Capital Outlay

What is a Capital Outlay?

Capital Outlay, also known as the capital expenditure refers to the sum of money spent by the company for the purpose of investing in the purchase of the capital assets such as plant, machinery, property, equipment or for extending the life of its existing assets with the motive of increasing the production capacity of the company. It is a disbursement of money that is intended to increase the company’s production capacity.

So, a capital outlay is money a company spends to either purchase a fixed asset or to extend its useful life. Fixed assets are those that appear on the balance sheet as property, plant and equipment, known as “PPE”. Capital outlays are also commonly referred to as capital expenditures, or just “CAPEX”. Since capital outlays are essentially investments in the company, the accounting treatment of CAPEX is different from that for operational expenses.

What Does Capital Outlay Mean?

From a financial standpoint capital outlays are crucial to grow a business. Companies that desire to expand need to invest heavily in fixed assets through capital outlays, also known as capital expenditures. This is the case for manufacturing companies like airlines or textile producers. Since the company’s productive capacity is tied to its machinery and equipment, these investments are the main way through which these companies can grow to reach a bigger portion of the market.

Capital outlays normally come from the purchase, development or construction of fixed assets but there are also cases where companies invest in the assets they currently own to extend their useful life. This is the case, for example, of aircraft, which can be remodeled in order to continue using them. This practice is less expensive than buying a new one and therefore it is more profitable for the company. On the other hand, a capital outlay has to be carefully planned, to understand if the purchase will actually add value to the company. Financial models are the tools employed by managers to calculate the profitability and value-adding potential of any capital expenditure.

Investment vs. Maintenance

When looking at capital outlays, it’s important to recognize the difference between investment and maintenance. Say you run a delivery company. If you buy a new truck, that’s a capital outlay; it’s money spent to acquire a fixed asset. If you replace the engine in an existing truck, that’s a capital outlay, too, because the new engine will give the truck a longer life. But replacing the tires on the truck or changing the oil is simply maintenance — things you do to maintain the truck in its current working condition. Maintenance costs are “revenue expenditures” (since they’re essentially the cost of earning revenue), not capital expenditures.

Accounting Treatment

Capital outlays are not treated as immediate expenses. Say your company spends $30,000 on a new truck. As far as accounting is concerned, your company has not surrendered any value. Before, you had $30,000 worth of cash. Now you have $30,000 worth of PPE. Your net assets remain the same. You will eventually report the cost of the truck as an expense; you just won’t do it all at once. The truck has a finite useful life, so you’ll gradually expense the $30,000 cost over that useful life, a process known as depreciation. Revenue expenditures, on the other hand, are expensed immediately. If an oil change for the truck costs $100, that gets reported as an immediate expense.

Capital Expense Classification

Companies have different expense classifications and financial formulas so they can figure out what will happen if their sales go down or up. Spreading out capital outlays costs over several years gives a more accurate expense of how much it costs to produce and sell a product, as well as run a company.

As an example, a copy machine that costs $10,000 may make one million copies before it stops working. If 200,000 copies are made every year, it costs the company $2,000 each year to own the machine for five years. Sometimes the company will record the total expense of the capital asset the year they purchased it to decrease income tax liability.

Capital Budgeting

Companies plan their capital outlays through a process called capital budgeting. A successful business recognizes that it has to invest in its fixed assets if it’s going to remain competitive. In capital budgeting, the company looks at potential capital projects in terms of the upfront investment they will require compared with the cash flows they will generate. If the return justifies the investment, the project is worth pursuing. A company’s capital budget is distinct from its operating budget, which is a budget plan for the day-to-day running of the business.

Advantages of Capital Outlay

  • It helps in capacity building of an organization, therefore, giving it a strategic advantage over its competitors in the long run working of the company.
  • It can help in achieving economies of scale and in a reduction of the cost of production by producing more and commanding better prices in the market hence increasing overall profitability.
  • Capital expenditure helps the company in attracting good talent that can work in the organization making it more robust and dynamic, furthering the process of providing better products and services.
  • It enables us to open up new avenues in terms of products, people, and places expanding its overall reach further into the markets and the economy.

Limitations

  • If it is not planned carefully, it can turn out to be a disaster. Therefore, every aspect should be understood and taken into consideration before making such decisions.
  • Sometimes outsourcing can be a much viable option instead of investing the own money, i.e., rather than producing itself, such function and responsibility can be given to someone else so that the burden is shared from management’s standpoint. So, this should also be considered as an option before making any such decisions.
  • An increase in capital outlay may end up creating complex bureaucratic structures in an organization that may make it rigid and inflexible in communication and works culture.
  • Sometimes market conditions or overall climate may adversely impact the expansion plans, so proper research and care are a must before taking any decision as it may prove to be a fatal decision.

Important Points

  • They are not considered and treated as the immediate expenses of the company. Rather it will be expensed gradually over the useful life of the assets in which the capital expenditure is made, i.e., every year assets will be depreciated in the books of accounts of the company.
  • Generally, the capital outlays are planned by the companies using the capital budgeting processes as with the help of capital budgeting; the company would look at all the potential investments available, and then out of all the available options, it will choose the one which will give the maximum benefit to it. Also, in the case of the single investment option company would get to know that whether it is beneficial for the company to invest the amount or not.
  • There are ways in which capital outlay can be made by the company, which includes purchasing new assets and extending the life of existing assets.

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