As many companies shift from traditional IT infrastructure to cloud computing, they are also rethinking how they handle cloud costs — from accounting to tax reporting.
Computing costs are predictable and relatively fixed in traditional IT environments. An organization purchases computing capacity upfront and uses it over time. The total cost of ownership is fairly easier to calculate with this setup.
By contrast, cloud computing operates on a pay-as-you-go basis, with no upfront payments. Resources and services are available on-demand, and IT spend fluctuates based on consumption.
The traditional approach prioritizes capital expenditure (CapEx), whereas cloud economics favors operating expenses (OpEx).
So, what’s the difference between CapEx and OpEx? Which approach is the most cost-effective? And what are some examples of each?
Table Of Contents
- What Is CapEx In Cloud Computing?
- What Is OpEx In Cloud Computing?
- Why You Need To Understand OpEx Vs. CapEx
- 10 Differences Between CapEx And OpEx In The Cloud
- How To Understand And Control CapEx Expenditure
- How To Understand And Control OpEx Cost In The Cloud
- Frequently Asked Questions About Capex And Opex In Cloud Computing
What Is CapEx In Cloud Computing?
CapEx is short for capital expenditure. Capital expenditure is the cost a business incurs to acquire assets that will provide benefits beyond the current year. CapEx is also referred to as PP&E, which stands for Property, Plant, and Equipment.
When a company invests money, uses collateral, or incurs debt in order to acquire new assets or increase their value over time, they incur capital expenditures. So, capital expenditures are usually long-term investments in the business.
Also, CapEx IT spending is often a one-time purchase of a specific high-dollar fixed asset during a single tax year, with little ongoing costs during that period.
Examples of CapEx expenditure in the cloud:
- Building/premises purchase
- Physical data center equipment like servers and networking infrastructure
- IT equipment for IT and office staff
- Installing local software or in-house applications
- Datacenter renovation
- Restoring an asset’s value through upgrades
- Repurposing an asset
- Setup and supporting infrastructure costs
- Repairs beyond routine maintenance
So, how do you identify capital expenditure?
What are the characteristics of CapEx expenditure?
The key to determining capital expenditure is to observe distinct concepts, such as where they should be accounted for and how they should be taxed. Here’s how.
- Long-term – Procured to provide benefits past the current tax year. Many assets, such as buildings, patents, and computers, remain economically viable for decades.
- Approval – The process involves a lot of long-term planning, including forecasting future demand versus potential returns in advance. So, CapEx-based IT spending often takes a lot of time to approve.
- Ownership – Once you clear the payment, you take full ownership of the tangible or intangible asset. You can finance the purchase with debt, savings, or retained profits.
- Responsibility – As the owner of the asset, you are in charge of all aspects of it, such as security, updates, upgrades, repairs, maintenance, and training employees. In addition, you decide who, what, and why to use the asset.
- Upfront cost – You pay for them in advance — before using them. Most CapEx projects are one-time investments, only requiring updates, upgrades, or replacements every five to ten years.
- High-ticket – Capital expenditure often covers assets, which can be costly to acquire but are essential for starting, running, and maintaining a business.
- On-premises – Most CapEx spend is often for physical, fixed assets that you will install, run, and maintain on-premises or within a physical data center.
- Tax treatment – Intangible assets are amortized over time, whereas physical assets are depreciated over their lifetime. So, you do not claim CapEx costs in their entirety the same year you incur them.
Say, you construct a new building for a data center at a modest cost of $800,000. You’ll only be able to deduct this expense over 39 years, which is the amount of time a nonresidential real property must be depreciated at the time of writing this (always consult your tax consultant). So, the maximum deductible amount in your tax return will be (800,000/39) = $20,512.82 per year.
- Financial reporting – While some capital expenditures are fully expensed the same year you make them, they usually go into the balance sheet as assets, not expenses. Only a percentage of it goes on the profit and loss statement (as a depreciation expense on an ongoing basis).
CapEx challenges to know
IT capital expenditures are not without challenges, such as:
- Requiring large amounts of cash upfront – This can reduce the cash flow available to invest in different revenue-generating streams.
- Provisioning challenges – Static hardware/software capacity estimates are error-prone. Overbuying/overprovisioning capacity hurts cash flow while underbuying/underprovisioning can lead to service interruptions or not meeting your customers’ service level agreements.
- Approvals processes that can lead to missing out – Involves lengthy and arduous processes for estimating budget, getting approvals, and releasing funds.
- The legacy trap and lock-in – Capital expenditure carries commitment risk. Once you purchase the technology, you are stuck with it for a while – even if technology advances or your company grows.
- Pivoting and repurposing can be expensive – It might not be possible to use existing technology or assets with the new direction you are going, so you’d need to buy all new IT equipment.
So, how are operating expenses different from capital expenditure in IT spending?
What Is OpEx In Cloud Computing?
OpEx is short for operating expenses, also known as operational expenses, and operating costs. Operating expenses refer to the money a company spends to run day-to-day operations.
Most of these expenses are used up within a year of purchasing them.
Also, operational expenses are pay-as-you-go, which means you deduct them as and when you need them. For this reason, firms often need to reduce OpEx spending without hurting their ability to produce, innovate, compete, and offer stellar customer experiences.
Note: Although “expenses” and “expenditures” are often used interchangeably, they are not the same thing. Accountants define expenditures as long-term payments based on long-term spending plans. But expenses usually refer to short-term spend.
Examples of OpEx expenses in the cloud
- Items that require a subscription fee, such as software licenses or cloud-based services such as SaaS, IaaS, PaaS, and DaaS
- Property leasing, such as leasing IT infrastructure on Amazon Web Services (AWS) for a monthly fee
- Ongoing web hosting
- Annual IT infrastructure maintenance agreements
- Software support
- Cost of goods sold (COGS), which are the direct costs you incur when building and running subscription-based software services. COGS are also referred to as the cost of sales. Contrary, operating costs comprise all expenses you spend to run your entire business, not just the revenue-generating activity.
- Rent and utilities overhead
- Wages and salaries
- General repair and IT infrastructure maintenance fees
- Research and development (R&D)
Now, here’s how to determine operating costs in your company.
What are the characteristics of OpEx expenses?
The following characteristics make OpEx spending easier to notice, account for, and budget for.
- Variable – OpEx spending is usage-based, and so fluctuates as consumption increases or decreases over a billing period. It offers flexibility to companies that need to constantly change their plans or resource utilization patterns to meet market demand. OpEx spending is therefore difficult to forecast and allocate to different cost centers.
- Short-term – You can also procure additional resources on-demand to meet temporary increases in demand. If cost savings are a priority during off-peak hours, you can terminate or scale down resources accordingly.
- Ownership – Cloud providers and third-party companies own the hardware and software they lease to you.
- Responsibility – Your service provider is responsible for updating, upgrading, and maintaining your hardware and software. This allows your IT team to focus on improving security, continuous innovation, and enhancing your core product features.
- Approvals – OpEx spending involves substantially less investment at a time, so it does not require much deliberation to procure. Executives, finance, and engineers make the decisions on the go to run day-to-day operations.
- Supporting infrastructure – OpEx expenditures cover the costs of running a service, unlike CapEx purchases that often require additional support at a separate cost. In cloud computing, managed services providers (MSPs) include all costs in a single subscription.
- On-going – Instead of a one-time, up-front payment, you pay a subscription fee on a pay-as-you-go basis. Furthermore, you pay only for what you use. This model frees up cash flow to invest in other areas that could generate new or additional revenue.
- Tax and OpEx spending – You fully deduct operating expenses within the same year you incur them.
Suppose you pay $20,000 in rent in one year. By claiming that $20,000 on your tax return, you will reduce your taxable profit by $20,000 — reducing your tax burden in that year.
- Financial reporting – OpEx purchases reflect in profit and loss statements (income statements). They are deductible from income as they occur.
But, like CapEx expenditure, the OpEx spending model is not flawless.
OpEx challenges to know
Operational expenses can pose difficulties in several ways. especially for companies that have a lot of their operations running in the cloud.
- Unpredictability – Operating expenses fluctuate with usage, making them difficult to predict.
- Cost visibility challenges – For cloud-based operations, in particular, many teams struggle to define who, what, and why their cloud costs are changing. When you don’t know what’s driving cloud costs, it becomes even more difficult to determine where to optimize costs without sacrificing innovation or failing to meet service-level agreements.
- Cost allocation issues – For example, some companies struggle to tell what to include in COGS versus regular operating expenses. This affects gross margin calculations, which, in turn, affect your profitability.
If you want to solve these challenges, you need to have full visibility into your operating costs as a bare minimum.
Why You Need To Understand OpEx Vs. CapEx
Understanding the difference between operating expenses and capital expenditures will help you decide when to go either way. The alternative may put you out of business. For example, SaaS companies that overreport COGS weaken their margins, which deters investors and hinders growth funding.
Yet deciding what expenses to record under OpEx vs. CapEx can be tricky in practice.
You can purchase new data storage systems if you require more storage space to host your data. Whether you pay cash or borrow to finance it, it will be a capital expenditure. In contrast, leasing additional virtual storage is an operational expense because it is ongoing.
