Capacity (the amount a firm can make) depends upon the resources, such as buildings, machinery and labour it has available. Capacity utilisation is the extent to which that capacity is being used. When the firm is making full use of all its resources, it is said to be working at full capacity or 100% capacity utilisation. This is a vital piece of information in the process of reducing waste in the production process.
Capacity utilisation (%) is calculated using the following formula:
For example, if a firm could produce 2000 units per month, but is actually producing 1200 in that period, its capacity utilisation is:
A firm's level of capacity utilisation is of considerable financial importance, because of the impact of fixed overheads per unit on profit margins. As a firm's capacity utilisation increases, the fixed overheads will decrease per unit as the overheads are spread over many more units of production.
A firm has fixed overheads of $24,000 per month and a capacity of 2000 units. The fixed overhead per unit would be $20 per unit at 60% capacity utilisation, but only $12 per unit at 100% capacity utilisation. Any price would have to at least cover the unit overhead cost.
There are many implications of lower unit costs for a business, both on price and profit. It is to be assumed, therefore, that firms would always seek to run at 100% capacity utilisation if this is possible. Most firms, however, will aim to operate close to full capacity, but probably not at 100% as this throws up a number of potential problems:
- All machinery and equipment requires some downtime for routine maintenance, without which breakdowns may happen. Would you like to fly in a plane that had not be maintained at all for several months, but simply cleaned and refuelled and put back in the air? Breakdowns are likely to be more expensive than accepting lower capacity.
- Working at full capacity may create stressed workers and managers, resulting in increased mistakes, accidents, lower motivation and productivity, absenteeism and higher labour turnover.
- A small amount of spare capacity is accepted as necessary to provide level of flexibility in case of need. Sudden surges of demand can be catered for in the short run by increasing output, not upsetting potential customers whose needs could not otherwise be met.
- Overtime payments may be necessary to reach full capacity, increasing labour costs
- For service companies, especially those offering personal services such as hairdressing or restaurants, high capacity utilisation may increase queuing times and may lead to poorer customer service. Overcrowding at holiday resorts and leisure parks will always reduce customer satisfaction levels. Think of those queues in theme parks!
- An overcrowded factory space may be less efficient as the firm suffers from diminishing returns as people get in each other's way and have to wait for equipment etc. As saying goes, 'too many cooks spoil the broth'.
You may well have seen this viral video for overcrowding in a wave pool in Tokyo - a definite case of maximising capacity!
High capacity utilisation will be more important for some firms than others. For example firms with low profit margins and high fixed costs. The recent global recession has led to greater competition in the market place for customers and many are looking to cut costs, and therefore to offer competitive prices by increasing their capital utilisation. The airlines and in particular, budget airlines see this as the only way they can retain market share.
Firms operating near capacity may have to consider investing in new premises or subcontracting or outsourcing orders to other companies which have spare capacity. Investment in new premises is likely to have upfront costs and should only be considered if the higher demand pattern is likely to continue into the long-run. Many businesses, particularly those in the service sector, cope with fluctuating demand by employing temporary or part-time workers. If demand then falls these temporary staff can be laid off without redundancy payments and part-time workers can have their hours reduced.
Alternatively, firms working at low capacity may have to rationalise their assets as they are likely to be losing money e.g. if a firm has three factories operating at 65% capacity, it may close one factory and distribute the production between the remaining two factories. Obviously a possible consequence of this is redundancy.