Capital Expenditure (Capex) is the expenditure used to create future cash flow benefits. This is when an organisation spends money to either buy a fixed asset or to add to the value of an existing fixed asset with a useful life that typically extends beyond the taxable year. Normally, this asset is ‘capitalised’ through its addition to an asset account, thus increasing the asset's basis (the cost or value of an asset as adjusted for tax purposes). The capital expenditure costs are then amortised or depreciated over the lifespan of the asset. Examples of capital goods are heavy machinery, buildings, vehicles, etc.
Operating Expenditure (Opex), for the purposes of this article, focuses on the operational expenditure associated with the operation and maintenance of those specific capital goods.
The importance of the distinction
“Capital procurement is a critical step in any project plan. If it is not managed correctly it could lead to consequences such as missed schedule milestones, poorly specified equipment, and poor vendor relationships. Value managed relationships with suppliers are often critical as there are usually only a limited number of role players in specific fields. These problems can doom a project when delays and budget overruns occur. During capital procurement there are certain calculations that need to be done. Examples of these are Total Cost of Ownership (TCO), total costs at a certain Return on Investment (ROI), make vs. buy vs. lease, etc”, Bezuidenhout continued.
Important aspects of capital procurement are:
- Analysing the efficient utilisation of capital equipment.
- Formulating the capital equipment replacement strategy, with the focus on the commercial impact beyond the price.
- Managing the capital budget and capital equipment replacement strategy.
- Predicting cost of maintenance and operating costs based on the economic lifespan of equipment.
- Involving a number of stakeholders once the procurement decision is taken, i.e. financial, marketing and operations, as well as establishing cross-functional sourcing teams.
- Arranging equipment demonstrations and trials with the necessary evaluation and indemnity documentation.
- Sourcing equipment in the global market.
- Maintaining a standardisation policy within the organisation.
- Supplying feedback on support levels delivered by specific equipment suppliers.
Operational procurement is often the deciding factor with regards to whether the cost of the capital goods is correct over the lifecycle of those goods. If the correct contracts are in place, the ‘after sales service’ is competent, and the cost of those services is reasonable, then the initial price paid for the actual goods is a small part of the equation. “Take an enterprise-wide computer system as an example: The initial purchase price of the licences and implementation of the system are a minority cost of the total cost of that system over its lifespan of say, five years. The cost of the development, support and upgrade of such a system often becomes a multiple of the initial cost of licenses and implementation”, Bezuidenhout explained.
Efficiency is a key focus. Cost is not only associated with the cost of the support after the sale. Additionally it is associated with how often that support is required and how effective it is. Close management of those suppliers is therefore required and strong service level contracts mitigate this risk. These contracts have to be maintained monthly, by, for example, adding new items, and changing price and catalogue details.
When taking into consideration the Opex portion of procurement, the following factors should always be considered:
- The expected lifespan of the associated capital goods.
- The propensity for operational costs to accumulate, accelerate and ‘get out of control’.
- The ‘in-source vs. outsource’ math.
- The workload required to manage operational expenditure and associated supply.
- The type of contracts that need to be put in place, and the length of such contracts.
- The preferred supplier list.
- The management of the different contract types.
“Organisations are increasingly under pressure to utilise their capital budgets wisely by making the correct decisions on what to buy and when to replace equipment. There is always a trade-off between replacing or upgrading existing ageing equipment and buying new technology that could possibly give organisations the competitive edge over the opposition. Organisations are also under substantial pressure to ensure that they do not overspend on either the initial purchase of the asset, or the operational expenditure during the lifespan of that asset. Often, this purchase cycle is inefficient because it was the domain of the engineers and / or the management of the organisation, and thus the exercise was often viewed as ‘out of the range’ of the procurement function. The pressure is then put on procurement to control the associated operational spend, but often the horse had already bolted”, Bezuidenhout concluded.
Article submitted by Annuska Bezuidenhout, a Senior Procurement Specialist at Volition Consulting Services.
Annuska Bezuidenhout can be contacted at the details below:
Telephone: +27 11 259 4380