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When your organization makes purchases, these items are either revenue or capital costs. How do these cost classifications differ? What different effects do they have on the finances of the organization? Use this article as a quick overview of the difference between these two types of cost.
What Is a Revenue Cost?
A revenue cost is the cost of purchasing an item for use within your organization. The item is useful to your organization for a year or less. It will be used up or stop being of benefit by the time 12 months is up, e.g. The price paid for printer paper is a revenue cost.
What Is a Capital Cost?
A capital cost is the cost of purchasing a fixed asset, e.g. The price paid for a filing cabinet is a capital cost.
What Is a Fixed Asset?
A fixed asset is something that is purchased by your organization for use in its operations. You will be able to use it for more than a year as it shouldn’t wear out or end up being of no benefit to you before the 12 months is up.
How Do You Decide If a Cost Is Revenue or Capital?
The main way to classify costs as revenue or capital is by considering the length of time that the item will be useful to the organization, i.e. the length of time that you will get benefit from it. This is known as its useful economic life. If the useful economic life is greater than a year, then you should consider capitalizing the cost. You must also own the item in question if you are going to classify it as a capital cost.
An example:
Your organization has a 10 year lease on a car parking space, and this has all been paid upfront in year one. The useful economic life of the asset is greater than one year as the company will get benefit from the parking space for 10 years. At first glance, it may seem that it falls into the capital cost category. Your organization, however, doesn’t own the parking space, so you cannot record it as an asset. It is a revenue cost.
Why Does It Matter How You Classify Costs?
Your organization will have one of two financial aims:
- public sector organizations: to make the best use of financial resources
- private sector organizations: to maximize profit
It is important to understand the difference between capital and revenue costs for budget purposes so that these aims can be achieved. Different costs are recorded differently in the profit and loss account and the balance sheet, so will impact on the financial performance of your organization. As a result, you will have to be aware of what type of cost is involved if you are purchasing items or investigating your options when making budget decisions.
In many organizations, it is easier to get approval for capital cost items than for revenue cost items. This is because a capital cost does not reduce the profit (or the money available to spend on other items) in the same way as a revenue cost does.
If you work in a public sector organization, the profit and loss account is important because it shows whether the organization is spending more money than it has or if it is not using all the funds that are available to it. Therefore, the aim of a public sector organization is to achieve a break-even position on its profit and loss account.
For private sector organizations, the profit and loss account is used to determine whether the objective of maximizing profit has been achieved.
How Are the Different Costs Recorded?
- Revenue costs. Revenue costs are attributed directly to an organization’s profit and loss account as expense items. Therefore, they impact on the organization’s profit position.
- Capital costs. Capital costs are not directly deducted from an organization’s income in the profit and loss account but are deducted by a process known as depreciation over the lifetime of the asset. The capital cost will generate an asset in the balance sheet.
Fixed assets are used by the organization over a number of years. The costs are normally paid at the time of buying the asset, but the benefits are received over a number of years. Therefore it isn’t sensible to show the cost of the asset in the profit and loss account in year one with no costs being shown in subsequent years. The accounting treatment for fixed assets avoids this problem. The treatment is in two stages:
- capitalization
- depreciation
Capitalization
Capital costs are not directly deducted from an organization’s income in the profit and loss account but are deducted by a process known as depreciation over the lifetime of the asset. The capital cost will generate an asset in the balance sheet.
Depreciation
Depreciation spreads the cost of using the asset over the length of time which it is in use. This cost is calculated as the cost of purchase less the resale value at the end of the useful economic life. You may find it useful to refer to the document ‘How to Calculate Depreciation’.
An example:
A filing cabinet is expected to be used for 10 years, at which point it is estimated that it cannot be sold for anything. The useful economic life is 10 years, and the cost to the business is £100 less £0, i.e. £100. Depreciation must therefore allocate the cost of £100 over the usage period of 10 years. This deducts £10 from the profit and loss account every year for the 10 years.
Do Revenue and Capital Costs Include Value Added Tax (VAT)?
The cost is the net price you were charged. This is the price before VAT is added. When talking about revenue or capital costs, you do not include any VAT that was charged.
e.g. A new desk is purchased for your organization. The pricing details are set out below:
- Net price: £100.00
- VAT charged @ 17.5% of net price £ 17.50
- Gross (i.e. total) price: £117.50
- the net price of £100.00 is the cost associated with the desk
