Capacity in business is the maximum output that a business can produce in a given period with the available scarce resources. Capacity utilization 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 capacity utilization?
Capacity utilization is the proportion of a firm’s current level of output being achieved as a proportion of its potential maximum output. It shows unused (idle) resources are there in a business organization.
Maximum capacity is the total level of output (number of products) that a business can achieve in a certain period of time such as one day, week, month or year. Typically, it is the total level of output that all of the existing factors of products – land, labor and capital – can produce.
The degree of total capacity being used in a firm is one of the main factors in determining the operational efficiency of a business organization.
How to measure capacity utilization?
Capacity utilization is measured using the following formula:
Rate of Capacity Utilization = (Current Output Level / Maximum Output Level) x 100%
When a firm currently produces 7,000 units per year, but the maximum number of products it can produce is 10,000, then its capacity utilization is 70%.
High-capacity utilization means that the level of output is close to its maximum – known as the productive capacity. Low-capacity utilization means that the business has lots of spare capacity.
Information on capacity utilization is used by managers, analysts and industry experts to compare how businesses perform against one another as well as how a single business is performing compared to the average in the industry and how capacity utilization differs from past periods.
Why is high-capacity utilization desirable?
When a firm is working at full capacity, it is achieving 100% capacity utilization. There is no spare capacity.
High-capacity utilization spreads out Fixed Costs (FC) and Variable Costs (VC) of production over a large level of output, therefore is financially desirable. This is the most important aspect of the concept of capacity utilization as it explains why the rate at which capacity is used is of such significance to operational efficiency.
Capacity utilization is likely to be relatively more important to businesses that have:
- High Fixed Costs (FC). Fixed Costs (FC) are incurred 24 hours a day. The higher the firm’s capacity utilization, the lower Average Fixed Costs (AFC) will be. When utilization is at a high rate, average Fixed Costs (FC) will be spread out over a large number of units. Unit fixed costs will be relatively low. The lower the firm’s capacity utilization, the higher Average Fixed Costs (AFC) will be. When utilization is at a low rate, average Fixed Costs (FC) will have to be borne by fewer units. Unit fixed costs will be relatively high.
- Low profit margins. Mass market products such as Fast Moving Consumer Goods (FMCG) have low profit margins, hence contribute little (per unit) to the overall profit of a business. They need to be sold in large quantities to be profitable and generate plenty of profit.
- High levels of Break-Even Quantity (BEQ). High capacity utilization is needed when a firm has a high Break-Even Quantity (BEQ). This can be because high production costs or because products have low profit margins.
- Low marginal costs. When this extra cost of providing a particular good or service to an additional customer is close to zero, then high capacity utilization will be important for achieving profitability.
Is constant full capacity utilization good for the business?
Full capacity happens when a firm produces products at maximum output.
All firms should be aiming to produce near or at 100% capacity at all times because of the following reasons:
- Lower unit Fixed Costs (FC). High capacity utilization will allow for the cost advantage. It means that unit Fixed Costs (FC) will be at their lowest possible level.
- Better corporate image. The business will be able to show off its production capabilities claiming that it is successful as it has no spare capacity available anymore. It will give managers a sense of pride that the firm they work for is so popular.
- Higher job security. When the business is constantly producing products filling in high demand, it will give employees a sense of security for their jobs as orders keep coming in.
However, there are also potential problems connected with operating near or at full capacity for a considerable period of time:
- Wear and tear of machines. High capacity utilization requires machinery to be used constantly without breaks which may not allow any time for servicing and maintenance. Insufficient time for maintenance may lead to future breakdowns which will delay production. This lack of servicing may store up trouble in the form of increased unreliability in the future.
- Workers burdened with stress. Too much expectations for production workers who are constantly required to work overtime will put additional workload on them raising stress levels. This may negatively impact product quality.
- Lower standards of customer service. For many businesses in services operating at or near full capacity may lead to lower standards of customer service. Regular customers may have to be turned away or kept waiting for long periods. This could encourage them to buy from competitors causing the firm to lose long-term clients.
Overall, having high capacity utilization itself does not guarantee organizational growth. In order for the business to grow it will have to take on more orders to meet rising levels of demand by expanding the scale of production.
Should the business work at full capacity or not?
When a business organization has been operating at close to or at full capacity for a long period of time, and the capacity is running short, then business managers will need to make some decisions.
- Should the firm keep working at full capacity and not expand, or increase its scale of operation?
- Should the firm outsource or subcontract more work to other firms, or keep producing within the current factory.
The final decision whether to work at maximum capacity or not will mainly depend on two factors – the cost of expanding the scale of business operations and the time to actually build a brand-new production facility.
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.