Purchasing servers, computers, and networking equipment from a vendor and installing them in a data center constitutes CapEx expenditure. However, renting virtual machines, compute capacity, and supporting infrastructure through a cloud provider like AWS factors towards operating expenses.
General maintenance and repairs to existing fixed assets, such as buildings and equipment, are also considered operating expenses. However, expenses become capital expenditures if the improvements extend the asset’s useful life.
In the next section, we’ll summarize the two spending models.
10 Differences Between CapEx And OpEx In The Cloud
For a quick assessment, here’s a side-by-side comparison of OpEx vs. CapEx spending.
Costs of long-term investments — benefits expected to last longer than one year.
Costs of day-to-day operations — benefits used up within the same year they are purchased/incurred.
Upfront, whether through cash from savings or retained profits or taking on debt.
Pay-as-you-go pricing, ongoing costs that are covered by income as they occur.
Huge investments that often tie up cash in long-term investments.
Relatively small, ongoing payments (monthly, quarterly, annually)
Often involves overbuying now to meet future capacity requirements then.
Frees up cash flow to invest in other areas because there is no large, upfront payment.
Ownership and responsibility
Buying transfers ownership to the buyer, including full responsibility and control, including access and building updates for both owned hardware and software.
A vendor, such as a cloud provider, is responsible for system updates, upgrades, and replacements for hardware and software.
Recorded in the balance sheet as assets, only appearing in income statements as deductions.
Recorded in profit and loss statements as expenses.
Deductible over the lifetime of a tangible asset. Amortized over the life of an intangible asset.
Deducted in full within the same year they are incurred.
Returns on Investment
Gradual over the life cycle of the asset.
Earned in shorter billing cycles.
Capital or borrowed cash from financial institutions.
Retained profits, savings, soft loans, bank overdraft.
Land, building, IT equipment, patents, etc.
Subscriptions, wages/salaries, marketing, etc.
How To Understand And Control CapEx Expenditure
Tracking capex costs for SaaS companies is relatively straightforward compared with OpEx. In most cases, the challenge is dealing with the long approval processes and bureaucracy involved in making a final decision.
Once that’s done, you can purchase a perpetual license, which you don’t need to renew each year. Or, you can purchase another asset outright and track its maintenance costs periodically, which isn’t nearly as complex as tracking OpEx in the cloud daily — even hourly.
How To Understand And Control OpEx Cost In The Cloud
Compared to locally installed environments, cloud computing can be particularly challenging because it’s inherently complex and dynamic. To succeed, you must collect, analyze, and understand all operating expenses centrally.
For SaaS companies, a large portion of expenses comes from cost of goods sold. COGS can be challenging to visualize, track in real-time, and optimize without hindering your ability to innovate continuously.
Yet, overreporting COGS has a direct negative impact on your margins, depressing investor confidence. The result is that your business may be undervalued, diminishing your ability to raise enough cash to finance growth.
Instead, you can use CloudZero’s cloud cost intelligence to:
- Identify the specific people, products, and processes driving your cloud spending.
- Discover what percentage of your total cloud spend is related to COGS.
- Understand your expenses over time and what drives them, so you can optimize usage
- Get a detailed breakdown of your cloud costs by an individual customer, product, software feature, team, project, engineering environment, etc.
- See precisely where you can optimize costs without compromising innovation, service level agreements, and system performance.
- Pinpoint the cost of supporting a specific customer or product feature, so you can tell how to price it profitably g to protect your margins.
Frequently Asked Questions About Capex And Opex In Cloud Computing
We’ve answered a few of your FAQs below.
Do you expense or capitalize software costs in SaaS?
SaaS companies follow different GAAPs (ASC 350-40 and 720-45) for capitalizing development costs. In accordance with these rules, preliminary project costs are expensed, but should be capitalized once the project plan completes and app development begins.
What are examples of CapEx in SaaS businesses?
Capital expenditures can include the costs of housing a physical data center, buying software licenses, upgrading hardware or physical infrastructure components, and maintaining servers locally.
Is headcount a Capex or Opex expense?
Their compensation is Capex if they deploy, manage, and maintain your physical infrastructure. You need people to care for that hardware, whereas a separate company handles that for you under OpEx.
What are the drawbacks of using OpEx in SaaS?
Aside from unpredictability, difficulties deciding what to expense as OpEx, and allocation challenges, OpEx expenses hold value only in the short term. Usually, once you spend the money, it has no further advantage.
How can you track OpEx accurately in the cloud?
You’ll need to capture cost data as it occurs, preferably in real-time. Robust cost optimization platforms like CloudZero can help you to not only track your real-time cloud costs but also detect abnormally high cost trends before they become surprise expenses.