What is Capacity utilisation?

QuestionsCategory: Financial AccountingWhat is Capacity utilisation?
Lalith George Staff asked 5 years ago
1 Answers
Ankush Mehrotra Staff answered 5 years ago

A firm’s productivecapacity is the total level of output or production that it could produce in a given time period. Capacity utilisation is the percentage of the firm’s total possible production capacity that is actually being used.
Capacity utilisation is calculated as follows:
Capacity utilisation (%) =
actual output per month (or per annum) x 100%
maximum possible output per month (or per annum)
For example, if a firm could produce 1200 units per month, but is actually producing 600 per month, its capacity utilisation is as follows:
Capacity utilisation % = 600 units per month x 100%
1200 units per month
= 50%
Financial implications
A firm’s level of capacity utilisation determines how much fixed costs should be allocated per unit, so as a firm’s capacity utilisation increases, the fixed costs (and therefore also, total costs) per unit will decrease. For example, if the firm above had fixed costs of £12,000 per month, the fixed costs per unit would be £20 per unit at 50% capacity utilisation, but only £10 per unit at 100% capacity utilisation.
It therefore follows that a firm should be most efficient if it is running at 100% capacity utilisation. However, if a firm is running at full capacity, there are a number of potential drawbacks:

  • There may not be enough time for routine maintenance, so machine breakdowns may occur more frequently and orders will be delayed
  • It may not be possible to meet new or unexpected orders so the business cannot grow without expanding its scale of production
  • Staff may feel under excessive pressure, leading to increased mistakes, absenteeism and labour turnover
  • If the factory space is overcrowded, work may become less efficient due to the untidy working conditions
  • It may be necessary to spend more on staff overtime to satisfy orders, increasing labour costs

NB – these drawbacks are not to be confused with diseconomies of scale, which can arise from a firm operating on a larger scale – e.g. by opening a larger factory. See separate revision note on economies of scale.
In general, businesses would feel most comfortable at something between 80 to 90% capacity utilisation because fixed costs per unit are relatively low and there is some scope to meet new orders or carry out maintenance and training. A firm that has just invested in major new facilities in anticipation of major growth could take some time before reaching a good level of utilisation, so it is important to consider sales trends when discussing capacity utilisation.
Causes of under-utilisation of capacity
There are a number of reasons why a firm might be experiencing low capacity utilisation, including the following:

  • New competitors taking market share or causing over-supply in the market
  • Fall in market demand due to changes in consumer tastes or fashion
  • Unsuccessful marketing – one or more aspect of the marketing mix may simply mean that the firm is not successful
  • Seasonal demand – this is especially apparent in the tourist industry where firms like hotels and leisure parks are full in the summer but see much lower utilisation at other times of the year

Exam hint: In examination questions on this subject, look for clues as to the root causes of under-utilisation so that you can assess whether it is a long term problem or not, and what the firm could do to remedy the situation
Problems arising from low capacity utilisation

  • Higher fixed costs per unit mean reduced profitability; if prices were raised to cover these costs, this would probably lead to reduced sales unless the product was price inelastic
  • Spare capacity can portray a negative image, particularly in a business where it can be seen that it is no longer busy – such as a shop or a health club – signifying loss of popularity
  • Staff can become bored and demoralised if they don’t have as much to do, especially if they fear losing their jobs

Benefits of low capacity utilisation
Low capacity utilisation is unlikely to be desirable in the long term as the higher unit costs will make it difficult to compete. However it is not all bad news and possible short term benefits include:

  • A firm may have more time for maintenance and repairs and for staff training, to prepare for an upturn in trade
  • There may be less stress for employees than if they were working at full capacity
  • The firm can cope with new orders; firms in expanding markets may expect to have low utilisation whilst they build their sales
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