Welcome to the first of my Model Everything series of articles. In this article I will be talking about the financial term called Capitalized Costs and how it can be used to model the profitability of ventures better.
What Is A Capitalized Cost?
A capitalized cost is essentially a cost that is displayed as it’s amortized value of the period of time, rather than a one off cost.
For example, if you buy a server for $20,000, and you expect to amortize that cost over 4 years, the capitalized cost would be marked as $5,000 a year over 4 years instead of a one off cost of $20,000.
Actually, it would probably depreciate differently over that period, but that’s another discussion.
Financial Modelling With Capitalized Costs
I like to capitalize costs when exploring the profitability of a venture because it prevents the delusion of profitability when there is none. In other words, you may not be making the profit you think you are because your capital expenditure costs are not included.
For example, you buy a server for $20,000 to host a web based product. Your first year isn’t profitable because you had hardware to buy. The second year is profitable and so is the third and forth year. you think you’re doing well until your fifth year when you realize that you have to re-buy the hardware you bought in year one because it’s old and needs replaced. Suddenly you’re not profitable again. Has the business really been profitable all those years?
Modelling profit using capitalized costs lets you work out the true cost, though I would recommend depreciating the cost evenly throughout the years for the purpose of simplifying your modelling (but obviously depreciating the assets as much as you can for tax purposes outside of your modelling).
You need to model the amortization into your cost planning, and that’s what cost capitalization does.
Nothing lasts forever, so it’s better to view everything as if it was effectively rented each year when trying to work out if a venture is profitable.
I hope that gives some food for thought and is useful.