Physical Capital

Allocated Loss Adjustment Expenses (ALAE)

What is physical capital?

Physical capital is one of what economists call the three main factors of production. It is made up of human-made material goods that aid in the process of creating a product or service. The machinery, buildings, office or warehouse supplies, vehicles and computers that a business owns are all considered part of its physical capital.

Key points to remember

  • In economic theory, physical capital is one of the three factors of production.
  • Physical capital consists of tangible and artificial objects that a company buys or invests and uses to produce goods.
  • Elements of physical capital, such as manufacturing equipment, also fall into the fixed capital category, which means that they are reusable and not consumed during the production process.

Explain physical capital

In neoclassical economic theory, the factors of production are the inputs necessary to engage in the production of goods or services in pursuit of profit. Economists generally agree that there are three main factors of production:

  • Land / natural resources/immovable. These factors include the land or property on which factories, shipping facilities or stores are built. Natural resources that emerge from the ground, such as the corn needed to make tortilla chips or the iron ore used to make steel, also fall into this category.
  • Human capital. This factor includes the work and other resources that humans can provide – education, experience or unique skills – that contribute to the production process.
  • Physical capital. Sometimes simply referred to as “capital,” this factor includes items or products made by humans that make the manufacturing process possible or allow it to run smoothly. Certain types of physical capital are directly involved in production, such as welding equipment that melts parts of a car on the factory floor. Others are indirectly involved, such as computers and printers at executive headquarters.

Physical capital and startups

New or start-up companies invest in physical capital at the start of their life cycle, often before producing a single good or obtaining their first customer. For example, a company that makes microwave ovens must make several investments before it can sell a single device: the company must build a factory, buy the machines it needs to make and assemble the ovens, and finally, she must create some examples of devices before all stores offer their product.

The accumulation of physical capital with established businesses and the associated investments required can be a significant barrier to entry for new businesses, particularly those in industries with high manufacturing intensity.

Diversification of physical capital is a measure of the level of diversification in a particular industry. Therefore, from a physical capital perspective, starting a new law firm is much easier than opening a new manufacturing plant. Theoretically, a lawyer would only need a desk – perhaps just a desk, even – a telephone and a computer. Relatively low physical capital is the reason, one economist might say, that there are far more law firms than steel manufacturers.

Evaluating Coca Cola as an example of physical capital

Experts agree that physical capital is an important consideration in the valuation of a business. Curiously, however, it can also be one of the most difficult assets to assess. On the one hand, there may be disagreement on what exactly constitutes physical capital – economists often disagree on the exact parameters of the three factors of production.

Take, for example, the head office of Coca-Cola Company in Atlanta. Some might consider this campus of office buildings, dominated by a 29-story skyscraper, as physical capital because they are artificial structures. office building or factory of a company. Others might consider the place of the business as falling within the land / real estate category. The same goes for the Coca-Cola bottling plant in Athens, Ga.

Second, physical capital is often relatively illiquid because it is generally designed to serve a particular purpose. The machine that puts caps on iconic Coca-Cola pop soda bottles won’t be of much use to anyone outside of another beverage company – and maybe not even then, since the machine is probably designed to fit the size and shape of the unique Coke glassware.

Most objects of physical capital are also fixed capital, which means that they are not consumed or destroyed during the actual production of a good or service but are reusable. As such, a fixed asset has long-term value, but that value can change over time. Usually it declines. Again, manufacturing equipment is a prime example: as the machine ages, it is worth much less; this is why investments in fixed capital are generally amortized on the company’s accounting statements over a long period (often decades). On the other hand, the value of physical capital can increase in value if the asset itself is upgraded or if there are changes in the business that affect its value.

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