Capacity utilisation

29.1 The importance of capacity

Few products have completely predictable sales and therefore there is a fine balance to be struck between using your factory capacity fully and therefore efficiently, and yet having the wiggle room to meet unexpectedly high orders.

So it is vital to have sufficcient spare capacity to cope with higher demand, while keeping maximum capacity low enough to keep costs down: a fine balance.

29.2 How is capacity utilisation measured?

A firm's maximum output level is determined by the quantity of buildings, machinery and labour it has available. Maximum capacity is achieved when the firm is making full use of all the buildings, machinery and labour available, that is, 100% capacity utilisation.

For a service business the same logic applies, though it is much harder to identify a precise figure. This is because it may take different times to serve each customer. Many servixe businesses cope with fluctuating demand by emoloying temporary or part-time staff. These employees provide a far greater degree of flexibility to employers. Part-time hours can be  increased, or extra temporary staff can be employed to increase capacity easily. If demand falls, temporary staff can be laid off without redundancy payments, or part-time staff can have their hours reduced, thus reducing capacity easily and cheaply.

29.3 How to utilise capacity efficiency

Fixed costs are fixed in relation to output. As fixed costs do not change with output means that they do not change per unit of output/ demand, so if output does not cover the fixed costs, they can become a huge burden.

The reason why capacity utilisation is so important is that it has an inverse effect upon fixed costs per unit. In other words, when utilisation is high, fixed costs are spread over many units. This cuts the cost per unit, which enables the producer either to cut prices to boost demand further, or to enjoy larger profit margins. If utilisation is low, fixed costs per unit become punishingly high. 

The ideal level of capacity utilisation, therefore, is at or near 100%. This spreads fixed costs as thinly as possible, boosting profit margins. There are two key oncerns about operating at maximum capacity for long, however. These are the risks that:

• if demand rises further, you will have to turn it away, enabling your competitors to benefit, and 
• you will struggle to service the machinery and train/ retrain staff. This may prove costly in the long term and will increase the chance of production breakdowns in the short term.

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

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