What is capacity utilisation?
Capacity utilisation is the proportion of maximum possible output currently being used.
The formula for capacity utilisation is:
Current output
——————————————— X 100
Maximum possible output
If an 80,000 seat-capacity stadium sold tickets for only 50,000 seats, the capacity utilitsation is 62.5% which is calculated as follows:
50,000
———— X 100 = 62.5%
80,000
Fixed cost and capacity
Capacity impacts fixed cost per unit. Because total fixed cost remains unchanged, no matter the output level, high capacity utilisation helps spread fixed cost over larger units, causing a fall in fixed cost per unit. From Table 1 below, the fixed cost per unit doubles from $10 to $20 when an aircraft capacity utilisation reduces to 50%. Lower cost per unit enables the firm to have a high profit margin or lower prices to boost demand.
Also, the business would have to sell more units to break even when it is not operating at full capacity.
Table 1: An aircraft capacity utilisation
Full Capacity | 75% Capacity (525 passengers) | 50% Capacity (350 passengers) | |
| Fixed cost (fuel bill) | $7,000 | $7,000 | $7,000 |
| Fixed cost per unit | $10 | $13.33 | $20 |
Full capacity
Full capacity or 100% capacity implies that the business fully uses all resources. There are no idle resources or spare capacity if a firm is operating at 100% capacity.
Advantages of full capacity
Lower fixed cost per unit
Operating at full capacity means that fixed cost can be spread over a large output, thereby reducing average fixed cost. Lower fixed cost per unit results in a higher amount of profit for the organisation.
More sales revenue
A company responds to high demand by fully utilising its resources. Therefore, 100% capacity means more sales revenue for the organisation as the business can fulfil more orders from customers.
Workers are motivated
The workers have a sense of job security if the firm is operating at full capacity. This improves the quality of the products they make. Customer satisfaction increases when the products meet their requirements.
Good reputation
A firm operating at full capacity is perceived as reliable because it would not have any problem fulfilling customers’ orders. A good reputation attracts more customers to the business and improves brand image.
Efficient utilisation of resources
A firm operating at full capacity is making efficient use of its resources. Efficient resource utilisation drives down costs and improves profit margin.
Disadvantages of full capacity
Breakdown of machinery
Full capacity utilisation does not provide time for regular maintenance. There is a production stoppage when machinery completely breaks down.
Inability to respond to increased demand
A sudden increase in demand cannot be met by a company operating at full capacity. This leads to lost sales as customers turn to competitors who could supply the product. This leads to permanent loss of customers if a business is known to be unable to meet demand when the need arises.
Workers are stressed out
Workers are always working with little time for relaxation. This is not ideal for their physical and mental well-being.
Quality may suffer
There is limited time for production planning and quality control which impacts the quality of the products. Low quality products result in customer dissatisfaction.
Excess capacity
Excess capacity occurs when the firm’s current output is below its maximum output. It is also known as spare capacity as not all the firm’s resources are fully utilised. Capacity may not be fully utilised if demand is low. Low capacity utilisation makes it difficult for the firm to cover its fixed cost, thereby causing high average fixed cost and low profit margin.
Advantages of excess capacity
Easily respond to rising demand
An organisation with excess capacity could easily increase production when demand unexpectedly increases.
Less breakdown of machinery
There is enough time for maintenance of machinery if there is spare capacity. The likelihood of breakdown and production stoppage is low as a result.
Quality is maintained
Quality is not reduced because production is not done in a hurry. There are fewer mistakes as there is ample time for proper planning and quality control. Consequently, the number of defective products is kept to the barest minimum.
Workers are not overworked
There is enough time for workers to relax which helps keep them healthy, productive and motivated
Disadvantages of excess capacity
Inability to enjoy economies of scale
Low capacity utilisation denies the company the opportunity to enjoy lower average cost from large scale production. This impacts profitability negatively.
High average fixed cost
Fixed cost per unit is high due to the inability to fully utilise all the resources of the firm. The output would not fully cover the fixed cost, resulting in a high fixed cost per unit. If a business has huge fixed cost, the inability to consistently fully use all the resources could result in losses and business closure.
Less sales
Spare capacity is synonymous with a low demand level. Low sales revenue reduces the profits of the firm.
Workers are demotivated
Workers do not feel that their jobs are secure when capacity utilisation is not 100%. Workers may lose their jobs if the firm cannot fully utilise its capacity due to reduced demand level.