Capital Expenditure and Revenue Expenditure
- Imagine you're running a business.
- You have to make decisions about spending money on:
- Long-term investments, like buying new machinery or building a factory.
- Day-to-day expenses, such as paying salaries or purchasing raw materials.
These two types of spending are called capital expenditure and revenue expenditure.
Capital Expenditure: Investing in the Future
Capital Expenditure
Capital expenditure refers to spending on non-current assets that a business will use for a long time.
- Capital expenditure refers to spending on non-current assets that a business will use for a long time.
- These assets help the business grow, improve efficiency, or increase production capacity.
Non-current assets are resources that provide value over multiple years, such as buildings, machinery, or vehicles.
A new restaurant may need finance to buy kitchen equipment, rent a space, hire chefs and wait staff, and promote its grand opening.
Characteristics of Capital Expenditure
- Long-term Use: Assets purchased are used for more than one year.
- High Cost: These investments often require significant financial outlays.
- Strategic Purpose: Aimed at growth, expansion, or improving competitiveness.
Examples of Capital Expenditure
- Purchasing Machinery: A factory buys new equipment to increase production speed.
- Building Facilities: A retail chain constructs a new store to reach more customers.
- Upgrading Technology: A company invests in a new IT system to enhance data security.
Capital expenditure is recorded on the Statement of Financial Position (Balance Sheet) as it reflects the value of non-current assets owned by the business.
Revenue Expenditure: Sustaining Daily Operations
Revenue Expenditure
Revenue expenditure covers the costs of day-to-day operations.
- Revenue expenditure covers the costs of day-to-day operations.
- These expenses are necessary to keep the business running smoothly but do not result in long-term assets.
Characteristics of Revenue Expenditure
- Short-term Use: Covers items or services that are consumed quickly.
- Recurring Costs: Includes regular expenses like salaries or utilities.
- Immediate Impact on Profits: Directly affects the business's profitability in the short term.
Examples of Revenue Expenditure
- Salaries and Wages: Paying employees for their work.
- Utilities: Covering electricity, water, and heating costs.
- Raw Materials: Purchasing components or ingredients for production.
- A restaurant spends money on ingredients, staff wages, and electricity bills.
- These are all revenue expenditures because they are essential for daily operations but do not provide long-term value.
Why Is Revenue Expenditure Important?
- Ensures Smooth Operations: Without these expenses, the business cannot function.
- Maintains Quality: Regular spending on maintenance or training ensures high-quality products or services.
- Supports Customer Satisfaction: Investing in customer service or timely delivery keeps clients happy.
Revenue expenditure is recorded on the statement of profit or loss (income statement) because it reflects the costs incurred to generate revenue during a specific period.
| Capital Expenditure | Revenue Expenditure |
|---|---|
| Benefits last for more than a year | Benfits last for less than a year |
| Non-recurring in nature | Recurring in nature |
| Purchase, modification or extension of a fixed asset | Day-to-day activities of the business |
| Adds value to the busines | Does not add value to the business |
Added Value
Added value refers to improvement or modification in something that increases its worth and utility.
Balancing Capital and Revenue Expenditure
- Successful businesses find a balance between investing in the future (capital expenditure) and managing daily operations (revenue expenditure).
- This balance is crucial for both short-term stability and long-term growth.
How Businesses Balance These Expenditures
- Strategic Planning: Prioritizing investments that align with long-term goals while ensuring sufficient funds for daily operations.
- Budgeting: Allocating resources effectively to avoid overspending in one area at the expense of another.
- Cost Control: Monitoring revenue expenditure to prevent waste and improve profitability.
- Companies can increase its capital expenditure to expand production but also focus on controlling revenue expenditure by monitoring raw material costs and optimizing operational efficiency.
- This balanced approach helped the company prepare for future growth while maintaining profitability.
To what extent does the distinction between capital and revenue expenditure rely on arbitrary human categorization?
Consider how more investment in capital equipment can affect creativity.
The Risks of Imbalance
- Overemphasis on Capital Expenditure:
- May lead to cash flow problems if daily operational costs are neglected.
- Could result in underutilized assets if investments are not aligned with market demand.
- Overemphasis on Revenue Expenditure:
- Limits long-term growth if the business fails to invest in new technology or expansion.
- May lead to inefficiencies if outdated equipment or processes are not upgraded.
- Understanding the difference between capital expenditure and revenue expenditure is essential for effective financial management.
- How might a business decide how much to allocate to each type of expenditure?
- What are the potential risks of focusing too much on one type of expenditure over the other?
Riddhi Manufacturing Company purchased a new machine for €100,000 in January 2025. This machine is expected to last for 10 years and will be used in the production of goods.
To install the machine, the company spent an additional €5,000. Later that year, the company spent €10,000 on repairing another older machine that had broken down unexpectedly during production.
Questions:
- Classify the €100,000 spent on the new machine and the €5,000 installation cost as either capital expenditure or revenue expenditure. Justify your answer.
- Explain whether the €10,000 spent on repairing the older machine should be classified as capital expenditure or revenue expenditure, and why this distinction matters for the company’s financial statements.
Solution
Question 1: Classify the €100,000 spent on the new machine and the €5,000 installation cost as either capital expenditure or revenue expenditure. Justify your answer. (10 marks)
Criteria for Evaluation:
- Correct Classification of Expenditures (6 marks):
- Capital Expenditure: The €100,000 spent on the new machine is classified as capital expenditure because it is a long-term investment that will provide benefits to the company over several years.
- Capital Expenditure: The €5,000 installation cost is also classified as capital expenditure because it is directly related to making the machine operational and is part of the cost of acquiring the asset.
- Justification and Explanation (4 marks):
- The student should explain that capital expenditures are those that involve purchasing or improving long-term assets, which provide benefits over multiple years (e.g., machinery, equipment).
- The explanation should also highlight that installation costs are considered part of the acquisition cost of the asset and thus are capitalized.
Marking Breakdown:
- 3 marks: Clear and accurate classification with correct reasoning.
- 2 marks: Classification is mostly correct with some explanation or partial reasoning.
- 1 mark: Incorrect classification with vague or weak justification.
- 0 marks: No correct classification or explanation.
Question 2: Explain whether the €10,000 spent on repairing the older machine should be classified as capital expenditure or revenue expenditure, and why this distinction matters for the company’s financial statements. (10 marks)
Criteria for Evaluation:
- Correct Classification (5 marks):
- Revenue Expenditure: The €10,000 spent on repairing the older machine should be classified as revenue expenditure because it is an ongoing maintenance cost aimed at restoring the asset's current condition rather than improving its value or extending its useful life.
- Explanation of Distinction (5 marks):
- The student should explain that revenue expenditures are short-term costs aimed at maintaining or repairing assets, while capital expenditures involve the acquisition or improvement of long-term assets.
- The distinction matters because capital expenditures are capitalized and spread across multiple years, while revenue expenditures are deducted from income in the year they are incurred, affecting the company’s profit and loss statement in the short term.
Marking Breakdown:
- 4-5 marks: Clear and accurate classification with a well-explained distinction between capital and revenue expenditure.
- 2-3 marks: Mostly correct with a partial explanation or reasoning for classification.
- 1 mark: Weak classification with minimal or unclear explanation.
- 0 marks: Incorrect classification or no explanation.
