4.10 - Capacity Utilisation
The meaning of maximum capacity and capacity utilisation
Maximum capacity refers to the highest level of output that a business can maintain consistently over a given period. This level varies depending on the type of business, such as the number of available room nights in a hotel or the total production possible from manufacturing resources.
Capacity utilisation measures how much of this maximum capacity is actually being used at any time. It is a key indicator of operational efficiency.
Operating at 100% capacity utilisation means there is no spare capacity left, with all resources fully in use. However, most businesses aim for high utilisation while keeping some spare capacity to handle unexpected demand or issues.
The term "sustained" in maximum capacity emphasises that it is the highest output level maintainable over a reasonable timeframe without causing long-term problems. Temporarily exceeding this level is possible but not advisable, as it can lead to risks like equipment failure or employee exhaustion.
How to calculate capacity utilisation
Capacity utilisation is expressed as a percentage, showing the proportion of maximum possible output that is currently being achieved.
Where:
- Current output level = The actual amount produced in the given period
- Maximum output level = The highest sustainable output possible in the same period
Worked example - Calculating capacity utilisation
A manufacturing firm has a maximum output level of 2,800 units per month. In June, it produced 2,100 units. Calculate the capacity utilisation rate.
Step 1: Identify the values
- Current output level = 2,100 units
- Maximum output level = 2,800 units
Step 2: Apply the formula
The effects of high and low capacity utilisation
The level of capacity utilisation directly impacts a business's costs and overall performance.
Effects of high capacity utilisation
- Fixed costs are distributed across a larger number of units, reducing the average fixed cost per unit.
- This can lead to lower overall unit costs, potentially increasing profits.
- It gives the appearance of a successful, busy operation and can enhance employee job security.
Effects of low capacity utilisation
Fixed costs are spread over fewer units, raising the average fixed cost per unit.
Advantages of operating at full capacity
- Achieves the lowest possible unit fixed costs.
- Maximises potential profits.
- Signals success to stakeholders.
- Provides job security for employees.
Disadvantages of operating at full capacity
- Can cause stress and burnout among employees.
- Leaves no room to handle sudden increases in orders.
- May not allow time for essential maintenance, leading to breakdowns.
Advantages of maintaining some spare capacity
- Provides flexibility for unexpected demand spikes.
- Allows time for maintenance and employee rest.
- Helps avoid the risks of overworking resources.
Managing excess capacity
Excess capacity happens when a business operates below its maximum capacity, meaning current output is less than what is possible.
Short-term excess capacity
Short-term excess capacity often stems from seasonal demand variations, where output temporarily drops.
Options include:
- Maintaining output and building stock - Produce at normal levels and store excess for future sales.
- Adopting flexible production - Use adaptable systems that can switch between products quickly to match changing demand.
- Implementing flexible employment contracts - Hire temporary or part-time staff to adjust workforce size without long-term commitments.
Long-term excess capacity
Long-term excess capacity may arise from economic downturns or technological shifts that reduce demand permanently.
Rationalisation:
Rationalisation involves closing underused production units.
Advantages of rationalisation:
- Lowers overhead costs by eliminating inefficient operations.
- Increases utilisation rates in the remaining units.
Disadvantages of rationalisation:
- Incurs redundancy costs for laid-off workers.
- Creates job security concerns and potential industrial action.
- Risks leaving the business short of capacity if demand recovers.
- May attract criticism for lacking social responsibility.
Research and development (R&D) for new products:
Advantages of R&D:
- Enhances competitiveness by introducing innovative offerings.
- Can prevent the need for rationalisation by boosting demand.
Disadvantages of R&D:
- Involves high costs and significant time investment.
- Carries risks if new products are launched without a strong market strategy.
Managing capacity shortages
Capacity shortages occur when demand exceeds a business's current maximum output, creating excess demand. Before acting, businesses should analyse the cause and expected duration to choose the right response, as short-term and long-term shortages require different approaches.
Timing is critical in these decisions—expanding too early without clear demand trends could result in future excess capacity if conditions change.
Options for addressing capacity shortages
Using subcontractors or outsourcing:
Advantages:
- Requires no large capital outlay.
- Can be arranged quickly for flexibility.
Disadvantages:
- Reduces control over quality.
- Increases administrative costs.
- May lead to delivery delays or uncertainties.
- Could result in higher unit costs compared to in-house production.
Investing in capital expansion:
Advantages:
- Provides a long-term increase in capacity.
- Maintains full control over quality.
- Enables use of the latest equipment.
- Can achieve economies of scale.
Disadvantages:
- Involves high capital costs and funding difficulties.
- Risks creating overcapacity if demand later falls.
- Takes time to implement, delaying benefits.