You know the saying, “You have to spend money to make money”? Well, it’s definitely true in business. Every company has expenses, from raw materials and labor to the tools you use in production.
What they don’t tell you is that there are different categories of expenses. Knowing these categories is essential for understanding how much money it takes to keep your business running.
One of the major expense categories of any business is capital goods. These are the assets you use to make your products or provide a service—think factories, buildings, and tools.
Let’s take a closer look at what counts as a capital good and how they affect your business bookkeeping.
What Are Capital Goods?
Capital is an umbrella term that refers to anything that provides value to your business. On the other hand, capital goods (also known as capital assets) are a specific type of capital.
Capital goods are used to create the goods you sell or the services you provide your customers.
They are not your final product.
Capital goods are used to create your final product, but they are not the final product.
For instance, let’s say you run a business where you sell custom t-shirts. The machine you use to print designs on the shirts is a capital good, and the custom shirts your customers buy are your final products.
They are man-made.
Keep in mind that goods, including capital ones, are man-made. Your business may also need raw materials or other natural resources like oil as part of the production process, but oil is not a capital good because it’s not man-made.
Instead, it will either be a cost of goods sold (if you produce petroleum-based products) or an operating expense (if you use it to power vehicles or generators).
They are used in the long-term.
Capital assets are also long-term, which means you’ll use them for more than one year. For example, a piece of office furniture (like a reception desk) is used for multiple years, so it’s considered a capital good. They are also referred to as durable goods since they last for a long time.
In contrast, things like pens and paper usually get used up within 12 months and are considered short-term assets (also known as current assets).
This is an important difference when it comes to accounting for your assets and deducting business expenses, and we’ll cover it later on.
Capital Goods Examples
Five examples of core capital goods include buildings, equipment, machinery, vehicles, and tools.
Here are some of the most common types of capital goods used by businesses, along with some examples:
- Buildings and facilities: Fixed assets like production sites, office buildings, and any place you deliver a service, such as a hairdresser’s salon.
- Factory equipment or machinery: Assembly line equipment or machines used to deliver your final product, whether it’s a good or service.
- Production technology: Similar to factory equipment, this includes any technology you use to create your final product. Examples include an espresso machine for a cafe or a table saw for a carpenter.
- Vehicles: These are considered capital goods when they’re used to create a product or deliver a service, such as the vans and trucks used by a moving company.
- Tools: Examples include voltage testers and hacksaws for an electrician or even brushes and scissors for a pet groomer.
- Electronics: If used as part of the service, such as camera equipment for a videography company.
- Software: If used as part of the product or service production, such as accounting software for an accountant.
- Power sources: Equipment used to power your production or operations, such as solar panels and industrial batteries.
- Infrastructure: Proprietary roads, trains, or even broadband lines.
- Furniture: Office equipment and fixtures.
- Musical instruments: For professional musicians who use them as part of their work.
How Are Capital Goods Different Than Consumer Goods?
After looking at the list above, you might wonder why some items like cameras or even cars are sometimes listed as capital goods when they’re also examples of final goods consumers buy.
This is where we get into the difference between capital and consumer goods. Consumer products are finished goods people buy and use for personal reasons. They provide utility—or what economists describe as the satisfaction you get when you buy a product for personal use.
The difference between capital and consumer goods can be boiled down into one main question: “Is this item for business or pleasure?”
Goods you purchase for business are considered capital assets, while those you buy for pleasure (personal use) are consumer goods.
Example
Let’s see how this works in an example.
If you run a hair salon and buy a blow dryer you use during haircuts and styling appointments, that’s a capital good. You use it to deliver a service.
But, if one of your stylists buys a blow dryer for personal use only, that’s a final product for them, which makes it a consumer good. They won’t use the blow dryer to generate income or deliver a service. They bought it for the satisfaction they’ll get from it.
Why Are Capital Goods Important?
As nice as it would be, you usually can’t run a business on sheer will alone. You need physical tools to manage the production of goods (or services in the service sector).
In fact, capital goods are one of the four factors of production you need to consider to run a business. The other three are:
- Natural resources (land, water, and oil)
- Labor (employees)
- Entrepreneurship (your idea and leadership)
When you combine these four inputs, you have the basic ingredients you need to run a business. As your core business needs, they usually make up your biggest spending categories. For instance, a study by JPMorgan Chase & Co found that the average small business spends an average of $45,000 on yearly payroll expenses for each employee.
