Needs for Capital Expenditure

Investment in fixed assets is generally undertaken because of the need to produce and sell goods or services in the future. It is a commitment to future profitability. Unless the ageing assets are replaced, we cannot compete with others who are just commencing similar types of businesses. Nor can we continue to enjoy the level of profits enjoyed in the past, when the assets were new, because we incur additional expenditure by maintaining them past their useful life.

Organizations may invest in new assets that are more reliable, and these investments result in cost savings. They may also invest in projects that can expand present capacity, or they may want to introduce new products that require types of machinery and equipment that differ from those that are in place.

Another reason for investing in an asset is that it may have completed its useful life and is due for replacement. Some organizations may invest for different reasons altogether, such as employee welfare or to comply with safety regulations.

The capital expenditure on fixed assets is thus incurred mainly for three reasons:

  1. When an organization commences a business, fixed assets such as office, factory and stores buildings, machinery, other equipment and motor vehicles are needed for its operations. Capital expenditure is thus incurred by the fixed assets required at commencement.

  2. An organization already in business has fixed assets and may update these by replacements or enhancements. A replacement might be necessitated by the expiry of an asset’s useful life. It might be replaced by an identical one with enhanced usefulness. For example, a computer printer which prints four pages per minute could be replaced by a similar one, or by a printer with eight pages per minute capacity. An asset enhancement need not take place at the expiry of its useful life. Other circumstances might necessitate enhancement earlier than the expiry date of its useful life. An analysis of costs and benefits is appropriate in these circumstances.

  3. An organization may wish to expand its activities by adding a new line of business or production. This leads to additions to the assets, thus incurring capital expenditure.