Fixed capital is a term that refers to assets that a company owns and uses in the operation of the business over a relatively long period of time. These assets, also referred to as fixed assets, include property, equipment, and plant assets such as buildings and furniture. They are not consumed in the production process and do not include inventory or assets produced or held for resale. The cost of a fixed asset is depreciated over its useful life rather than deducted as an expense in the year of purchase.
Firms that are considered capital intensive are involved in an industry that requires large expenditures in fixed capital. The oil industry is an example where large expenditures must be made prior to start-up. An oil company must have massive equipment to find, collect, and product products from oil. Another example would be the pharmaceutical companies, which must invest in equipment for research and development.
Industries in which companies must finance extensive fixed capital cause a situation in which it is difficult for new firms to break into the business. The requirement for a high level of fixed capital is one of the barriers of entry that causes a specific industry to have limited competition. Companies that have been in business some time may mitigate some expenses after developing economies of scale in which supplying a product costs less per unit because of the large number of units the company is able to produce.
In order to depreciate or subtract the cost of fixed capital assets, it is necessary to determine the depreciable value of the items. Usually an asset’s value is its cost, but a calculation may be required to determine the absolute physical life. While a piece of equipment may be functional for a longer period of time, the absolute physical life refers to how long the item will be useful. Any equipment that has a technological basis to it may become obsolete due to new discoveries or improvements on the market. Depreciation should take place only over an asset’s useful life.
There are many techniques for depreciating the value of a fixed capital asset. Depreciation methods include straight-line, declining-balance, and unit or activity method. All but the last method assumes that depreciation is an element of time; that is, the asset becomes less useful the longer it is in production. Activity-method depreciation connects depreciation cost to the actual productivity of an asset. The purpose of any depreciation method is to match the cost of an asset to its income producing usefulness.
