Introduction Capital goods can be described as goods that are used in theproduction of other goods, rather than being bought by consumers. They areman-made, tangible, durable, and provide value to the business over the courseof their life cycle by generating output and income. From an accounting pointof view, capital goods are treated as fixed assets, such as plant, property andequipment. Examples of capital goods are machinery used in production,vehicles, buildings, furniture and office equipment, or computer software.Capital goods can be essential for a company to carry outtheir primary function. A logistics company cannot operate without its’ fleetof vehicles and a manufacturing organisation will need specific machinery toproduce goods.In this text, I will discuss the classification of capitalgoods, what differentiates them from consumer goods and the different decisionsto be made in their acquisition.
I will then discuss the circumstances thatwill influence the decision of the company to buy new or used capitalequipment. Finally, I will identify and discuss the different ways to financecapital purchases. Capital goods vs Consumer GoodsGoods, in general, can be divided into two categories,capital goods and consumer goods, with the main difference being how they areused.
Capital Goods are products that are used to help increase future productioncapacity, for example, property, plant or equipment. The end users of capitalgoods are usually businesses. All products that are not capital goods areconsumer goods.
Consumer goods are made for day-to-day use to fill immediateneeds, like food, or long- term needs, such as clothing, jewellery,televisions, and refrigerators. Consumer goods are usually used by ordinarypeople. The key difference between capital goods and consumer goods is theirutilisation. As a simple example, consider an oven, which could be categorisedas a consumer or capital good. When bought by an individual for their ownpersonal use, it is a consumer good, but if bought by a bakery owner for makingfood to sell, it would be a capital good.
Classification of Capital GoodsCapital goods generally fit into one of three categories –plant, property or equipment. This covers a wide range of capital assets, frombuildings, production machinery and equipment used to assist production. Machineryused in production and the buildings in which they are stored, a fleet ofdelivery vehicles, a warehouse and racking system and software such as aMaterial Resource Planning (MRP) system are common examples of capital goods. Forthe most part, capital goods are not sold to create revenue. They indirectlycreate revenue by assisting in the production of consumer goods. Capital goodsare fixed assets of producers which are repeatedly used in production of othergoods and services.
While they make production of other goods possible, theythemselves do not get transformed in the production process. This distinguishescapital goods from production inputs such as operating consumables (e.g.packaging supplies, cleaning supplies and maintenance supplies) and inventorywhich is converted into finished goods.In accounting terms, capital goods are treated as fixedassets.
Capital goods would not be expected to be consumed within a single yearof production, and therefore must be depreciated over the course of theiruseful lives, with the business taking partial tax deductions spread over theyears that the capital goods are in use. This is done through use of suchaccounting techniques as depreciation, amortization and depletion. Purchasing Capital GoodsAs a procurement professional, I have many items, productioninputs, materials and consumables that I purchase daily.When purchasing capital goods, however, carefulconsideration must be given to the procurement process because such decisionswill have far reaching consequences, due to the long-life cycle of the good andthe high level of capital which will be tied up.
Capital purchased decisions are often made at a seniormanagement level, but the involvement of the procurement department isimportant. Short-term benefits may need to be sacrificed for thebenefit of the business’ future plans for growth.For instance,a common mistake buyers make is to focus on an attractive purchase price,rather than the strategic importance of the company’s present and future growthplans.
Some of the most important research that must be conducted whenpurchasing capital equipment is identifying the total cost of ownership. Thisis the total investment required to purchase the asset, transport,installation, personnel training, life time maintenance, service contracts andall other operating costs. This must be balanced against the expected revenueto be generated by the investment.In order to reduce operating costs, the company mustcarefully identify their needsStandardisation is one way to do this, by purchasing equipmentthat is similar to and compatible with already existing assets, thus reducingthe need to hold extra spare parts and invest in further training for operatorsand maintenance personnel. Ryanair are an example of a company that hasstandardised equipment to simplify their supply chain, which has been ofsignificant financial benefit to them. They standardised their fleet ofaircraft to one type, Boeing 737s.
