Capital intensive is the processes or industries that need enormous capital investments in plants, tools, machinery, etc to create products or services in high volumes and keep up with optimum levels of net revenues and ROIs. Such organizations have a higher extent of fixed assets in comparison to the total assets or resources.
Capital intensive can also be understood as the limit of the business organization estimated in light of capital invested by the business in its plant, tools, machinery, and other fixed assets for optimizing the production that outcomes in the earnings of the greater ROIs and profits. The examples of capital-intensive industries incorporate a Car Company, Gas and Oil production, Real Estate, Manufacturing Firms, Metals, Mining, etc.
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What is Capital Intensive?
Definition: Capital intensive is defined as the industries or processes or projects that require a high percentage of investment in fixed assets such as fixed capital, machinery, or a plan to produce a good or service. Capital intensive projects have a high percentage of fixed resources PP&E (property, plant & equipment). Businesses functioning in capital-intensive industries enterprises are commonly marked by significant degrees of depreciation or devaluation.
In simple words, it is a production process that requires a high level of investment in fixed resources (machines, capital, plant) to deliver. Such a production process will have a moderately low proportion of labor input and will have higher labor productivity. Also, it will more often than not have a high ratio of fixed costs to variable costs. Accordingly, the production process might have economies of scale.
Understanding Capital Intensive
We all know that all kinds of businesses need funding or capital to run and manage the business, but a capital-intensive business is estimated in light of the capital invested by it in buying the fixed assets. It is characterized as the capacity of the business or company to put investments into fixed assets or resources. The use of higher investments prompts better ROIs that bring about more financial backers and ultimately optimize the market share.
A few organizations that are capital-intensive need higher capital to channel the business operations which implies that the maintenance cost is additionally high in such ventures. These organizations have higher operating leverage as working expense becomes higher because of high investments in fixed resources that are PP&E.
However, such industries also have a bigger volume of sales. These industries stand in the market due to the services they give, labor efficiency, maintenance of the assets, risk factor, productivity, and many other factors. To put it plainly, in case the capital expenditure is substantially more than the labor expenditure then the business would be capital intensive.
Importance of Capital Intensity
Capital-intensive businesses will quite often have higher degrees of operating leverage that can be understood as the ratio of fixed costs to variable costs. Therefore, such industries need an optimized volume of production to give a sufficient ROI. It additionally implies that little changes in sales can prompt huge changes in profits and return on invested capital.
Hence having higher operating leverage makes capital-intensive industries more vulnerable to financial slowdowns compared to labor-intensive businesses or organizations since they need to pay fixed costs like overhead on the plants. Such types of costs have to be paid in any event no matter industry is going through a recession or not.
Some of the reasons behind the importance of capital intensive industries are-
1. Labor Productivity
The higher investments in capital increase labor productivity. Capital intensity, as well as labor productivity, are crucial in deciding economic growth in the long run. The capital-intensive methods can be key reasons behind optimized output and everyday comforts.
The promotion of a capital-intensive industry also requires a huge interest in fixed resources. Such sorts of huger investments require adequate reserve funds or savings or the ability of firms for financing the investments.
3. Skilled Labor
The capital intensity for the most part demands a highly-skilled workforce. With optimized capital intensity, there come laborers who work with the machines with adequate abilities and skillsets.
4. New Trade Theory
As per this theory, production concentrates on specific areas. Frequently the specialization takes place because nations were quick to produce and profited from their capital intensity.
Measuring Capital Intensity
Other than the operating leverage, the capital intensity of an organization can be measured through the calculation of the number of assets required for producing a dollar of sales that will be total assets divided by the sales taking place. This is the opposite of the asset turnover ratio which is also a sign of the effectiveness with which an organization is using its assets and resources for producing ROIs.
Hence, to measure capital intensity, you should compare capital and labor costs. Generally, capital-intensive firms have high depreciation costs as well as operating leverage.
All in all, the capital-intensity ratio is- Total Assets/ Sales.
Impact of Capital Intensity on Earnings
When it comes to capital-intensive firms, it is important to understand they utilize a great deal of financial leverage, as they can involve plant and equipment as the collateral. In any case, having high operating leverage as well as financial leverage might be very risky in letting sales fall deals fall surprisingly.
Such industries also have high depreciation costs, experts involved in covering capital-intensive industries regularly add devaluation or depreciation back to net income utilizing a metric called EBITDA that includes earnings before interest, taxes, depreciation, and amortization. With the help of EBITDA, it will become simpler to compare the performance of companies in the same industry.
