Capacity utilisation is measured using the following formula:

This means that if a company is able to produce 100,000 units a week, but it only produced 75,000 units per week, it would be operating at 75% efficiency.  A rugby stadium capable of holding 80,000 is at full capacity when all the seats are filled.

Capacity (the amount a firm can make) depends upon the amount of buildings, machinery and labour it has available.  When the firm is making full use of all its resources, it is said to be working at full capacity or 100% capacity utilisation.

The same logic applies to service sector industries, though it is harder to identify a precise figure.  This is because it can take a different amount of time to serve each customer.  Demand may exceed capacity at certain times of the day or year, this will lead to queues forming.  At other times staff may not have anything to do.  A service business wishing to manage costs effectively will measure demand at different times of the day and then schedule the staffing levels to match.

Many businesses (particularly service sector) are better able to cope with fluctuating demand by employing temporary or part-time workers.  There are more and more temporary and part-time workers in the UK now as they can increase capacity easily and quickly.  If demand then falls temporary staff can be laid off without redundancy payments and part-time workers can have their hours reduced, thereby reducing capacity easily and cheaply.  This flexibility is good for business as it can help to reduce any expensive spare capacity.  This situation, however, may not be as appealing to the workers who have far fewer rights than their full-time predecessors and colleagues.

Fixed Costs And Capacity

Fixed costs remain the same irrespective of the level of output.  This means that fixed costs will remain the same whether capacity is 50% or 100%. 

If a football club has a large expensive playing staff, it will have large fixed costs.  What is the effect of capacity on the fixed costs?

When the stadium capacity utilisation is at 50%, then £10 of the ticket price is needed for the players’ wages alone.  When the stadium is full (i.e., full capacity) the fixed costs are spread over many more tickets, reducing the fixed costs per unit to £5.

This shows the higher the capacity utilisation, the lower fixed costs per unit will be.  This enables the producer to either cuts prices to boosts demand or enjoy higher profit margins.  This means that increasing capacity utilisation is a valid method for increasing a firm’s profitability.  If capacity utilisation is low, the fixed costs per unit may become too high forcing the business into bankruptcy.

The ideal capacity is therefore at or near 100%, this spreads the fixed costs as thinly as possible.  There are three concerns about operating at or near 100% capacity utilisation:

·        If demand rises, it can only be met by competitors as you are already working flat out.

·        The risk that you will never have time to service machinery, change/improve production methods or train/retrain staff.  This may increase the chances of production breakdown.

·        It can lead to managers and workers being over worked and can increase stress levels.

The production ideal, therefore, is a capacity utilisation of around 90%.

How To Increase Capacity Utilisation

There are two approaches to increasing capacity utilisation:

·        Increase demand for existing products by promotional activity, price cutting or re-positioning in the market.  It could also be possible to launch new products.

·        To lower the capacity by either reducing the factors of production employed or to move to smaller premises.  The danger with moving to a smaller building is that if demand picks up in the future, it will be very difficult to increase supply in response to it.  This process is known as rationalising.

Which approach a firm chooses to take will depend upon the cause of the low capacity utilisation.  Is it due to known temporary shortfall, such as a seasonal decline or due to an economic recession, which may last for 18-24 months.  It can be a mistake to reduce capacity in the long run, however it may be necessary in order to ensure short-term survival.  It is therefore important to identify whether the short fall is short or long term.

Operating At Near Full Capacity

Operating at near full capacity can have a number of advantages:

·        Its fixed costs per unit are at their lowest possible level.

·        The firm is assumed to be using all of its fixed assets effectively, therefore profits should be high.

·        It will be perceived as a successful country both internally and externally leading to positive effects.  Internally, employees will feel a sense of pride working for such a successful organisation.  Externally, if customers know that a firm is working at full capacity it will assume that it is offering a good product.

Firm’s operating at or near full capacity may wish to increase their total capacity, this can be done in a number of ways:

·        Employing more workers.

·        Building larger buildings for manufacture or providing service.

·        Purchasing more raw materials/stock.

Further Reading

Capacity utilisation of Zambia's car manufacturers
What is Capacity Utilisation?
Capacity Utilisation of Various Industries
Aims of the Austrailian Government Relating to Capacity Utilisation
Combing capacity utilisation rates lift as business sentiment improves
Utilisation rates in the wool industry.
Durgapur Steel Plant Capacity Utilisation Case Study
Indian Public Sector Capacity Utilisation Rates
What is productivity
How productivity is improved