Capacity Utilisation

Whether the issue is the number of tickets sold at a theatre or how many pieces of furniture roll off a production line, capacity utilisation is something that concerns all businesses. By carefully matching the number of items it produces to the demand for its output, a business can improve its efficiency and become more competitive.

Capacity and Capacity Utilisation

A business’s capacity is the maximum output it is able to produce within a period of time. Capacity utilisation refers to the percentage of this output that is actually being produced. A car factory may be capable of making 500 cars a day — this is their capacity. At a particular point in time, they may only be making 450. This might be due to various reasons, such as a lack of demand, a conscious decision by the business, or inefficiencies in the production process.

Whatever the reason, capacity utilisation is calculated by the actual output, divided by the maximum possible output, multiplied by 100. Our car factory is therefore operating at 90% capacity utilisation. While it will vary widely from industry to industry, this happens to be around the level that many businesses aim for, as there can be issues when capacity utilisation drops too low, or gets too high.

Under- and Over-Utilisation of Capacity

Businesses will generally be more concerned if their capacity utilisation drops too low, as this means that their fixed costs (those that have to be paid regardless of quantity produced) will be spread over less output. If this is the case, the average cost of each unit produced will quickly spiral, making it very difficult to remain competitive. Higher unit costs will either necessitate hiking prices, or eat into profit margins.

Imagine an airline that consistently operates with only a handful of seats booked on each flight. The fixed costs of operating (such as fuel) will be spread so thinly that the cost per passenger becomes too high for the airline to make any profit. This is why airlines tend to overbook flights, in the hope that they can still fill the plane even when some passengers fail to arrive.

Trying to attain very high levels of capacity utilisation can bring its own problems, however. If that car factory is making 500 cars a day, every day, the workers will likely become overworked and stressed. Machines also need downtime for maintenance and repairs, which is impossible when a business is producing at maximum capacity. The business may also find itself having to turn down one-off orders, which can be damaging in the long term. A loyal customer who wants to make a purchase, but is not able to because the business has already hit capacity, can very easily fall into the hands of a competitor.

Managing Capacity

All of this means that businesses need to think carefully about matching supply to demand, ensuring that capacity utilisation does not rise or fall to an undesirable level.

If the problem is over-utilisation of capacity, some strategies to resolve this may include:

• Increasing prices — this will dampen down demand while also increasing the profit margin on each sale. However, care must be taken to avoid upsetting loyal customers who may be unhappy about paying more.
• Business expansion — opening more premises or taking on more staff would be the obvious solution, but the risk is that you over-invest and are quickly left with the opposite problem of under-utilisation.
• Outsourcing — hiring an external firm to take care of all or some of the production of certain output. However, this can be an expensive solution, as external firms will usually charge more as they aim to maximise their own profits.

If the problem is under-utilisation of capacity, some strategies to resolve this may include:

• Reducing prices — this will help to boost sales, bringing demand more in line with the output the business is capable of producing. The problem is that the profit margin on each sale will be reduced. Some businesses already operate on such slim margins that this may not be not a realistic option.
• Marketing campaigns — an increased spend and focus on marketing via promotions is another way to try to boost demand. This is likely to be expensive, though, as it adds to fixed costs (and therefore also unit costs). Moreover, there is no guarantee that new marketing campaigns will translate into rising sales.
• Laying off staff — a supply side approach would be to close down some stores and make redundancies. While this tackles the immediate problem, it is very costly to go through this process and then to recruit again if utilisation of capacity rises in the future.

When deciding on the most appropriate strategy, it is vital to consider whether the problems with capacity utilisation are short- or long-term. A business would be foolish to invest heavily in expansion if capacity utilisation is likely to fall back in the near future. However, it may be better served by expansion than outsourcing if over-utilisation of capacity is likely to persist over time.

The infographic at the top of the page can be downloaded here: