092007_Capital Expenditures or OSP Expenses

Capital Expenditures or OSP Expenses?

May 27, 2016
Why You Need to Know the Difference by: Brian Lackovic (This article originally ran in the August 2008 issue of OSP Magazine) Most engineers do not want to be accountants, […]

Why You Need to Know the Difference

(This article originally ran in the August 2008 issue of OSP Magazine)

Most engineers do not want to be accountants, but OSP engineers and
facility planners have a considerable impact on capital budgets and may
not even know it. Despite constantly weighing financial analysis
decisions in OSP design that maximize capacity under the constraint of
minimized cost, many key designers and planners are not trained in
financial management, and thus maintain a minimal understanding of what
capital is and why it is important to the telecom business.

The bottom line of any business is to perpetuate growth. There are
two kinds of costs to any enterprise: capital expenditures (CAPEX) and
expenses. Capital grows the business; expenses do not. Expenses are
costs spent to run the daily operations; they generally are for
short-term assets (current assets) that do not provide revenue to the
company for greater than one fiscal year. Expenses do not add long-term
value to the company. They include costs for office supplies, employee
cell phone bills, office utilities, employee salaries (in general),
company travel, training, overhead, etc. CAPEX are costs spent on
long-term assets (fixed assets) that generate revenue to the company
for greater than one business year. Typical CAPEX include the material
and labor associated with acquiring assets such as DLE, cable,
terminals, poles, conduit, manholes, construction vehicles, buildings,
and certain equipment and tools.

Why does it matter to a company if a cost is called capital or
expense? Expense dollars are completely subtracted from income during
the year they are incurred, whereas CAPEX dollars are only partially
subtracted from income in the current year. CAPEX dollars for a given
fixed tangible asset are deducted from income (called depreciation) in
increments over years for the expected useful life of the fixed asset;
in other words, until the asset has fully depreciated. This is similar
to the value of a new car (i.e., an asset) that depreciates each year
from its dealer purchase price.

Bottom line: think of both capital and expenses as costs that hit
the income statement. The difference: expenses hit in the current year;
capital hits in deferred increments year after year. It’s all a matter
of timing.

Material and Labor

What does it mean for telecom companies? Repairing existing plant in
OSP is considered an expense because it is work done to maintain an
existing asset (i.e. cable, terminal, conduit, manhole, etc.). It does
not add new value to the company; rather it restores the value of the
asset to an existing condition that has already been booked by the
company. Think of it this way: repairing a terminal does not generate
new revenue; it maintains an existing revenue stream, thus it is an
expense. Repairs, including any applicable engineering and construction
labor, are always included in the financial statements in the year in
which they were made.

However, placing new DLE, cable, terminals, poles, etc., is
considered a capital expenditure since new revenue will be generated
for years after its placement. New service will be provided to new
customers on this new plant. This cost will be capitalized since it is
growing the business. Unlike expense, the cost for material and labor
(which includes engineering and construction labor) associated with new
plant installation will be incrementally subtracted from income for
years on the income statement. The number of years depends on the
average life expectancy of each OSP material, which accounting offices
base on statistical charts.

The Retirement Unit

Where is the line crossed when replacing plant is considered expense or
capital? Replacing a defective 25-pair copper terminal with a similar
terminal is an expense. But what about 2,000 ft. of defective aerial
copper cable? Thus the retirement unit was born.

The retirement unit is a company’s definition of the minimum value
of capitalized plant in OSP. It is also known as an item of plant or a
continuing property record. Whether it’s two spans of cable, 300 ft. of
buried cable, or a 100 pr terminal, replacing any item of plant less
than a retirement unit is considered an expense because, by definition,
it does not add new value to the company. Conversely, the costs
associated with replacing items of plant equal to or greater than a
retirement unit would be capitalized.

The cost of removal of an item of plant is also considered to be
capital since it is labor associated with removing the fixed asset from
the field at the end of its useful life. An item of plant’s financial
existence begins with the engineering labor that designed it, continues
with the material and construction labor that installed it, and ends
with the labor that removed it. The cost of removal is not to be
confused with retirement costs, which are used to update tax records.

Wall Street and Capital

Whether borrowed from creditors or from shareholders, how a company
spends money communicates to its investors the company’s vision for
survival. Thus, the deployment of capital is one of the most important
decisions corporate leaders can make. Wall Street looks closely at a
company’s CAPEX to determine not only its exposure to risk and debt but
also how it views future economic conditions. Money invested in new
DLE, cable, terminals, etc., carries risk since the demand for the
asset(s) is based on a forecast for service that may not fully
materialize. For new ventures (i.e., new types of service), the risk is
even greater. Credit managers closely watch a company’s solvency and
liquidity by monitoring capital expenditures.

When companies increase their capital spending from prior years, it
indicates optimism with future borrowing conditions and a possible
stronger upcoming economy. Some industries, such as telecom, are more
capital-intensive than others. Increased capital spending means a
company is trying to enter a new venture or is encountering financial
fatigue with its existing assets and needs to replace them. Either way,
increased capital spending is not necessarily a bad sign. It means a
company is attempting to redefine itself as all enterprises must do to
stay competitive.

Year-over-year decreases in capital spending indicate caution in the
marketplace. It means borrowing money may be too expensive to make a
profit and may lead to contraction in the economy. But remain sanguine.
Companies that reduce spending and return profits to shareholders are
typically rewarded on Wall Street.

The Difference Matters

Justifying how capital is spent within a company is crucial, and it
involves identifying the cost of capital. The idea is simple. Since the
money for capital spending is essentially borrowed from somebody else,
the cost of capital is best thought of as the interest owed to them
while borrowing their money. Companies have only two sources for
capital: creditors and stockholders. Since each are paid a different
rate of return for use of their money, the cost of capital is the
average rate a company pays to its investors. Spending capital on OSP
makes sense only if it earns more than the cost of installation within
an acceptable payback period. Capital spending involves long-term
assets that must achieve a minimal rate of return. Wall Street rewards
companies with decreasing costs of capital and increasing returns on

Capital expenditures in telecom are triggered mostly by growth
forecasts whether for new subscribers on existing service platforms or
for a new service type altogether. Capital is also driven to a smaller
extent by the failure of a significant segment of existing plant.

Since OSP engineers and facility planners initiate the work
authorities for material and labor between the central office and the
customer demarcation point, the responsibility of accurately coding the
costs properly to capital or expense lies with them. They are the
gatekeepers of a very important decision that can affect the long-term
commitment of funds on the financial statements for many years

About the Author

ISE Staff