Is product design a capital expenditure or operating expense?

#TLDR: Well, it depends

Capital expenditures or CapEx are a company long term expenses while operating expenses or OpEx are a company day to day expenses

Companies have to consider the product itself when deciding whether design is a capital expenditure or operational expense.

When companies face economic hardship, budgets get tighter. Design is one of many costs that companies need to pay for, but the question they face is — how to track them?

A mentor once told me that in a recession, companies could unlock their budgets for product design by classifying it as a capital expenditure. This was intriguing, so I decided to do a little research.

What I found was a solid argument for design as a capital expenditure in certain circumstances. But design needs to meet specific criteria. In this article I’ll share that criteria so you can decide what works best for your company.

What are capital expenditures (CapEx) and operational expenses (OpEx)?

Capital expenditures (CapEX) and operational expenses (OpEx) are major categories into which companies track the costs of doing business.

Companies in the United States treat each of the categories differently in their financial statements using generally accepted accounting principles (GAAP). Publicly-traded U.S. companies must follow GAAP rules when they prepare their financial statements. Non-publicly traded companies aren’t required to use GAAP, but many do because lenders (like banks) and creditors really like GAAP. It makes the information in a financial statement more trustworthy, so investors are more likely to invest in a company. This maintains faith in the financial markets and keeps the economic engine turning.

It is possible to present financial information without using GAAP, such as through pro forma, but investors may be skeptical. The financial information could be used in a way to mislead. That’s why many companies use GAAP. They are still allowed to present figures that don’t conform to GAAP, as long as the figures are clearly identified.

GAAP rules specify the difference between capital expenditures and operational expenses. We’ll explore those next.

CapEx overview

Think of CapEx as investments for the future. Purchases that fall in this category take the long-term view. A company buys goods and services that are expected to improve the company over the long-term, and these expenses are categorized as capital expenditures.

Here’s an example of a capital expenditure: when a manufacturing company buys a new plant so it can expand operations. Or when a tech company acquires a patent for a new technology that will enhance an existing product.

Capital expenditures are typically big ticket items that companies use to make upgrades for long-term investments. And companies can either use cash or credit to pay for CapEx purchases.

OpEx overview

Operational expenses are the day-to-day expenses a company incurs. These are things like payroll, rent, software licenses, and even ongoing marketing. OpEx keeps the business running, but it needs to be managed efficiently. If a company spends too little or too much, they could cause the business to suffer damage.

OpEx holds short-term value rather than providing long-term benefit to the company.

Both CapEx and OpEx reduce a company’s net income, but the way they affect it differs. CapEx can be depreciated over time, while OpEx is expensed right away. That means CapEx would be capitalized on a company’s balance sheet, while OpEx is recorded on its income statement.

Ongoing marketing, such as search engine optimization, content writing, or ad campaign development is typically considered OpEx.

Diagram depicting the Business Cash Flow relationships of Financial Accounting on white grid paper with pen and ruler.

Expense or capitalize new software or website development?

GAAP rules get really complex with this question about whether to expense or capitalize the development of a new software product or website.

I did quite a bit of research to find answers about whether or not to capitalize or expense software costs, and it felt like I was peeling back layers of an onion. Like the U.S. tax code, the question is complex.

In general, U.S. GAAP rules allow companies to capitalize the costs of developing and implementing a custom software product or website, though not at every stage. The project also needs to meet specific criteria.

In some industries, like tech or healthcare, custom software development is considered R&D (research & development). In the past, companies were allowed to expense R&D activities (treat them like OpEx).

But the tax code has changed, and as of 2022, companies are now required to capitalize R&D (treat it like CapEx). This means that companies can no longer deduct R&D in the same fiscal year they happen, which affects tax deductions. To counter this, companies can apply for an R&D tax credit for qualified activities.

Benefits of capitalization

While companies that treat software development as a capital expenditure can’t deduct the entire cost in a single year, they can now deduct the cost over multiple years, which allows them to save on taxes over time.

Capitalization also can show a short-term profit for companies. Software development is removed from their EBITDA (earnings before interest, tax, depreciation, and amortization) calculation, which is a key metric for profitability. That means that the company appears more profitable, which can mean a lot to investors.

Challenges of capitalization

But there’s a downside. Capitalization requires a future benefit, and it can be tough to know whether a project will result in future revenues if you have multiple projects going at one time. That’s why some big tech companies only capitalize a small percentage of their R&D expenses.

In addition, software products under development using agile may not align with GAAP rules and only qualify as OpEx. In order to be CapEx, a company must be able to determine technological feasibility of a feature. And that can be tough to determine with agile. So it gets really tricky.

You should clearly define how you will define feasibility at the start of a project if you plan to use agile methodology.

Should you expense or capitalize product design? 

Here’s the question I really wanted to know — can companies capitalize product design? Capitalization of product development can benefit B2B SaaS and health tech companies because of the long-term tax benefits and its effect on EBITDA. So is product design included?

While companies would classify ongoing marketing activities as OpEx, should they do the same for product design?

The Financial Accounting Standards Board (which makes the rules for GAAP in the U.S.) defines the “R” in R&D as “‘planned search or critical investigation aimed at discovery of new knowledge’ that could lead to new products. And it defines the D part of R&D as using and turning those “research findings or other knowledge into a plan or design” of a new product.

So design activities for a new B2B SaaS or health tech product that could benefit revenue streams in the future would be CapEx. And it would be the same for an overhaul or enhancement, as long as the project meets the complex criteria for software or website development.

That means investing in design could provide a long-term tax benefit and help a company’s EBITDA metric.

In conclusion: Talk to your CFO

There’s a case for capitalizing product design. No matter what, be sure to consult an accountant or your CFO when deciding whether to expense or capitalize a website, software development or product design. Better to be on the safe side.

That said, it’s valuable to understand the options, especially when a company needs to consider how investors will view its income and balance sheets. Investing in design can ultimately lead to long-term profits, and sometimes a company needs to think about how they will pay for that investment.