Sunday, April 09, 2017

Your real project costs

At the top of the budget hierarchy in most companies and organizations stand two major kinds of budgets, a capital budget, and an operating budget. These two kinds of budgets do not overlap: they handle distinctly different spending categories. Capital and operating budgets, moreover, are built through different budgeting processes, by different managers, and they use different criteria for prioritizing and deciding spending.

A capital expenditure (CapEx) is defined as an expenditure contributing value to the property and equipment of a business. It is an expenditure toward capital assets, as contrasted with spending that covers operating expenses (OpEx) or purchase of investments unrelated to the company's primary business.

Many projects I am involved in only looked at the potential (and mostly theoretical) business benefits and the CapEx cost upfront. They "forgot" or "ignored" the OpEx side of the project. These can be very high compared to the initial project costs. Especially when you implement a new technology/product in your company where there is no team yet that understands it and is able to run it without help from outside.

Even when working with both CapEx and OpEx a number of "hidden" costs are easily forgotten, hence the concept of Total Cost of Ownership (TCO) for 3 or 5 years.

Let me start with a quick definition of CapEx, OpEx, and TCO.

Capital Expidenture (CapEx)

CapEx is an expense where the benefit continues over a long period, rather than being exhausted in a short period. Such expenditure is of a non-recurring nature and results in an acquisition of permanent assets. It is thus distinct from a recurring expense.

For tax purposes, CapEx is a cost which cannot be deducted in the year in which it is paid or incurred and must be capitalized. The general rule is that if the acquired property's useful life is longer than the taxable year, then the cost must be capitalized. The capital expenditure costs are then amortized or depreciated over the life of the asset in question. Further to the above, CapEx creates or adds basis to the asset or property, which once adjusted, will determine tax liability in the event of sale or transfer.

Included in capital expenditures are amounts spent on:

1. acquiring fixed, and in some cases, intangible assets
2. repairing an existing asset so as to improve its useful life
3. upgrading an existing asset if it results in a superior fixture
4. preparing an asset to be used in business
5. restoring property or adapting it to a new or different use
6. starting or acquiring a new business

An ongoing question for the accounting of any company is whether certain expenses should be capitalized or expensed. Costs which are expensed in a particular month simply appear on the financial statement as a cost incurred that month. Costs that are capitalized, however, are amortized or depreciated over multiple years. Capitalized expenditures show up on the balance sheet.

Most ordinary business expenses are clearly either expendable or capitalizable, but some expenses could be treated either way, according to the preference of the company. Capitalized interest if applicable is also spread out over the life of the asset. The counterpart of capital expenditure is operational expenditure (OpEx).

Operating Expidenture (OpEx)

An operating expense, operating expenditure, operational expense, operational expenditure or OpEx is an ongoing cost for running a product, business, or system. Its counterpart, a capital expenditure (CapEx), is the cost of developing or providing non-consumable parts for the product or system. For example, the purchase of a software involves CapEx, and the annual maintenance fee, power, and maintenance costs and people running the software represent OpEx.

In business, an operating expense is a day-to-day expense such as sales and administration, or research & development, as opposed to production, costs, and pricing. In short, this is the money the business spends in order to turn inventory into throughput.
On an income statement, "operating expenses" is the sum of a business's operating expenses for a period of time, such as a month or year.

Operating expenses include:

1. license fees
2. maintenance and repairs
3. people who operate the software
4. training
5. first, second and third level support

To summarize the key differences between CapEx and OpEx are:

Total Costs of Ownership (TCO)

Total Cost of Ownership (TCO) is an analysis meant to uncover all the lifetime costs that follow from owning certain kinds of assets. As a result, TCO is sometimes called life cycle cost analysis.

Asset ownership brings purchase costs, of course, but ownership also brings costs due to installing, deploying, using, upgrading, and maintaining the same assets. These after-purchase costs can be substantial. Consequently, for many kinds of assets, TCO analysis finds a very large difference between purchase price and total life cycle costs. And, the difference can be especially large when ownership covers a long time period. As a result, TCO analysis sends a very strong message to corporate buyers, capital review groups, and asset managers:

Those who purchase or manage IT systems have had a keen interest in TCO since the late 1980s. At that time, IT industry analysts began publishing studies showing a very large difference between IT systems prices and systems costs. And, not surprisingly, these soon got the attention of IT vendor sales teams and marketers.

Competitors of large companies, for instance, used their own TCO results to argue that the systems of these large companies were overly expensive to own and operate. This kind of argument is possible because the five-year total cost of ownership for major hardware and software systems—from any vendor—can be five to ten times the hardware and software purchase price. The same is currently happening with the move to the cloud.

TCO for large projects and purchases is very helpful in the following:

1. Budgeting and planning
2. Asset life cycle management
3. Prioritizing capital purchase proposals.
4. Evaluating capital project proposals
5. Vendor selection.
6. Lease vs. buy decisions.

Why does it matter?

In order to make a good decision about starting, continuing or ending a project you need a good overview of the costs of the project. Just using the direct costs of the project are usually only a small part of the truth.

Consider TCO instead of project costs when making decisions!

Posted on Sunday, April 09, 2017 by Henrico Dolfing