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Physical Capital

Human-created tangible assets or inputs that are used to support the production of goods and services

What is Physical Capital?

Physical capital refers to the human-created tangible assets or inputs that are used to support the production of goods and services. It is one of the main factors of production in classical and neoclassical economics. Examples of physical capital include machinery, buildings, vehicles, equipment, etc.

 

Physical Capital

 

Summary

  • Physical capital refers to the tangible goods and assets that are created by humans and used to support the production process.
  • Physical capital, human capital, and land and natural resources are the three factors of production in classical economics.
  • Valuation of physical capital can be challenging due to its illiquid nature, as well as the ambiguous distinction between physical capital and land and natural resources.

 

Understanding Physical Capital

In economics, capital represents the man-made assets that support economic activities. Physical capital, as a subset, refers to the durable non-financial assets used in the process of producing goods and services. It is also known as real capital, capital stock, or capital assets. Examples of physical capital include machinery, tools, buildings, inventory, and so on.

Physical capital is one of the factors of production in Adam Smith’s Classical Economics theory. Together with land and natural resources as well as human capital, the three factors will support the process of production and contribute to the real GDP growth of an economy.

 

Three Factors of Production

 

The distribution of cost among land and natural resources, human capital, and physical capital can be used to price the product or service produced. These factors together can also be used to value a company.

 

Valuation of Physical Capital

As a tangible asset on the balance sheet, physical capital is an important component of a company’s valuation. However, it is quite difficult to properly assess the physical capital of a business because of the ambiguous boundary among the factors of production.

For example, some analysts consider the headquarters building of a company a part of its physical capital, but some might classify it as land. Economists remain divided on the exact classification criteria for each factor of production.

Many types of physical capital, such as machines and equipment, are fixed assets with years of economic life. Although the physical capital is not consumed out or destroyed during the production process, its value often diminishes over time due to depreciation. The book value (historical cost minus accumulated depreciation) is subject to depreciation assumptions, such as the remaining life, salvage value, and depreciation methods. A fixed asset’s book value can be very different from its fair market value.

The illiquid nature of physical capital provides another challenge in its valuation. Sometimes, machines and equipment are customized and can only be used for certain purposes. For example, a beverage company owns a particular bottle design. The bottling machine that it uses might be designed to fit the special shape of the bottles. It makes the resale of the machine more difficult and thus affects its fair market value.

 

Physical Capital and Factors of Production

 

Physical Capital vs. Human Capital

Human capital refers to the labor hours and other resources or value-adds that humans can provide, including education, specialty skills, or even innovative ideas. Unlike physical capital, human capital is intangible.

While manufacturing companies typically own a large proportion of physical capital, technology companies rely more on intellectual or human capital. This also partially explains the high price-to-book ratios of many tech firms, as the value of human capital is not reflected on the balance sheet.

The value of human capital is very difficult to measure due to its intangible nature. To what extent the value creation of a company can be attributed to its human capital is ambiguous and can only be assumed. One of the methods to evaluate human capital is through the market-ups on the goods or services that a company produces. Premiums on salary and costs of employee benefit programs is another commonly used method.

 

Physical Capital vs. Land & Natural Resources

Land and natural resources are also an essential part and often appear as raw materials in the production process. It includes naturally existing goods such as land, soil, minerals, and water resources. Both physical capital and land and natural resources are tangible assets of a company. The major difference is that physical capital is created by humans, while land and natural resources exist in nature.

Some goods might even show features of both factors, which can cause conflicts regarding the categorization. In the corporate building example discussed above, the building itself is man-made, but a large portion of the value of the building comes from the land, which naturally exists.

 

Additional Resources

CFI offers the Capital Markets & Securities Analyst (CMSA)® certification program for those looking to take their careers to the next level. To keep learning and advance your career, the following resources will be helpful:

  • Tangible Assets
  • Human Capital
  • Neoclassical Economics
  • Asset Valuation

Financial Analyst Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes!