What Is Capacity Utilization Rate?
Capacity utilization rate measures the percentage of an organization’s potential output that is actually being realized. The capacity utilization rate of a company or a national economy may be measured in order to provide insight into how well it is reaching its potential.
The formula for finding the rate is:
(Actual Output / Potential Output ) x 100 = Capacity Utilization Rate
A number under 100% indicates that the organization is producing at less than its full potential.
The capacity utilization rate is the percentage of potential economic output that is achieved compared to the actual output beyond which the average cost of production increases.
Capacity utilization or capacity utilisation is the extent to which a firm or nation employs its installed productive capacity. It is the relationship between output that is produced with the installed equipment, and the potential output which could be produced with it, if capacity was fully used. The Formula is the actual output per period all over full capacity per period expressed as a percentage.
What Does Capacity Utilization Rate Mean?
Capacity utilization is an economics concept which refers to the extent to which an enterprise or a nation actually uses its installed productive capacity. Thus, it refers to the relationship between actual output produced and potential output that could be produced with installed equipment, if capacity was fully used.
Potential output can represent the maximum amount of output that can be produced short term with the existent stock of capital. As such, a standard definition of capacity utilization is the weighted average of the ratio between the actual outputs of firms to the maximum that could be produced per unit of time, with existing resources. Output could also of course be measured in physical units or market values.
Many organizations may experience an increase in their average cost of production as output increases and before the absolute physical limit of capacity is reached. This can happen even in the absence of additional resources being used. An alternative approach, sometimes called the “economic” utilization rate, is therefore to measure the ratio of actual output to the level of output, beyond which the average cost of production begins to rise.
In the 1970s, American businesses carried a great deal of excess capacity. In the 1980s, businesses improved their capacity utilization by as much as twenty percent. In today’s business climate, organizations are much more cost conscious and accountable to the organization’s business objectives. Today’s organizations must be able to strategically identify the strongest project mix that will deliver the highest return from their workforce. New project requests must be objectively modeled against current projects, capacity and projected costs/return. Organizations now engage in capacity planning to ensure the most effective and efficient use of their resources. Capacity planning assures appropriate capacity levels to meet business objectives and project management needs.
How to Use the Capacity Utilization Rate
The concept can be misleading from several perspectives. First, a firm should only produce as many products as are immediately needed; any additional use of capacity is only going to result in unneeded products that will be stored as inventory, resulting in unnecessary inventory holding costs and the risk of obsolete inventory. Second, the measure is based on a theoretical capacity level that is unsustainable over the long term, since downtime is needed for repairs and maintenance.
A better view of the capacity utilization rate is to focus it solely on the bottleneck operation of a business. The firm cannot generate any additional throughput unless this one operation is properly managed to achieve the highest possible utilization rate. Focusing on the capacity utilization of any other work center in a business is actually counterproductive, since doing so creates an inherent incentive to increase its usage, even when it is not necessary to do so.
Example of Capacity Utilization
Suppose XYZ Company is producing 20,000 and it is determined that the company can produce 40,000 units. The company’s capacity utilization rate is 50% [(20,000/40,000) * 100]. If all the resources are utilized in production, the capacity rate is 100%, indicating full capacity. If the rate is low, it signifies a situation of “excess capacity” or “surplus capacity.”
It is unlikely that an economy or company will function at a 100% capacity rate as there are always hurdles in the production process (such as the malfunction of equipment or unequal distribution of resources). A rate of 85% is considered the optimal rate for most companies. The capacity utilization rate is used by companies that manufacture physical products and not services because it is easier to quantify goods than services.
Economic Significance of Capacity Utilization
If demand in the market increases, it will raise the capacity utilization rate, but if demand decreases, the rate will fall. Economists use the rate as an indicator of inflation pressures. A low capacity utilization rate will result in a decrease in price because there are excess capacity and insufficient demand for the output produced.
