Review Capital and Operating Costs

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Tutorial.png Unit 3 

Introduction | Capital and Operating Costs | Depreciating Capital Costs


At the outset, it is important to distinguish between two different categories of expenditure: operating costs and capital costs.


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Definition

The term operating costs refers to any expenditure on things whose value is used up within the same financial year.


Operating costs are sometimes referred to as revenue costs because they are normally met by the income (or revenue) that a business earns in the current financial year. Operating costs can either be recurrent, such as staff salaries that must be paid every year, or non-recurrent, such as once-off payments for consultancy services or specialised advice.


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Definition

By way of contrast, capital expenditure acquires or produces an asset whose value continues to be used (or consumed) over several financial years.


Expenditure on the construction of an office building is a typical example of a capital cost for an ODL institution. Although the cost of constructing a new building is very substantial, its benefits (in terms of office accommodation for the institution’s staff) are used over the lifetime of the asset, which is typically forty to fifty years. Normally, capital expenditure is non-recurrent or recurs only after several years.



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Activity

Exercise 3.1: Classifying Costs as either Operating or Capital Expenditure

This exercise may be done on your own, with a partner or in a small group.

  • Take out the list of different costs that you worked with in Unit 1.
  • Decide whether each cost you listed should be classified as Operating or Capital expenditure.
  • In the last blank column, write either an ‘O’ (for Operating) or a ‘C’ (for Capital).

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Clearly, items of expenditure such as staff salaries or the printing of study materials should be classified as operating costs. Although costs incurred in constructing a building should be treated as capital expenditure, renting or leasing of buildings is an operating cost. In some accounting systems, provision is made for a portion of the capital budget to be spent on periodic maintenance of buildings. The provision of ICTs for staff at an institution’s head office and for students in study centres includes both a capital component (purchase of equipment) and an operational component (telecommunications charges, payment to an Internet Service Provider, consumables such as printer cartridges, etc.). Even though staff training is usually treated as operating expenditure, it should arguably be considered a capital investment, as the added value it generates benefits the institution over a period of several years.

Many open schools, colleges and universities absorb the costs of developing new courses and study materials within their recurrent budget, but Rumble (1997, pages 47-50) argues forcefully that these should be treated as capital expenditure. “Just as the purchase of land, buildings and equipment is an investment for the future, so the development of course materials is an investment that pays off over the life of the course (Ibid., page 47).”

No accountant would charge expenditure incurred in constructing a building or procuring equipment to a single financial year. Likewise, it makes no sense to charge the full costs of developing study materials to the first year of the course. This is particularly important when calculating the fees that students must pay for a new course.