Capacity Utilization: Impact, Options, and Outsourcing

Posted on Jan 3, 2025 in Economy

Capacity Utilisation

It is the proportion of maximum output capacity currently being achieved. The degree of capacity being used is a major factor in determining the operational efficiency of a business. Maximum capacity is the maximum level of output a business can achieve in a certain time period. If a firm is working at full capacity, it is achieving 100% capacity utilisation. Capacity utilisation is used to compare how one firm is performing compared to the average or how capacity utilisation differs from previous periods.

Capacity Utilisation – Impact on Average Fixed Costs

It helps to explain why the rate at which capacity is used is of such significance to operational efficiency. When it is at a high rate, average fixed costs will be spread out over a large number of units, and therefore unit fixed costs will be low.

Drawbacks to operating at full capacity for a considerable amount of time:

  • Staff could be under pressure due to the workload, and this could raise stress levels.
  • Regular customers who wish to increase their orders will have to be turned away or kept waiting for long periods.
  • Machinery will be working flat out, and there may be insufficient time for maintenance and preventative repairs.

Excess Capacity – What Are the Options?

This exists when the current levels of demand are less than the full capacity output of the business – also known as spare capacity.

If spare capacity is just a short-term or seasonal problem:

  • Maintain high output levels and store them in stock; it could be expensive and risky if sales do not recover.
  • Adopt a more flexible production system allowing other goods to be made that might be sold at other times of the year.
  • Offer only flexible employment contracts to staff so that during periods of low demand and excess capacity, staff can be laid off and costs saved.

If spare capacity is a long-term problem and if demand cannot be revived by means of promotion, a cut in production capacity should be considered.

This is often referred to as rationalisation, and it will have both cost and industrial-relation implications.

Rationalisation:

Reducing capacity by cutting overheads to increase the efficiency of operations, such as closing a factory or office department, often involves redundancies. The drawbacks are that if capacity is cut too much and demand returns, the firm will not respond, and customers will get disappointed. Also, staff redundancy will lead to lost job security and worker motivation – and bad publicity in the media.

Excess Capacity – Evaluating the Options

Excess capacity in the short term.

The business may consider marketing solutions, such as cutting prices or entering overseas markets to increase sales.

AdvantagesDisadvantages
Option 1: Maintain output and produce for stocks
  • No part-time working for staff.
  • Job security for staff.
  • No need to change production schedules or orders from suppliers.
  • Stocks may be sold at times of rising demand.
  • Unsuitable for perishable stocks.
  • Stock-holding costs.
  • Demand may not increase as expected.
Option 2: Introduce greater flexibility into the production process:
  • Part-time or temporary labor contracts.
  • Flexible equipment that can be switched to making other products.
  • Short-term working.
  • Production can be reduced in bad periods and increased when demand is high.
  • Other products can be produced that may follow a different demand pattern.
  • Avoids stock build-up.
  • Staff could be demotivated by not having full-time work.
  • Fully flexible and adaptable equipment can be expensive.
  • Staff may need to be trained in more than one product – may add to costs.

Excess capacity in the long term

This could be caused by economic recession, technological changes, or promotional campaigns by rivals.

AdvantagesDisadvantages
Option 1: Rationalise existing operations and cut capacity
  • Reduces overheads.
  • Higher capacity utilisation.
  • Redundancy costs for staff payments.
  • Staff uncertainty over job security.
  • Possible threats of industrial action.
  • Business could be criticised for not fulfilling social responsibilities.
Option 2: Research and development into new products.
  • Will replace existing products and make the business more competitive.
  • If introduced quickly enough, might prevent rationalisation and the problems associated with this.
  • May prove to be expensive.
  • May take too long to prevent cutbacks in capacity and rationalisation.
  • Requires long-term planning.

Working at Full Capacity

This is when a business produces at maximum output. When this happens, other decisions have to be taken:

  • Should the firm increase their scale of operation by acquiring more production resources?
  • Should it keep their working capacity by outsourcing?
  • Could the quality of products obtained from subcontractors be assured?
  • Should it keep the existing capacity in order to prevent a future demand fall?

Outsourcing

This means using another business to undertake a part of the production process rather than doing it within the business using the firm’s own employees.

Reasons for outsourcing:

  • Reduction and control of operating costs.
  • Increased flexibility.
  • Improve company focus.
  • Access to quality service or resources.
  • Freed-up internal resources.

Drawbacks of outsourcing:

  • Loss of jobs within the business, which can have a negative impact on staff motivation.
  • Quality issues, as the manager can’t control.
  • Security, as using IT could lead to data loss.

Evaluation:

Having closed or run down a whole department to outsource its functions can be time-consuming and expensive to reopen. One thing that should be clear are the core activities that must be kept within the direct control of the business.