrights (i.e, intangible assets).
- Buildings (e.g., data centers).
What IT Expenses Are Included in OpEx?
OpEx includes IT costs for:
- Cloud computing subscriptions (e.g., IaaS, SaaS or PaaS)
- Equipment leases
- Software maintenance (e.g., associated with a perpetual license) – typically annual costs
- Software subscriptions
- Utilities, telecom and internet services
CapEx vs. OpEx
|In CapEx, the assets purchased are expected to provide value beyond a single year, thereby providing long-term value to the company. There is usually a large upfront cost involved.
|In OpEx, the item is fully “consumed” in the tax year in which it is purchased. The cost may be spread out over the course of the year, e.g., as a monthly subscription payment.
|CapEx assets must be depreciated and deducted on an amortized basis over the life of the asset.
|OpEx expenses are fully deductible in the tax year in which the expense is incurred.
|CapEx requires accurate budgeting, which could make cost estimation quite complicated. Due to this, there are chances of over- or under-budgeting in the CapEx model.
Higher levels of budget approval are likely to be required for a large CapEx purchase.
|OpEx is an ongoing cost and is usually incurred monthly/annually.
The low or zero upfront cost associated with an OpEx purchase means that budget approval is often easier.
|CapEx asset purchases generally provide less flexibility. It’s harder to increase or decrease capacity in this model.
|OpEx purchases, such as SaaS and IaaS subscriptions, provide greater flexibility to increase or decrease capacity.
Should You Use OpEx or CapEx?
Purchasing your IT hardware and incurring a capital expense gives you the advantage of greater control over those assets. However, it comes at the cost of high upfront charges and more complex accounting over the life of the assets. Also, purchasing equipment locks you into a certain level of capacity that is relatively hard to change.
The OpEx spending model is simpler, more flexible and potentially more economical. It generally requires less stringent budget approval and is easier to work with from an accounting perspective. Businesses can purchase cloud service subscriptions that provide a bigger portion of their IT infrastructure and have less to worry about when it comes to hardware maintenance and other costs. They can easily increase or decrease the capacity of the service as well. That’s why many companies prefer the OpEx model over the CapEx model for improved business agility, lower upfront costs and reduced management costs.
Deciding which spending model is best for your business in a given case will depend on a number of factors such as corporate policies, cash availability and your business goals.
Check out our 2021 IT Budgeting Checklist to develop an efficacious budget and secure funds for all your IT initiatives.