It’s a good idea to track and manage these core production costs, so you know exactly how much it’s costing you to produce your goods. That can help you figure out if you’re making a profit or need to cut back somewhere. To help streamline labor costs, you can use software like Hourly that helps you run payroll seamlessly and keep track of (and pay!) payroll taxes and other expenses.
If you want more insight into the costs of your capital goods, it’s important to know how they get treated in business accounting.
Let’s dig in.
Understanding Capital Goods and Accounting
Since capital assets stay useful for multiple years, their total expense gets broken down over time using an accounting method called depreciation.
Let’s take a closer look at how it works.
Depreciation
As a small business owner, you can deduct business expenses from your total earnings when tax time comes around. This lowers your reported income, which can give you a much-needed tax break.
Since capital goods are used to operate your business, you can deduct them as expenses. However, they are treated differently than your typical office goods (like printer paper or pens) since you don’t use them up in one tax year.
Example
Think about it this way. If you buy a box of printer paper, you may consume it within one year. So you can deduct that entire expense during the year you bought it, and it’s all done. This short-term cost is a current expense since you expect to use the paper within 12 months.
But, let’s say you run a food truck business, and you expand and buy a second truck. That second truck is an asset that will give you value for several years. (You don’t just use it up in one year.)
If you bought the new truck for $70,000 and deduct the entire expense in the year of purchase, you’ll have unusually high expenses, and your profit will appear lower.
This is where depreciation comes in. It lets you connect the cost of a big-ticket item with its value since you spread out the cost over the asset’s useful life.
In other words, instead of deducting the full $70,000 during the year you bought the truck, you’ll spread this cost over the seven years of use and deduct $10,000 each year.
Why Use Depreciation?
By spreading out an expense via depreciation, your expenses are more stable and actually reflect the cost of the assets you need to run your business.
You also have the added benefit of spreading out the tax savings of the truck. You get to deduct $10,000 in expenses yearly for seven years instead of front-loading a big tax deduction in year one.
If you follow the Generally Accepted Accounting Principles (GAAP), you have to use depreciation to expense capital assets you plan to use for over one year.
Capital assets you depreciate over time show up in the Depletion, Depreciation, and Amortization (DD&A) section of the income statement and on the asset column of your balance sheet.
What is Depletion?
Depletion is an accounting tool similar to depreciation, but instead of spreading out the cost of a physical asset, you account for the cost of a long-term natural resource. (This doesn’t really apply to capital goods since a natural resource isn’t a capital good, but if you do use these natural resources, this info could be helpful.)
For instance, let’s say you own a construction company that builds new homes, and you cut down your own timber.
Say you spend $100,000 cutting down timber you’re going to use for a few years. Since you’re not going to use up the entire natural resource (timber) in a year, you don’t deduct the full cost. Instead, you’ll spread out that $100,000 over time using depletion.
Cost Depletion vs. Percentage Depletion
You can use two methods here: cost depletion and percentage depletion.
Cost depletion is pretty straightforward. You deduct the cost of the resource you use each year until you’ve gone through it.
For example, if you use timber worth $25,000 in the first year, you deduct that as an expense. The remaining $75,000 stays listed on your financial documents as a long-term asset, which you’ll deduct year by year.
Percentage depletion is only used for landowners (or royalty holders) that extract and sell natural resources, like gas and oil. It’s not common, so we won’t go into too much detail. But, basically, it’s a tax deduction that lets businesses write off a certain percentage of the money they earn from selling natural resources each year.
Most businesses that need to account for depletion will use the cost method, which gets reported on the Depreciation, Depletion, and Amortization (DD&A) of the balance sheet too.
Understanding Capital Goods and Your Business
Accounting can be tricky enough when you’re just keeping a personal budget. As a business owner trying to perform an economic analysis or prepare a budget, you’ve got even more moving parts. Ultimately, you need to know how long-term assets, such as capital goods, are managed in your books.
By spreading out the cost of big-ticket items over time, you get a better idea of what it really costs to run your business.
Now that you know which assets count as capital goods and should be depreciated, you can call your CPA or log into your accounting software to ensure everything looks right!
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