This resulted in improved buying power dueto volume, reduction in the variation of spare parts required and the simplificationof maintenance requirements. New vs UsedWhen faced with the challenge of purchasing capitalequipment, one of the first decisions a company must make is weather to buy newor second hand. There are pros and cons to both options, and both should becarefully examined before the decision is made. While used equipment will bethe better option in terms of price, it may be outdated technology, not comewith a warranty or other protection for the buyer and could present furtherhidden financial costs which were not considered.
For the premium price of newequipment, the buyer will probably have warranty protection and will have thecomfort of knowing that they are the first owner, eliminating the worry of anyhidden issues. On the other hand, new equipment will depreciate fastest in its’first few years of productivity, meaning that is unlikely the buyer canrecuperate the cost of the purchase if they ever decide to sell it on.When deciding which option to pursue, there are a number offactors to consider – the company’s financial position and cash flow, thecompany’s public image, the function the equipment will be carrying out, its’expected performance and life-cycle expectancy. A company must carefully assesstheir unique requirements and make their decision based on this.If a company is in a position to buy new equipment, thereare a number of benefits.
Buying the newest technology can give a competitiveadvantage in the marketplace. New equipment will, for the most part, be coveredby a warranty and maintenance contract, meaning less financial risk if theproduct fails and less down time due to breakdowns.For core operating equipment expected to last a long time,new is often a better option. The fast rate of depreciation in value initiallyis not of much concern as the company will not plan to sell the product on. Newproduction equipment with the newest technology can help companies increaseoutput and give advantage in the marketplace by being able to offer somethingthat competitors cannot.Some companies must consider their public image whendeciding between new and used equipment. A premium logistics company may wantto purchase a new fleet of vehicles regularly to give a good impression ofthemselves, as drivers showing up to customers in older worn vehicles mayaffect how their customers perceive them and alter their opinion of thecompany.A new business that is just starting up may not be able to investfinancially in new equipment and machinery, so used or refurbished would be anattractive lower cost option to get up and running.
If there is no competitive advantage to buying newequipment, then a company should consider the option of buying it second hand.Forklifts would be an example of a piece of machinery that companies wouldoften buy used rather than new. Many businesses will only need to use them occasionally,running up low hours on the clock. While they may be important for the businessto carry out operations (loading / unloading vehicles, accessing racking), theused market will often offer many options at a fraction of the cost of buyingnew. Forklifts and other lifting machinery are durable and service contractscan often be acquired at a reasonable cost. Financing Capital AcquisitionsAny capital acquisitions made by a company will requirefinancial investment. Usually the decision will be made by cross functionalteams within an organisation – finance, procurement, technical and seniormanagement – due to the high level of investment required, and the importanceof technical input to ensure the purchase is the best fit for the business.
Thegoal is to identify the financing option that will result in the most efficientuse of your working capital and provide you with the most flexibility when itcomes to ownership of the assets. The funds used to finance capitalacquisitions are commonly referred to as Capital Expenditure (CapEX). Thecompany can spread the cost of this expenditure over the operational life-cycleof the asset. There are a number of different ways a company can financeCapital Expenditure, which I will outline below. Each method of financing hasadvantages and disadvantages, so careful consideration must be given to ensurethe most suitable method is used.Internal FinancingTo acquire a capital asset, a company can finance thepurchase internally from their cash-flow.
This option has the benefit ofownership of the equipment immediately. The company may also benefit from taxincentives over the course of the life cycle of the equipment. Bank LoanThere are a variety of loans available to businesses, whichvary in amount, interest rate, loan term and repayment options. A company canresearch the different options to find the most suitable for their situation.Borrowing money in this way can free up working capital thatmay be required for the day-to-day business operations, or may be betterinvested in another area. The loan can be structured based on the type of assetbeing bought, and spread across the useful life of the asset.
Commercial Hire-PurchaseA hire-purchase is a financing option in which the buyerpays an initial deposit to acquire the goods, and then pays regularinstalments, plus interest, to the seller until the goods are fully paid for.This option does not require the large initial investment and may suitbusinesses who do not have sufficient cash flow or security for a bank loan.The ownership of the goods does no pass to the buyer until the final instalmentis payed in full. ConclusionCapital acquisitions of plant, property or equipment willrepresent a significant financial investment for a company.
Capitalacquisitions and the procurement of capital assets are important strategicdecisions for any business. Managed well, they can offer significant financial benefitsand competitive advantage to a business. However, the wrong investment couldhave a devastating impact.