Capitalization Cost

Updated on April 23, 2024
Article byMilan Jha
Edited byPallabi Banerjee
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Capitalization Cost?

Capitalization Cost is an expense that the company makes to acquire an asset that they will use for their business, and such costs are shown on the company’s balance sheet at the year-end. These costs are not deducted from the income, but they are depreciated or amortized.

Capitalization Cost

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It helps the organization when it comes to investment, which the company makes in big assets, and that asset qualifies; the criteria should be capitalized. Still, on the contrary, the company should take extra care while finalizing its accounts because all big expenses related to the assets cannot be considered Capitalization Costs. That has to be expensed off during the period it is incurred.

Capitalization Cost Explained

The term capitalization cost refers to the expense incurred in the business for acquisition of fixed cost. The value is added to the balance sheet. The acquisition can be in the form of purchase or building it for the purpose of growth and expansion.

Net capitalization cost is considered to be a fixed asset which has a depreciation or amortization cost that is expense over the life of the asset. But even in some cases, the items like wage and salary is also capitalized.

Capitalization is done for assets shown in the fixed asset in the balance sheetFixed Asset In The Balance SheetFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.read more. Then they are depreciated over a period. It is an expense to acquire the asset to put it to use in the business. There are several expenses that a company incurs.

Therefore, the asset purchased is expected to give benefit and generate revenue over a long period of time. The cost incurred during building construction is a perfect example of the same, where the cost of construction and the interest payment on borrowed amount, both are capitalized. Sometimes assets like machinery and plant are renovated or upgraded to bring them to a working condition. For the purpose of net capitalization cost, there may be various charges like installation cost, labor and transportation charges, purchase of latest machinery parts, chemicals etc, which are required to upgrade it. These expenses are often capitalized in the balance sheet.

The concept follows the matching principle according to which cost incurred while buying or setting up of the asset should match with the revenue earned from it.  The process allows companies to spread heavy expenses over a long period of time due to which the company can avoid showing a huge and substantial cost incurred during one financial year, which may adversely affect profitability.

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Capitalization Vs Expensing Explanation Video

 

Examples

Let us understand the concept with the help of some examples.

Example #1

Capitalization Cost Examples

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Example #2

Suppose a company makes a payment of $ 10000 on paying salaries to their employees or paying rent of the business premises, then it is not a capitalization cost. It is a normal expense that a company will incur.

However, suppose the company makes a $10000 payment to buy a machine that it will use in the business. It is a capitalization of the cost of the company. It will get depreciated over the useful life of the asset. Therefore, whenever the company invests money to acquire an asset that will be useful for the company, which is considered a capitalization cost.

How To Calculate?

Journal Entry

Let us understand the journal entry used for the purpose.

We treat it as an asset for the company, which will be depreciated. In the books of accounts, we have to debitDebitDebit represents either an increase in a company’s expenses or a decline in its revenue. read more the asset with the purchase amount and credit the account which paid for the asset, i.e., Cash or Bank a/c.

Reduction

Since the cost is ultimately a cash outflow for the company, even though it is spread out over a long period to reduce its negative effect, it is necessary to identify ways and means to reduce it or keep it under control so that the financial resource allocation is done in an optimum manner in various areas of the business.

In case of borrowing, the borrower has to make a down payment that reduces the total amount required as loan. Therefore, a great way to reduce the capitalization cost of buying an asset like real estate by taking loan is to make maximum possible down payment.  The overall financing cost is lowered due to less loan and less interest payment.

Heavy goods like vehicles, machinery are often leased instead of directly buying them. Leasing requires less financing because it is similar to renting, which is suitable for borrowers with limited budget. In lease, the depreciation is to be charged only for the number of years of leasing.

It is also necessary to do some negotiation while purchasing any asset that will be capitalized. Many financial institutions offer rebates or trade-in allowance or some kind of incentives and discounts to customers. This can bring down the cost significantly.

Thus, the above are some of the ways in which capitalization cost can be controlled or reduced to get a better deal.  

Advantages

Some advantages of the concept are given below.

Disadvantages

Here are some disadvantages of the concept.

It helps the organization when it comes to investment, which the company makes in big assets, and that asset qualifies; the criteria should be capitalized. Still, on the contrary, the company should take extra care while finalizing its accounts because all big expenses related to the assets cannot be considered Capitalization Costs. That has to be expensed off during the period it is incurred.

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