What is physical capital? Physical Capital identifies in the modern world one of three crucial variables to production; machinery, raw materials, and labor. By definition, physical capital refers to the equipment used to make a product and also the raw materials necessary to make that product. It can be compared, in some ways, to the money that funds the operation of a business. If you do not have money, you cannot operate your business.
In the case of businesses, “capital” refers to the total value of all assets – including land and fixtures – that a business possesses. The more total capital assets that a business possesses, then, the higher the level of operations. For instance, let’s assume that Company A has a capital A, and Company B has capital B. In this example, the difference between the capitalization is what is known as the “equity component.”
There are two important questions to answer when we talk about what is physical capital. The first question to answer is: What is the total value of the inventory of each firm? This is commonly referred to as gross capitalization. The second question to answer is: How much total revenue is derived from the sale of tangible assets? This is commonly called gross profit. In order for a business to determine its total return on investment (ROI), both of these figures must be determined.
Let’s assume that we want to assess the physical capital assets of Company A, and Company B. We know that each firm has a capital A, and capital B. Now, since it is impossible to know exactly what is physical capital, we must assume that the value of each firm’s inventory is equal to the value of its capitalization. This might seem like a lot of math, but it really is not. Just subtract the capitalization from the value of the tangible assets of each firm, and you get the exact value of what is physical capital.
Now, let’s assume that each firm operates in different markets. For example, let’s assume that Company A manufactures components. It sells those components to firms that need them to make their products. Firm B would purchase the components from the supplier and then sell the components to firms that actually build their products.
When we add up the costs of manufacturing the components, and then add them to the costs of selling them, we get the cost of manufacturing the item. If the cost of manufacturing is more than what is the cost of selling the item, then we must question whether the firm should continue to invest in the physical capital assets. If the firm continues to invest in the physical capital, then the firm will be forced to shut down its production line. However, if it seems like the firm is generating enough sales to justify continuing to invest in the physical capital, then it makes sense to add that into the equation.
The final step in analyzing what is physical capital is to figure out what the net asset value is for each firm. Net asset value takes into account all of a firm’s tangible assets, and all its liabilities. In a perfect market, all firms would have equal net worth. However, since there are no perfect markets, and competition can be fierce, the net worth of each firm is likely to vary from other firms in the market.
Investing in physical capital can be a wise decision. Physical assets, like manufacturing equipment and machineries, can increase the value of a firm. However, it may not be worth it unless the firm can make a profit on its invested funds. To determine what is physical capital, the firm should add the value of its tangible assets, its variable assets, and its liabilities, and calculate the firm’s net worth.