Finance/Accounting 101: Capital and Operating Expense

Capital Expenditure – CapEx (Finance/Accounting): Includes all spending on an asset that is supposed to last for over a year (Apptio, 2018).  Usually, it is used to undertake a new project, but it can be used for purchasing or changing equipment, buildings, etc. (Investopedia, n.d.b.). CapEx contains depreciation, look at my previous post for that (Apptio, n.d.; Investopedia, n.d.b.). A car is a great example for your personal CapEx, given that it depreciates over time and you purchase or lease it typically for more than a year.

Operating Expense – OpEx (Finance/Accounting): Includes all the ongoing costs for running as normal (Apptio, 2018; Investopedia, n.d.a.). For instance, OpEx could include rent, equipment, inventory costs, marketing, payroll, insurance, and funds allocated for research and development (Investopedia, n.d.a). Essentially, if you look at the rent you pay for living or for driving, that can be considered your own OpEx.  If you also consider your health, dental, vision, disability, housing, car, etc. it can also fall under this category.  Even gas to fuel up a car, given that it is used to make your asset operable fits under this category.  According to Apptio (2018), bills like electricity, water, etc. can fall under this category as well.

You can be more CapEx or OpEx heavy in your budgets.  Each with their benefits.  For instances being more CapEx heavy, your costs are more predictable in the long run and you can easily calculate your net worth. In that scenario, you may not have enough cash to continue to pay for some opportunities.  If you are more OpEx heavy you tend to save more money for investment purposes.  Here you have more flexibility to take on an opportunity, but its harder to show/calculate your net worth.

Another way to look at this is OpEx is like the cloud service on your phone, you pay for what you use, be it 5 gigs, 25 gigs, 50 gigs, etc. Whereas, CapEx is steady and saying I rather pay for the entire asset and enjoy as much or as little as I want.


Finance/Accounting 101: Sunk and Opportunity Costs

Opportunity Cost (Finance): Is the cost one misses out on, when you go with one option over another (Investopedia, n.b.a.).  This usually occurs when you have limited resources.  If you have little money to budget, if you factor out all your needs, you only have so much left for your wants.  You cannot buy all your wants and therefore when you buy one want you may not be able to afford another.  The biggest limited resource we have is time, and time is usually associated with money.  When I did my doctorate, I couldn’t use that time to go to law school, so my opportunity cost was law school during my doctorate.  However, going to law school now will mean that the opportunity cost I have to pay is time with family, friends, and pets.  As Ursula from the little mermaid said “You can’t get something for nothing,” even free things have their cost.  You can get a free cookie, cake piece, ice cream, or pizza slice, but that may mean more time in the gym to burn those unneeded calories.

Opportunity cost can be calculated in dollars, time, or any other metric, but since you forgo that opportunity in exchange for another, you cannot claim it in accounting purposes. However, calculating it can be extremely useful for decision making.

Sunk cost (finance/accounting): It is the cost that has already been incurred to date that cannot be recovered, especially when deciding whether to continue to invest or divest (Investopedia, n.d.b.).  There is a fallacy that we as humans tend in include sunk cost when making our decision to continue moving over.  For instance, if you had a major in college, let’s say physics and you are on your senior year, and you realized you want to be a biologist instead.  The decision you have to make is to finish physics as a double major with biology, finish physics and stay in that field, or stop studying physics and pursue biology.  The sunk costs are all the classes that won’t count towards a degree in physics.  Some people may look at the problem and say they are 3-4 classes away from the degree, I might as well suck it up.  Or others may say, I have enough for a minor, and I should cut my losses.  When making a decision, like this, we should look at the problem new, without looking at what was already invested, because if you hate physics, but are 23-4 classes away, you will hate those three or four classes and your future career.  It makes no sense to continue.

In sunk cost, it doesn’t mean that you cannot try to claim some value from what you invested in.  For instance, claiming a minor in physics, or seeing which of those credits can transfer to lessen the load of classes you want to take for a biology major.  That is a smart way to minimize sunk cost.  But, if there is a sunk cost, it is ok.  The problem is not to keep wasting resources towards a lost cause and increasing the sunk cost.

Personally, I fall victim to this sunk cost fallacy a few times, when it comes to being a life-long learner.  Especially when reading a book.  Just because I checked out a book in the library doesn’t mean I have to read it from cover to cover, especially if I don’t like it after a few chapters.  But, again we have a tendency to want to see things through to the end.  The letting go of a book exercise is a great exercise in building resilience against the sunk cost fallacy.  Give it a try.  Has there been a book on your nightstand that you just don’t want to read anymore? Then let it go.  Donate it to a library, to a school, etc.  Relish in the fact that you didn’t give in to the sunk cost fallacy to keep reading that book to the end.


Finance/Accounting 101: Direct and Indirect Costs

Direct Cost (Finance/Accounting): Can consist of fixed and variable costs, but that is 100% dedicated to a service, an asset, etc (Apptio, 2018; Investopedia, n.d.a.).  Imagine you buy a new laptop.  The cost is fixed direct cost to acquire it.

Indirect Cost (Finance/Accounting): Are costs that are shared amongst a service, an asset, etc. (Apptio, 2018).  Let’s look at the laptop you just bought above.  Even though the price of the physical laptop is fixed and direct, you have indirect fixed and variable costs associated with it.  Some of the indirect fixed cost will come from purchasing software, OS license, virus and malware detection software, etc. While some of the indirect variable cost will come with how much electricity you will spend to keep your laptop’s battery charged. Indirect costs can be hard to find if your budget isn’t transparent (Apptio, 2018).


Finance/Accounting 101: Fixed and Variable Costs

Fixed Expense (Finance/Accounting): Are expenses that remain the same over time (Apptio, 2018; Investopedia, n.d.a.).  If you have a gym membership, you are charged a flat membership fee each and every period.  Thus, you know how much you can and should budget for.

Variable Expense (Finance/Accounting): Are expenses that change over time (Apptio, 2018; Investopedia, n.d.b.).  A great example is for those people who don’t have unlimited talk, text and data plan on their cell phone.  Given that we are measuring the exact minutes we spend each month talking, or the amount of text we send or receive, or how much data we download, this person’s cell phone bill will be variable. Here, you don’t know how much you can budget for.  Things happen.

Variable expense isn’t necessarily bad nor is fixed expenses good.  It depends on context, asset, service, etc.  Therefore, one should regularly evaluate their budget and see if what they have as fixed or variable expenses are justified. The benefit of a variable expense is you have the most leverage on how much you can consume or spend, giving you greater control over your budget rather than a fixed expense.  This leverage gives you budget flexibility (Apptio, 2018).

A healthy budget would take into account fixed and variable costs and will have an appropriate mix of the two.


Finance/Accounting 101: Amortization and depreciation

The Matching Principle (accounting): Expenses are matched to and recorded in the period where you have realized the benefits (Accounting Coach, n.d.).  It doesn’t matter when you received or sent an invoice out, it matters only when you get paid or you pay the invoice (Apptio, 2018).  In other words, I get my credit card statement on the 23rd of the month (a weird date, but it is what it is).  The credit card company cannot realize the benefit/payment of the invoice until I pay it, therefore it is a liability for them (Accounting Coach, n.d.).  Usually, people have about a month or less to pay back their balance in part or in full.  Until I decide to pay them the credit card company cannot account for the money, which means the credit card company cannot say it is Revenue (Accounting Coach, n.d., Apptio, 2018).  This is because, how can the credit card company say I paid them for the service rendered if I haven’t cut the check or e-paid my bill? However, when I do pay, I can pay it on the 23rd, 24th or the 2nd of the month. Once I pay my bill, either in part or the full amount, the credit card company can say they realized the benefits for the service rendered (in this case, me borrowing money on credit).

Depreciation and Amortization (accounting/finance): This refers to how money is spread throughout the lifetime of the product or service (Apptio, 2018).  The best example we have for amortization is a mortgage on a house.  When I bought my house, I got a long printout (excel sheet style and a waste of trees) of how much I will be paying for my mortgage, how much of that will go to escrow, how much of that will go to the principle and how much of that goes to the interest.  The mortgage schedule shows that over time I will pay more into my principle and less into the interest, which tends to lower the book value of my housing loan (Investopedia n.d.a.).   If I were to sell the house, and it losses value during a housing bubble, then I will be in a budget shock (Apptio, 2018). The reason is that the entire amortization schedule is due in full at the date of closing, and I will be on the hook for the difference.

So, let’s look into buying a new car! When we buy a shiny new car and drive it off the lot, it is said to depreciate over 20% in a matter of seconds.  Over the course of the first two years, the cost of the car will further depreciate, therefore the best advice usually is to wait 2-5 years after the car has been manufactured to keep most of your money, given that the most depreciation occurs in the first 2-5 years (2 Cents, 2018).  Thus, depreciation is not necessarily the loss of intrinsic value for car usage, just a loss of financial value over time (Apptio, 2018).  Depreciation is accounted for in taxes or in accounting books, it can be used to illustrate the loss of value of an asset over the life of the asset (Apptio, 2018; Investopedia, n.d.b.).

Note that in business, assets can be tangible, usually a physical server, a building, etc., or intangible, like patents or copywrites, etc. (Apptio 2018).