Section A ‒ Capital vs Operational expenditure

Capex vs. Opex.
The difference between capex versus opex has been described in great details many times already. Most literature will mention that capex relates to items that have a useful life beyond the current fiscal year. Alternatively, that capex increases the lifespan of its underlying asset — for example, a project of replacing a roof on a building. However, capex also include elements such as inventory and the purchase of property (buildings).

On the other hand, opex is usually described as all the maintenance and repairs of things. By nature, operational expenditures also includes many different elements, such as administrative expenses and utilities. Basically, the regular costs of running a business that is not capex, fall under the opex family.

In theory, the difference between the two worlds of capex and opex is clear. Moreover, for most of the purchases, it is. After all, if a company purchases a new production unit line, there is no debate, as it will fall under capex — same thing for buying new buildings.

However, the line does get blurred rapidly. For example, let’s take a building. Let’s consider a large shopping center of 1 million square feet. We know that shopping center roofs are built in many sections, and these sections do not always age the same way or at the same speed. Building managers often perform heat scans to see if there is moisture in the roof membrane and this enables them to determine which section of the roof needs to be replaced, and which sections can remain in place for a few additional years. The building managers will then plan which sections will be replaced each year. So, chances are, if the building managers have 10-year plans, they will try and replace roughly the same area of the roof each year. The logic behind this is that it enables them to even out the costs and avoid years with peaks (spiking costs) and valleys.

In the case of shopping centers, roofs are often large expenditures. That by itself would tend to put them in the capex group. In addition to this, they surely do extend the life of the building. After all, a building with no roof will deteriorate rapidly. Also, good luck finding any tenants for a shopping center with no roof, or a leaking one. So, the roof replacement has all the characteristics of a capex. It is a big expense item, and it adds years of lifespan to its underlying asset (the building beneath it). In this case, the building owners could pay for the roof replacement and amortize it over its useful life.

However, let’s consider an example here where the 1 million square foot building has five large roof section. In our case, let’s assume that the building manager needs to replace 20 percent of the total roofing area each year for the next five years (each section of roofing is the same size). The annual amortization is the portion of the roof that the owner recharges to the tenants. The owner amortizes each section of roof on ten years, with the balance (non-amortized) carrying interest (at 10% per year) which is also charged back to the tenants (along with the annual amortization).

The chart below illustrates the area of roof replaced as well as the cost. For simplicity of this example, we do not show any inflation in the replacement cost, although we know that in real life, inflation needs to be considered. We also suppose that the roof replacement happens on Jan 1 of each year and the landlord invoices the tenants on Dec 31 for the full rechargeable amount (amortization and interest).

The first row of the chart indicates the annual cost of roof replacement.

The second row indicates the total cost to date for roof replacement

The third row indicates the amortization for that year

The fourth row shows the unamortized amount (what remains to be amortized)

The fifth row indicates the interest that the building manager applies to ‘carry’ the unamortized portion of the roof. We put an interest rate of 10% here for ease of calculation, and we suppose that the interest is calculated once at the end of the year instead of monthly as we would see in real life. This 10% is the interest rate that the building manager charges to the tenants in the shopping center for financing the roof replacement.

The last row indicates the total annual amount to be recharged to the tenants in the shopping mall.

We can show the table with the proper labels here:

As we can see in this example, the recharges to the tenants continue past the roof replacement period. We stop the chart at year six, but it will take until year 14 to amortize all the roof replacements simply because the last year of the roof replacement, year 5, needs to be amortized. If we calculate the total interest in this example, it comes to exactly $900,000. This extra cost is on a total roof replacement of $2,000,000. The interest alone adds a 45% cost to the tenants compared to a situation where the landlord would recharge the full roof replacement cost each year

Now, let’s consider a second example where another building manager of a one million square foot shopping center has a 5-year roof replacement plan. In this second example, the manager plans to replace 20% of the roof each year, just like in our first example.

Only here, the manager argues that roof replacement is not capital in nature, but operational (an opex). The argument here is that although the roof does add life to the building, replacing the roofing membrane is merely a repair. Although the amount spent is large, the value of the roof compared to the cost of the building is relatively small. So, the managers decide that it is merely an extensive repair, but not a capital one. In this situation, the case for making the expense a capital one is a less clear cut.

The chart below shows what happens in this situation.

In this situation, the annual amount recharged to the tenants is the full roof repair cost. This case makes for a higher rechargeable number for years 1 to 5, but as we can see on the chart, year 5 is the last year where the tenant is charged. In this case, the total amount recharged over the five years is $2,000,000, with zero interest paid by the tenant.

As we can see, a simple decision to expense the repairs versus capitalize and amortize them can make a substantial difference in what is recharged to the tenants. Depending on the tenant, it can mean an added cost or saving. For example, if a tenant takes a 15-year lease starting on year one of the roof repairs, that tenant will end up paying 45% more if the landlord decides to make the expense a capital. That tenant might prefer that the landlord expense the roof repairs and recharges a higher amount for a few years instead of a lower amount for many more years.

Note: in this example, we did not examine every possibility, such as the tenant preferring to have the landlord recharge the roof repairs with interest if the interest rate charged by the landlord is lower than the cost of capital for the tenant. The examples above are only meant to show the potential differences that can arise from deciding if an expense is a capital one or an operational one.

Recap

Capital expenditure is easy to identify until they are not. Since each company is different and will have a different type of costs, it is essential to determine from the start what will always constitute capex, what is clearly operational (opex), and how the ‘grey zone’ will be defined. In all cases, have the consistency of action is always the best. So, if we catalog roofing repairs as capex, they should ever fall into that category and not change from year to year.

Capital expenditures are often, because of their nature, significant in cost. Because of this, the capex budget in companies can represent a sizeable amount. Hence the need to do proper management of it.

However, how do we define proper management of capital expenditure? After all, if a manufacturer needs a new production unit, then they need to purchase it (or lease it) — the same thing for a building that needs to be purchased. If the roof of a building is at the end of its life and is leaking, the debate as to replace it or not is usually a pretty short one. Some expenditures need to happen right away or at least at a predetermined time, and no amount of management will change that.

So, what capex should be managed, and how?

To answer this question, let’s look into part two of this guide.