What is Capacity Utilization?
Capacity utilization refers to the manufacturing and production capabilities that are being utilized by a nation or enterprise at any given time. It is the relationship between the output produced with the given resources and the potential output that can be produced if capacity was fully used.
Capacity utilization can also be defined as the metric used to calculate the rate at which the prospective levels of output are being met or used. The rate is displayed as a percentage and provides an insight into the total utilization of resources and how a company can increase its output without increasing the costs associated with production. The capacity utilization rate is also called the operating rate.
Formula for Capacity Utilization
The mathematical formula for calculating capacity utilization is:
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. This means that the higher the capacity utilization, the lower the cost per unit, allowing a business to gain an edge over its competitors. This is why 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
Effects of Low Utilization
Low capacity utilization is a problem for fiscal and monetary policymakers who use such policies to stimulate the economy. In 2015 and 2016, many European economies such as France and Spain struggled with the consequences of low capacity utilization. Despite the governments’ intervention through historically low interest rates, inflation remained significantly low with a threat of deflation.
The low capacity utilization led to high unemployment that created slack in the economy, making it hard for prices to react to monetary stimulus. With excess capacity, an increase in the production of goods did not require a significant investment in capital.
When a company faces an increase in demand for its goods, it is often able to meet the demand without raising the cost per unit. The company can optimize its output level with no additional cost for investment in better infrastructure.
The capacity utilization rate is useful to companies as it provides an insight into the value of production and the resources being utilized at any given time. It determines the company’s ability to cope with a rise in the production of output without increasing costs.
A reduction in the rate indicates an economic slowdown while an increase signifies economic expansion.
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