Physical CapitalTangible human-made properties that support the production of goods or services

In economics, there are three main factors of production.

They are the following:

• Land, Natural Resources, and Real Estate
• Human Capital; and
• Physical Capital

These three factors will support the business in the production of goods and services. They will ultimately support the business in its profit generation.

Land, natural resources, and real estate (or simply land and natural resources) refer to land or property on which factories, office buildings, and warehouses are built.

They may also refer to land and any natural resources that one can find on it such as oil, minerals, gemstones, water, etc.

Other natural resources include crops that grow out of the land such as corn, potatoes, carrots, etc.

The business will either sell these natural resources as is or process them into other products such as chips. Finally, real estate refers to man-made structures that house a business’s many functions (e.g. factory, warehouse, shipping facility).

Human capital (or labor) refers to the work that individuals contribute during the production process. It not only includes labor but also includes other resources that individuals can provide such as expertise, knowledge, skills, and experience.

Physical capital refers to tangible human-made properties that facilitate the production of goods or services.

Examples include machinery, equipment, computers, etc.

In accounting, we refer to these properties as tangible assets.

Some types of physical capital are directly involved in the production process. Others indirectly support the production process.

In this article, we will be going in-depth regarding physical capital.

What counts as physical capital?

What are examples of physical capital?

Is physical capital important for a business?

How can a business benefit from having physical capital?

Let’s try to answer these questions as we go along with the article.

What is Physical Capital?

Physical capital is one of the three main factors of production (in classical or neoclassical economic theory).

The other two factors are land and natural resources, and human capital.

It refers to human-made properties that support and facilitate the production process of a business.

For example, the machinery, equipment, and building that the business uses for the production of goods are part of its physical capital.

Other types of physical capital only indirectly support the production process. Examples of these include the printers and computers that the administrative staff of the business use.

The cost distribution among the three factors (land and natural resources, human capital, and physical capital) can often determine the price of the goods or services that result from the production process.

These three also contribute to the valuation of the business.

Physical capital may also include liquid assets such as cash, inventory, or any asset that is readily convertible into cash.

This type of physical capital will comprise the working capital of the business.

Physical capital that provides benefits to the business for multiple periods is what we refer to as fixed capital.

Fixed capital is not consumed during the production process, but they deteriorate in value due to depreciation.

Speaking of depreciation, physical capital that has a useful life of more than 1 year will naturally deteriorate either due to the passage of time or the natural use of the asset.

For example, a machine that a business uses in its production process will eventually fall off in terms of performance.

It will sometimes malfunction. As the machine is used more, these instances of malfunction will become more frequent.

Eventually, the machine will become inoperable and will necessitate replacement.

When the asset becomes fully depreciated, it becomes worthless (unless it has salvage value).

Physical Capital and Start-ups

New or start-up businesses that require a lot of physical capital will initially have to invest a majority of their resources in acquiring such physical capital.

This is extra risky as these businesses will have to invest in these properties even before they can produce a product or secure a steady revenue source.

For example, if a business wants to produce and sell bread, it will have to invest first in machinery and equipment that facilitates the production of bread.

In addition, the business will have to secure space to house the production process. That’s a lot of capital to consider.

Depending on the type of business, the necessity of physical capital may pose a significant barrier to entry for new businesses.

Typically, a manufacturing business will need to invest a lot in physical capital.

This is why we don’t see a new “Coca-Cola” or “Pepsi” type of business pop up every day.

In contrast, it’s relatively easier to start a business that provides services that don’t require many tools.

For example, a tutorial business will not need much physical capital. It might only need tablets or computers.

It can also rent the space that it requires, which makes the cost of starting the business easier to manage.

Challenges in The Valuation of Physical Capital

Physical capital is an important factor in the valuation of the business.

However, there is the issue of physical capital being difficult to properly assess.

There are two factors that contribute to this difficulty in valuation: (1) the ambiguous boundary among the factors of production, and (2) the (mostly) illiquid nature of physical capital.

Let’s discuss first the ambiguous boundary among the factors of production.

Some analysts consider the headquarters building of a business as part of its physical capital. However, other analysts consider the same property as land.

Because of this divide in the classification of some human-made properties (particular buildings), it’s difficult to accurately assess the value of physical capital.

As for the illiquid nature of physical capital, it provides difficulty as most assets that fall under physical capital are purpose-oriented.

This means that while they may have value for the business, they may not have for other businesses.

For example, the Coca-Cola Company uses machinery that specifically caters to its production process.

The Coca-Cola Company probably customizes its machines to fit the unique size and shape of its Coke bottles.

This customization makes the machines more difficult to resell as they may not be useful for other businesses.

It will surely affect the fair market value of the machines.

Lastly, for some businesses, a majority of their physical capital is fixed assets such as machinery and equipment.

These assets have useful lives of more than a year.

While they don’t get consumed or destroyed during the production process, their value still deteriorates due to depreciation.

This can create a difference in the book value of the assets and their fair market value.

Also, owing to their long useful lives, the value of such assets can still change over time.

Physical Capital vs Human Capital

Human capital refers to the contribution of individuals to the production process of a business.

This includes labor and other resources such as knowledge, skills, expertise, and experience.

These resources are intangible in nature. On the other hand, physical capital refers to tangible human-made properties that support and facilitate the production process.

This is the first difference between the two: human capital is intangible, physical capital is tangible.

In accounting, physical capital will appear on the balance sheet.

They are usually recorded at cost.

On the other hand, human capital won’t appear on the balance sheet (except for when it’s a component of goodwill).

This is why businesses that rely more on human capital rather than physical capital have high price-to-book ratios.

Physical Capital vs Land and Natural Resources

Both physical capital and land and natural resources are tangible in nature.

This means that they have physical forms.

Where they differ is who made them. Physical capital refers to human-made properties.

On the other hand, land and natural resources exist in nature (except for buildings that are human-made).