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Capital cost: Definition, meaning & what it includes

Capital Cost

Construction projects need a sizable amount of money to keep them operable. Capital costs are integral in ensuring a project proceeds according to plan. It will be exceedingly difficult to plan for a construction project's expected and unexpected costs without catering for capital costs.

Poor management of capital costs can prevent a project from taking off or cause it to go beyond the budget. Therefore, you need accurate cost estimates from the onset of your project to portray the expected costs accurately. Below are a few things you need to know about capital costs and their importance in a construction project.

What is Capital Cost?

Capital costs are one-time expenditures on the construction, enhancement, or acquisition of assets such as equipment and land that will benefit the project for more than one financial year. The money is necessary to move the project from a concept to commercialization.

It is easy to identify expenditure on the acquisition of assets, but it is not that straightforward when determining capital enhancement costs.

Capital enhancements lengthen an asset's lifespan or increase its value and usefulness.

Capital costs do not depend on accounting and tax laws. Therefore, it is necessary to distinguish between capital and revenue costs as there is significant accounting and taxation on revenue costs.

Capitalized costs allow contractors to recognize significant expenses over time and do not have to include them as considerable negative numbers on the profit and loss financial accounts. This allows for systemic accounting of the value of assets as they depreciate during the expected useful life.

For instance, if a construction company buys an asset such as a computer or equipment, the cost would be capitalized as an asset in the company's balance sheet. Intangible assets such as software and trademark are also counted as capitalized costs.

capitalize costs in construction

When to capitalize costs in construction

Companies capitalize on costs in construction when they expect to utilize a purchase over a long time. Contractors usually capitalize costs if they are income-generating or will be in use over one fiscal year.

The principle in capitalizing costs is that the value has not left the company, even though the company has used money. Capitalizing costs show higher profits on the profit and loss statement.

All other costs besides capital costs are recorded as purchases or expenses on the Profit and Loss statements.

Construction companies need laws governing capitalization policies. There are clear IRS and FASB policies that companies need to follow before creating or implementing capitalization policies.

There are also policies governing the auditing of financial statements, and companies need to be consistent when creating capitalization policies. The policies need to be the same for tax reporting and bookkeeping purposes.

Contractors can always change their capitalization policies from one fiscal year to another. To best take advantage of capitalization policies, you need to consult your construction CPA to guide you on what best suits your situation. 

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What do Capital Costs in Development Include? 

Capital costs in development include:

  • Land acquisition costs
  • Commissions on different materials
  • Demolition of a site to prepare for new construction
  • Consultant fees 
  • Materials, plant, and equipment charges
  • Labor costs
  • Fixtures and fittings
  • Insurance, taxation, financing, and inflation costs
  • Associated direct development costs
  • Purchasing intangible assets like software and licenses

There are also day-to-day operational costs such as wages, utilities, rent, sales, maintenance, repairs, and administrative expenses that fall among capital costs.

In many commercial settings, accounting practice allows the capitalization of certain operational costs. A company's profitability can be enhanced or degraded depending on the treatment of items on its expenditure.

In construction, capital costs are complex since additional complexity arises when a project involves new construction, repair, or refurbishment. For instance, consultant fees are short-term, but they are classified as capital costs in new developments.

Accounting rules permit treating costs such as consultancy fees as an integral part of a development budget. Therefore, including such costs as assets improve a company's profitability since these costs would have otherwise been included in the company's income, thus increasing taxable income.

There are specific capital costs categories subject to capital allowance and tax-deductible amounts. These mainly include equipment, fixtures, and fittings. However, consultant fees and stamp duty land taxes do not qualify for capital allowances.

Factors affecting capital costs

Factors affecting capital costs

Project managers need careful planning to find opportunities to reduce capital costs. Leveraging different approaches and alternative solutions helps minimize overall costs. Some of the factors that affect capital costs include:

Assessing all the available options helps understand all alternative approaches that help project managers make sound decisions regarding capital costs.

In the past, project success largely depended on a contractor's experience. However, sometimes operating conditions change drastically, making it even hard for seasoned veterans to keep up. 

Understanding capital costs helps in proper monitoring and control of project processes and helps improve a project's efficiency, which leads to better overall results.

Key Takeaways

  • When a company capitalizes on costs, it gradually spreads the costs over time to avoid significant deficits on its balance sheet. 
  • Capitalizing costs allows a company to avoid huge expenses from its current expenditure.
  • IRS regulations and accounting laws govern capitalized and non-capitalized costs. 
  • Capitalized costs are typically the cost of assets that depreciate over time, and the depreciation schedule matches their revenue generation period.
  • Intangible costs such as the purchase of licenses and certain labor costs are also capitalized together with tangible assets.

Summary

Contractors and project owners need to evaluate capital costs and new technologies related to their projects. Proper assessment of capital costs can yield cost reductions and increase the time value of projects.

Almost every year, construction companies build new assets or revamp existing assets. Without proper project planning, it can be challenging to obtain all the metrics necessary to justify the capital costs essential for kickstarting a project.

Understanding capital costs also helps project owners to avoid going beyond the project's budget, increase a project's efficiency, and improve safety and quality requirements.