In addition to these, the following are some of the major positive effects of high capital intensive-
- It assists in increasing labor productivity and production capacity
- Optimized capital intensity prompts long-term economic growth
- Increased capital intensity also develops the market standing and growth in market share
- Capital intensity is also responsible for promoting the introduction of new technology because unless there is new and efficient innovation, no company will be able to invest in the asset
Does capital intensive production cost jobs?
Boosted capital intensity can be a reason behind the job of a few workers since they are will not be generally required after the advancements.
This can prompt structural joblessness temporarily. Nonetheless, the growth of more capital-intensive industries creates new types of job opportunities like jobs in AI, software design, marketing, etc.
Additionally, such industries can prompt lower costs and higher wages that cause an optimized interest for a more assortment of services.
Examples of Capital Intensive
Some of the common examples of such industries can be transportation sectors such as airways, railways, waterways that need loads of investments in purchasing the transportation medium or creating the transportation medium.
Profits of such industries rely on operational expenses. This means higher operation expenses like labor costs, repairs, maintenance, admin expenses, salaries, etc will ensure lower profits. Profits may also get reduced due to higher depreciation costs.
Example of High Capital Intensive Industries
In case you are a utility service provider who wants to set up a plant for offering electricity, then for this, you will be required to build either wind, coal, or nuclear power stations.
After doing this, you will be supposed to set up a transmission sector alone with the retail sector and billing.
For all such requirements, there will billions of USD dollars needed as upfront costs that will be included as assets in the balance sheet of the company.
Example of Low Capital Intensive Industries
If you are a software supplier, you will be supposed to make programming products and sell them for a profit. For this case, there will be no direct upfront costs. You will just need to hire engineers and hence, the main upfront expenses will be their compensations or salaries.
Capital Intensive vs Labour Intensive
Capital intensive is associated with the amount of capital invested to build the income and profit while labor-intensive talks to the amount of money spent on training to work in order to optimize their efficiency of work which will bring about optimized production.
Capital intensive prompts an increment in operating and other upkeep costs while labor-intensive prompts ideal use of labor resources which lessens the production cost. Capital intensive businesses need a huge amount of money while to be labor-intensive businesses demand an effective and enthusiastic labor force.
Advantages of Capital Intensive
Some of the upsides of capital intensive processes are
- Such businesses have less competition in light of the great capital necessity
- Financial backers or investors are more pulled-in to capital-intensive ventures as a result of better ROIs
- Investments of capital-intensive businesses significantly comprise investment in fixed assets essentially plant and machinery that is considered as safe in comparison to the other sort of investment as the businesses can appropriately use the asset to acquire the profits
- The non-operating expense such as deprecation is high in capital-intensive that gives the advantage in the tax payment as high depreciation offers low profit and consequently low tax
Disadvantages of Capital Intensive
Some of the notable downsides of capital intensive companies are
- Such companies have a high risk because of the huge investment
- At first, the misfortunes or the losses will be more because of huge investments as well as the depreciation
- The liquidity stays low in such businesses as 60+% of resources or assets generally comprise capital assets
- Maintenance cost in such organizations are quite high as the fixed assets and machinery requires consistent maintenance
While winding up this post, it is clear that capital intensive refers to those businesses or companies that invest more in capital resources or assets. In general, seventy to eighty percent of total assets comprise fixed assets, machinery, and plants. Such industries require heaps of money for industry survival.
In such businesses or industries, the operating and maintenance cost will also be more as the assets need constant servicing and maintenance. However, such businesses save the tax as the devaluation or depreciation and other expenses are higher which brings about lower ROIs.
These businesses or companies suffer misfortunes or losses at first yet over the long run, these companies or businesses acquire higher profits. In such industries, long-term growth is considered good. But the gamble or risk included in such industries is additionally higher, thus the competition is impressively low.
While deciding whether a business or company should go for capital intensive setup or not, a few reasons or decisions go in the process. In some of the organizations, being initial capital intensive is mandatory like power, utilities, automobiles, while there are other businesses where being high capital intensive is a choice such as software, streaming, etc.
All in all, analyzing the power that a company has and the capacity it has to keep the market share will help in understanding how capital intensive a business or project ought to be.
How effective and profitable do you consider capital-intensive companies that demand large amounts of investments?