Economies with a capacity ratio of much less than 100% can significantly boost production without affecting the associated costs.
Many capitalist economies face high excess capacity rates, and economists use the rate as an argument against capitalism, stating that resources are not as well allocated as they could be. However, regardless of economic conditions, there will never be full capacity utilization as inefficiencies in resource allocation always exist in an economy.
The capacity utilization rate is an important indicator for companies because it can be used to assess operating efficiency and provides an insight into cost structure. It can be used to determine the level at which costs per unit go up or fall. When there is a rise in output, the average cost of production will decrease.
It means that the higher the capacity utilization, the lower the cost per unit, allowing a business to gain an edge over its competitors. Many large companies aim to produce as close to the full capacity rate (100%) as possible.
Although attaining a full capacity rate is not possible, there are ways companies can increase their current utilization rate, including:
- Employing more staff and encouraging overtime to ensure that all production targets are being met
- Spending less time on the maintenance of equipment so that more time can be spent on the production of goods
- Subcontracting some of the production activities
If market demand grows, capacity utilization will rise. If demand weakens, capacity utilization will slacken. Economists and bankers often watch capacity utilization indicators for signs of inflation pressures.
It is often believed that when the utilization rate rises above somewhere between 82% and 85%, price inflation will increase. Excess capacity means that insufficient demand exists to warrant expansion of output.
All else constant, the lower capacity utilization falls (relative to the trend capacity utilization rate), the better the bond market likes it. Bondholders view strong capacity utilization (above the trend rate) as a leading indicator of higher inflation. Higher inflation — or the expectation of higher inflation — decreases bond prices, often prompting a higher yield to compensate for the higher expected rate of inflation.
Implicitly, the capacity utilization rate is also an indicator of how efficiently the factors of production are being used. Much statistical and anecdotal evidence shows that many industries in the developed capitalist economies suffer from chronic excess capacity. Critics of market capitalism, therefore, argue the system is not as efficient as it may seem, since at least 1/5 more output could be produced and sold, if buying power was better distributed. However, a level of utilization somewhat below the maximum typically prevails, regardless of economic conditions.
Capacity Utilization and the Business Cycle
Capacity utilization overall fluctuates with the business cycle.
Companies adjust their production volumes in response to changes in demand. Demand declines sharply during recessions as unemployment rises, wages fall, consumer confidence decreases, and business investment dips.
The Fed has published capacity utilization figures since the 1960s, spanning a number of economic cycles. All-time-high levels approaching 90% were achieved in the late 1960s and early 1970s. The deepest declines occurred in 1982 and 2009 when capacity utilization fell to 70.9% and 66.7%, respectively.
The Fed’s numbers are published monthly in mid-month for the previous month but may later be revised.
Effects of Low Capacity Utilization
Low capacity utilization is a concern for fiscal and monetary policymakers. In 2015 and 2016, several European economies, including those of France and Spain, were struggling with the effects of low capacity utilization.
Despite monetary stimulus leading to historically low-interest rates, inflation remained below target levels for extended periods, and the threat of deflation loomed.
Low capacity utilization and high unemployment created so much slack in those economies that prices were slow to react to stimulative efforts. With so much excess capacity, rising product activity did not require significant capital investment.
Importance of the Capacity Utilization Rate
Understanding the capacity utilization rate is extremely important for companies and entire economies because it allows a foundation for planning the use of resources to produce the highest quality goods.
The capacity utilization rate also gives insight into how well companies and economies maximize revenue and profits while meeting increasing product demands. Additionally, planning for capacity use requires knowledge of market demand and how it affects operational capabilities and current processes.
It’s also important to note that the capacity utilization rate provides valuable information into the efficiency of a company’s or economy’s operational processes. For instance, a capacity utilization rate that is less than 85% can indicate a need for improvement in production methods, staffing or another aspect of business applications. Conversely, if a company operates significantly higher than full capacity, it could risk depleting its resources too quickly.