What’s it: Capital goods refer to man-made goods useful for producing goods or providing services. Machinery, buildings, equipment, and logistics vehicles are examples. They are strategic to support production activities.
Investing in capital goods is vital. It’s not just to replace worn-out capital goods. But, it is also to increase production capacity. When investment exceeds depreciation in capital goods, the company or the economy can produce more goods and services. And, specifically for the economy, it increases potential output.
Capital goods vs. raw materials vs. consumer goods
Capital goods are different from raw materials. Both are used during the production process. However, the raw materials will be further processed and converted to become output. Therefore, they will be part of the output.
On the other hand, capital goods do not make up or form output. Let’s say it’s a production machine. Companies use it to help convert and process raw materials into output.
Capital goods help process inputs into outputs, which can be other capital goods, intermediate goods, or consumer goods. In other words, we use them to make other things. Furthermore, capital goods are also used for other productive activities such as delivering goods from warehouses to customers.
Meanwhile, consumer goods are used by consumers to fulfill their needs and wants. They are for final use and have no future productive use.
For instance, a car is a consumer good when we buy it as a personal car. But, on the other hand, trucks are capital goods because we use them, for example, to transport consumer goods from factories to warehouses.
In conclusion, consumer goods directly satisfy the needs and wants of consumers. Meanwhile, capital goods are not, but we use them as a means to produce consumer goods. In other words, they satisfy the needs and wants of consumers indirectly.
Examples of capital goods
Capital goods vary between businesses. They can cover fixed assets, such as buildings, equipment, machinery, vehicles, and equipment. For example, hair clippers are also a capital item for hairdressers, with whom they provide services. Likewise, a coffee machine is a capital item for a coffee shop.
For financial companies, office buildings, tools, computers, or other equipment in the office are other examples of capital goods. They use it to facilitate their efforts to provide services.
Furthermore, in the economy, capital goods also include public goods such as roads, railways, ports, airports, and telephone networks. They are part of a country’s infrastructure and contribute to expanding the productive capacity of the economy.
Capital goods industry
The capital goods industry comprises companies where most of their revenue comes from manufacturing or distributing industrial equipment and goods for productive purposes. For example, they manufacture heavy and light equipment, machinery, industrial components, and construction equipment. Likewise, manufacturers of automobiles, aircraft, and engines fall into this category. Their products are then sold and used by other companies to make, deliver and provide goods and services.
The capital goods industry includes various businesses. For example, they may produce items such as:
- Cables, electrical wires, electrical components or equipment, electric turbines, and heavy electrical machinery.
- Heavy trucks, rolling machines, construction equipment, earthmoving equipment, and agricultural machineries such as tractors and planting and fertilizing machines.
- Industrial machinery and components such as presses, machine tools, compressors, elevators, and escalators.
- Civil aerospace and military products such as aircraft.
The importance of capital goods
Capital goods are factors of production besides land, labor, and entrepreneurship. It determines the productive capacity and becomes a barrier for new players to enter the market. In addition, spending on capital goods provides insight into the future direction of the economy.
Determining productive capacity
Capital goods contribute to the production capacity of companies and the economy. As a result, businesses often spend a lot of money buying them. How much is spent? That’s capital expenditure (CAPEX).
When a firm buys capital goods, we expect the company to produce more output, which in turn, more income in the future. But, you also should be careful in drawing conclusions. You should not only look at capital expenditures but also depreciation. Let’s take two other related terms.
- Gross investment – the amount of money the company spends on purchasing capital goods. It is another name for capital expenditure.
- Net investment – gross investment minus depreciation.
Production capacity increases as long as the net investment is positive. It shows new assets are increasing faster than obsolete assets (depreciating). Thereby, the company can produce more output in the future. As a result, their business size grew, and so did the size of the economy.
Then, for the aggregate figures of the economy, infrastructure spending by the government is just as important as capital spending by businesses. Infrastructure is vital to better well-being and higher standards of living. It is strategic to build the economy by reducing logistics costs, improving human capital, and encouraging economic activity.
Quantity and quality
When linking capital expenditures to productive capacity, we should focus on quantity and quality. Indeed, increasing the number of capital goods allows firms or the economy to produce more goods and services.
However, quality also determines productive capacity. Therefore, when quality improves, for example, due to technological advances, we can also produce more output.
For example, advances in production machinery make businesses produce output faster. Another example is computers vs. typewriters. By using a computer, a writer can write much more than using a typewriter.
An indicator for the direction of the economy
Expenditure on capital goods is one indicator to see the direction of economic growth in the future. Capital goods investments are expensive and require more consideration, such as the current capacity utilization rate, cost of funds, and demand prospects.
So, when capital investment increases, it marks a positive economic outlook in the future. Manufacturers are confident about the growth and demand for their products, making them bold to increase capital expenditures. That most likely indicates economic prosperity (expansion) continues.
On the other hand, if demand conditions are bad, such as a recession, they will usually delay buying. This is because they are pessimistic about their future growth and demand.
Capital investment as a barrier to entry
Capital-intensive industries often have high barriers to entry. Firms depend on expensive capital goods, which can deter new entrants from entering the industry.
Two possible consequences. First, new entrants need significant funds to purchase these capital goods. Otherwise, they cannot operate efficiently and bear higher costs, making their product prices less competitive in the market.
Second, new entrants must quickly have a customer base large enough to reach higher economies of scale. They have to think about how to sell their product. Consumers are often reluctant to switch to new products because they do not have a reliable track record. In this case, entering the market by acquiring an existing player makes more sense than developing it internally. It allows them to have a customer base without having to build it from scratch.
Capital goods in accounting
Companies often use the terms capital goods and fixed assets interchangeably. They present it in the financial statements as fixed assets or property, plant, and equipment (PP&E). You can find this account in the balance sheet, to be precise, in non-current assets.
Capital goods that are not consumed by the business in an operating cycle cannot be fully charged into the income statement in the year of purchase. Instead, they must be depreciated over their useful life. Then, the company records depreciation expenses in the income statement.
Meanwhile, the company uses accumulated depreciation as a deduction from fixed assets on the balance sheet. In other words, the fixed asset account in non-current assets is a net number, i.e., after deducting accumulated depreciation.
Furthermore, for capital expenditure, you can find it in the cash flow statement under cash flow from investing activities.