This is a detailed article about excess capacity.
Capacity in business is the maximum output that a business can produce in a given period with the available resources. It is a measure of the business’s ability to deliver goods or services to its customers. Capacity can be measured in terms of physical resources, such as the number of machines or production lines, or in terms of human resources, such as the number of employees or hours of labor available.
What is excess capacity?
Excess capacity, or spare capacity, exists when the current levels of demand for a business’s products are less than the full production capacity of a business.
Low levels of capacity utilization will typically lead to high unit Fixed Costs (FC).
How to overcome excess capacity?
When a firm is not working at full capacity, there is still spare capacity that can be utilized.
When making decisions about how to deal with excess capacity it is important to consider both the length of time that the spare capacity might exist for and the causes of the problem. Before this question can be answered, the time factor needs to be considered. So, what options do firms have when attempting to reduce excess capacity?
A. SHORT-TERM PROBLEM OF EXCESS CAPACITY
This might be caused by seasonal downturn or fashion changes.
SOLUTION 1: Higher inventory levels. Maintain high output, but produce for adding to stocks. In this way there is no need to change orders of raw materials from suppliers, tweak production schedules or decrease the number of production workers. Additional stocks may be sold later at times of higher demand considering that sales will recover in the near future. However, this might be an expensive solution because products might go out-of-date quickly and there will be stock-holding costs. It is also not suitable for any perishable stocks such as fresh food or raw meat. Additionally, demand may not recover fast enough as expected forcing the firm to sell the goods at a substantial discount.
SOLUTION 2: Greater flexibility. Adopt a more flexible production schedules during periods of low demand, lay off some staff and offer only flexible employment (part-time and temporary labor contracts). In this way production can be reduced during slack periods and increased when demand is high. Another option is to produce other goods that can be sold to different type of customers considering that the business has staff, machines and other resources to be flexible enough to produce other things. However, this might add to cots as fully adaptable equipment can be expensive and staff will need to be trained in producing more than one product. Also, it may have negative impact on motivation and staff morale not to have full-time permanent contracts.
SOLUTION 3: Changes in marketing strategy. Consider innovative marketing solutions to the problem of excess capacity such as coming up with new promotional campaign to increase demand for the product, cut prices for products with high Price Elasticity of Demand (PED) or enter into new markets in an effort to increase sales. In this way, higher sales will automatically lead to higher capacity utilization. However, spending more on marketing activities does not necessarily generate more sales. There will be other factors that influence the level of demand as well that needs to be considered such as availability of substitutes or disposable income of customers.
B. LONG-TERM PROBLEM OF EXCESS CAPACITY
This might be caused by economic recession, technological changes or promotional campaigns by competitors.
SOLUTION 1: Rationalization. Spare capacity might simply exist because of excess capacity when the business is too large, so closing down existing operations (shops, factories, offices, etc.) will automatically reduce excess capacity. Cutting overheads will increase efficiency of operations leading to higher capacity utilization. Rationalization has both cost and industrial-relations implications. A cut in production capacity will cause job losses, uncertainty about job security and low motivation, but it is often necessary to maintain the firm’s profitability. Additionally, when capacity is cut back too much, any unexpected upturn in demand may leave the business with too little capacity to fulfill demand leading to having disappointed customers. The firm may also have bad publicity in the media due to possible threats of industrial action or not fulfilling social responsibilities.
SOLUTION 2: Research and Development (R&D) into new products. Instead of reducing the size of the business, the firm can focus on developing and launching new products in addition to existing products, or replace existing products. This will make the business more competitive in the long-run. If products can be introduced fast enough, it may prevent the need of rationalization and all the problems associated with scaling down business operations. However, Research and Development (R&D) is always an expensive process that takes too long and costs to much. It may simply not be enough to prevent short-term cutbacks in capacity and rationalization as it typically requires long-term planning. When new products are introduced in a hurry without a clear market strategy, they may be unsuccessful causing risks to brand image.
In short, capacity management is the process of ensuring that a business has the right amount of capacity to meet customer demand. This involves forecasting demand, planning for production, and managing resources effectively. Capacity management is important for businesses of all sizes, but it is especially important for businesses that operate in competitive industries or that have cyclical demand.
