Capital efficiency has to do with understanding the ratio of output in comparison to the amount of capital expenditure involved in maintaining the operation of a business or a product line. This simple comparison serves as a way to determine if a particular operation should be continued as is, continued with some adjustments, or abandoned and the resources diverted to other projects.
The basic formula for calculating capital efficiency involves dividing the average value of output by the rate of expenditure for the same period of time. Output divided by expenditure will help to make it clear if a venture is currently generating a modest profit, is approaching a point where profitability will be realized once expenditures are decreased, or if there is no real value in continuing to fund the venture. While the latter situation is one to avoid at all costs, the two former possible states are not situations that should be considered negative.
Because many business ventures begin with a higher level of capital expenditures, a project rarely realizes a profit in the first stages of the operation. The expectation is that after the initial launch, some expenses will be settled and not be recurring. As the rate of expenditure decreases and the output or production increases, the opportunity for profit expands. For this reason, periodic calculation of the capital efficiency of a project can help investors know that the project is heading in the right direction.
Once this forward trend results in the realization of a small profit, factoring the capital efficiency can still contribute to tracking the gradual increase in profits. Capital efficiency can also help refine the production process, by alerting officers of the project that there may be additional areas where expenses can be cut without harming the quality of the product and realize an even greater profit. Periodic calculations of the capital efficiency during the life of the project can also call attention to trends that are negatively impacting the project, allowing time to make changes before a profitable venture devolves into a project that is losing money.