Fixed capital

In economics and accounting, fixed capital is any kind of real, physical asset that is used repeatedly in the production of a product. It contrasts with circulating capital such as raw materials, operating expenses and the like. It was first theoretically analyzed in some depth by the economist David Ricardo.

Thus fixed capital is that portion of the total capital outlay that is invested in fixed assets (such as land improvements, buildings, vehicles, plant and equipment), that stay in the business almost permanently—or at the very least, for more than one accounting period. Fixed assets can be purchased by a business, in which case the business owns them. They can also be leased, hired or rented, if that is cheaper or more convenient, or if owning the fixed asset is practically impossible (for legal or technical reasons).

Refining the classical distinction between fixed and circulating capital in Das Kapital, Karl Marx emphasizes that the distinction is really purely relative, i.e. it refers only to the comparative rotation speeds (turnover time) of different types of physical capital assets. Fixed capital also "circulates", except that the circulation time is much longer, because a fixed asset may be held for 5, 10 or 20 years before it has yielded its value and is discarded for its salvage value. A fixed asset may also be resold and re-used, which often happens with vehicles and planes.

In national accounts, fixed capital is conventionally defined as the stock of tangible, durable fixed assets owned or used by resident enterprises for more than one year. This includes plant, machinery, vehicles and equipment, installations and physical infrastructures, the value of land improvements, and buildings.

The European system of national and regional accounts (ESA95) explicitly includes produced intangible assets (e.g. mineral exploitation, computer software, copyright protected entertainment, literary and artistics originals) within the definition of fixed assets.

Land itself is not included in the statistical concept of fixed capital, even though it is a fixed asset. The main reason is that land is not regarded as a product (a reproducible good). But the value of land improvements is included in the statistical concept of fixed capital, being regarded as the creation of value-added through production.

Estimating the value

Attempts have been made to estimate the value of the stock of fixed capital for the whole economy using direct enterprise surveys of "book value", administrative business records, tax assessments, and data on gross fixed capital formation, price inflation and depreciation schedules. A pioneer in this area was the economist Simon Kuznets.[1]

The so-called "perpetual inventory method" (PIM) used to estimate fixed capital stocks was invented by Raymond W. Goldsmith in 1951 and subsequently used around the world.[2] The basic idea of the PIM method is, that one starts off from a benchmark asset figure, and adds on the net additions to fixed assets year by year (using gross fixed capital formation data), while deducting annual depreciation, all data being adjusted for price inflation using a capital expenditure price index. In this way, one obtains a time series of annual fixed capital stocks. This data series can also be modified further with various other adjustments for prices, asset lifetimes etc. (several variants of the PIM approach are nowadays used by economic historians and statisticians).

However, it is widely acknowledged that it is extremely difficult to obtain any accurate measurement of the value of fixed capital, especially because even the owner himself or herself may not know what the assets are currently "worth". What they are worth may become apparent only at the point where they are definitely sold for a price. Some valuations for fixed assets may refer to historic cost (acquisition cost) or book value, others to current replacement cost, current sale value in the market, or scrap value.

The depreciation write-off permitted for tax purposes may also diverge from so-called "economic depreciation" or "real" depreciation rates. Economic depreciation rates are calculated on the basis of the observed average market prices that depreciated assets at different ages actually sell for. Sometimes statisticians try to estimate the average "service lives" of fixed assets as a basis for calculating depreciation and scrap values, based on the observed length of time that fixed assets are actually held and used by their owners who own the business.

Almost always, the capital stock estimate which statisticians arrive at is a theoretical estimate based on a variety of data sources, and it does not correspond to the historical cost of fixed assets nor to actual depreciation write-offs. However, it is believed to be a more accurate representation of the true value of the fixed capital stock.

Investment risk

A business executive who invests in or accumulates fixed capital is tying up wealth in a fixed asset, hoping to make a future profit. Thus, such an investment usually implies a risk. Sometimes depreciation write-offs are also viewed partly as a compensation for this risk. Often leasing or renting a fixed asset (such as a vehicle) rather than buying it is preferred by enterprises because the cost of using it is lowered thereby, and the real owner may be able to obtain special tax advantages.

Sources of funding for fixed capital investment

An owner can obtain funding for purchase of fixed capital assets from the aptly named capital market, where loans are given on a long-term basis. Funding can also come from reserve funds, the selling of shares, and the issuing of debentures, bonds or other promissory notes.

Factors which influence fixed-capital requirements
  • The nature of the undertaking: the nature of the business certainly plays a role in determining fixed capital requirements. A florist, for example, needs less fixed capital than a vehicle-assembly factory.
  • The size of the undertaking: a general rule applies: the bigger the business, the higher the need for fixed capital.
  • The stage of development of the undertaking: the requirement of capital for a new undertaking is usually greater than that needed for an established business that has reached optimum size.
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See also

References
  1. Simon Kuznets, Gross capital formation, 1919-1933. New York: National Bureau of Economic Research, 1934.
  2. Raymond W. Goldsmith, A Perpetual Inventory of National Wealth. Studies in Income and Wealth, Vol. 14. New York: NBER, 1951, pp. 5-74.
  • Bureau of Economic Analysis, Fixed assets and consumer durable goods in the United States, 1925-1997 (September 2003)
  • Canberra Group on Capital Stock Statistics Conference, March 1997
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