Physical capital includes equipment, machinery, building and vehicles employed and owned by an organisation. It caters to one of the production elements besides labour and land. If the assets are made of fixed capital, it refers to the fact that the money is not consumed in the production process.
Did you know? Adam Smith's Classical Economics theory, which is where the idea came from, lists physical capital as one of the components of production.
What is Physical Capital?
The definition of physical capital suggests that it is one of the three essential components of production, which consists of artificial tangible items that help create a service or product. The buildings, machinery, warehouse or office supplies, computers and vehicles owned by a company are its physical capital.
Land, physical capital and labour form an essential part of production. Property or land includes manufacturing facilities, factories or warehouses. It involves natural resources like ores extracted from mines for the steel industry. Labour means the human resources, including skilled and unskilled workers employed by a company. The third element is physical capital which consists of physical assets used by the company.
Requirements for Production Process of Physical Capital
Examples of it will be assets and tools facilitating the production process. The welding machinery that joins various car parts in the automotive industry can be considered an essential part. Other investments include printers and computers, which also contribute to the process of the company's production.
The company must start investing in physical capital before receiving the first order. A manufacturing brand needs to invest in the property, purchase machinery and plant, build a factory and create connecting lines to make the initial batch of items.
Physical capital is subject to considerable investment. Therefore, industries which require extensive investments to be established might need help to start with physical capital. A new company will only be able to enter this industry if it has comprehensive investment capability in physical capital. As an example of physical capital, the telecom industry requires lump sum investment for telecom towers in India.
Physical capital is primarily liquid. The manufacturing procedure can not be broken up to be sold, and some facilities are specifically designed for specific products. If there is any sale, it has to be constructed of the whole undertaking. Since it is meant to be depreciable, a company can charge depreciation costs on the assets.
Factors of Production
Economists believe that there exist three factors of production.
Land, Real Estate and Natural Resources
These include the property or land upon which stores, shipping facilities and factories are built. Natural resources collected from the ground, for example, the corn which constructs tortilla chips or the iron from which steel is made, belong to this category.
Human capital includes labour and other human resources like skills, education or experience that can help the production procedure.
Physical Capital or capital depicts human-made products or items that ensure the manufacturing procedure or make it run as smoothly as possible. Some forms of it can directly affect production, and equipment welding used for fusing parts of vehicles on the factory floor can directly affect production. Other physical means like printers and computers in the executive headquarters are indirectly involved in the process.
Startups and Physical Capital
New startups tend to invest in a company’s physical capital at its early stage, even before producing or manufacturing a single product or securing the first client or consumer. This is mainly to do the basics right for the company which can not be attained without adequate start-up capital.
Entrepreneurs use startup capital to cover some or all of the necessary costs associated with starting a new business. This includes hiring new employees, paying for office space, permits, licencing, inventory, market research, manufacturing products, marketing, and any other operational costs. Hence, it happens to be a major problem that physical capital solves.
For example, a microwave manufacturing company must make as many investments as possible before selling any of its devices. The company has to construct a factory, buy the machinery necessary for manufacturing, assemble the microwaves, and then create some sample ovens before distributing them to stores.
For startups, especially those in the manufacturing industry, accumulating physical capital with reputable firms and the related money needed might be a barrier.
Diversification in a particular industry is gauged using physical capital diversification. Founding a new law practice requires significantly less physical capital than starting a manufacturing facility because a lawyer simply needs an office with a desk, phone, and computer on paper.
What Is an Example of Physical Capital?
According to economists, physical capital lends an integral part in the company’s valuation. However, physical capital is one of the most complicated assets to evaluate correctly. First, experts hold different opinions on what physical capital is constituted of. Often economists disagree on the parameters of the factors of production. For example, look into Coca-Cola soft drinks company’s corporate headquarters in Atlanta. Some experts might consider the office building campus to be physical capital as those are artificial buildings. However, some might also consider that the corporate plaza belongs to the real estate or land category.
Secondly, physical capital is generally illiquid, as it fulfils a specific purpose. For example, Coca-Cola owns a particular machine to put caps on the soda pop bottles specially manufactured by them. This machine is of little use to other beverage company since the design, size and shape is probably made to fit the unique coca cola glassware only.
On the other hand, most items of physical capital are fixed capital which indicates that they are subject to not being destroyed or consumed while in the process of production of service or goods, but they can be reused. Therefore, a product of fixed capital has long-term yet everchanging value, which usually declines over time.
Another prime example of this would be manufacturing equipment- with time, the machine ages, and its price and worth goes down; thus, fixed-capital investments are depreciated on the brand’s accounting statements over the decades. The worth of physical capital increases only if the asset upgrades itself or specific changes in the firm can directly affect the value.
Valuation of Physical Capital
Physical capital plays an essential role as a tangible asset in company valuation. Although, it is challenging to accurately assess the physical capital of a company due to the ambiguous boundary held among the three factors of production. For example, companies' headquarters buildings are considered physical capital, while some classify them as land. Thus, experts have different opinions on the classification criteria of each factor of production.
Physical capital, namely, machines and other equipment, are fixed assets with years of economic life. However, its value diminishes over time because of depreciation. The accumulated depreciation subtracted from historical cost gives the book value subject to assumptions like savage value, remaining life and depreciation methods. A fixed asset’s fair market value differs from its book value.
The illiquid nature of physical capital also makes machinery resale quite tricky, affecting the product's fair market value.
A component of the whole organisation is physical capital. As a resource for the company, it adds to the earnings. It gets its value from how highly the organisation is regarded overall. The value of the physical capital is impacted by any organisational changes, such as a demerger of the undertaking or a merger with another company.
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