written by khatabook | November 9, 2022

Understanding Physical Capital | Factors, Examples, Etc.

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Table of Content


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.

Also read: What Is Accounting Rate of Return (ARR)? Explained With ARR Formula & Example

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.

  1. 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. 

  1. Human Capital

Human capital includes labour and other human resources like skills, education or experience that can help the production procedure. 

  1. Physical Capital

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.

Also read: What Is Source Document? Understanding Source Documents in Accounting And It's Types

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. 

Also read: What Is Branch Accounting? Learn About Branch Accounting Types & Examples

Conclusion:

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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FAQs

Q: What is the difference between physical capital and fixed capital?

Ans:

Physical capital refers to assets like machinery, building and vehicles owned and employed by the company. This constitutes one of the factors of production other than labour and land. The fixed capital assets indicate that they are not consumed or destroyed in the factory's production and manufacturing process.

Q: What is physical capital, for example?

Ans:

It consists of human-made items that help manufacturing and production. Real estate, cash, inventory and equipment are examples of physical money. The values are listed in order of solvency on the balance sheet.

Q: Why is physical capital important in our economy?

Ans:

Physical capital is essential since it increases the productivity of services and goods, which helps in the growth of the economy. The machinery inside a corn chips factory ensures the production of more corn chips than the amount which the workers can produce.

Q: What is physical capital in Economics?

Ans:

In economic theory, physical capital is one of the three production components. It consists of human-made tangible objects that a brand invests in or buys and uses to produce goods.

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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.