Capacity Utilization

Assessment of whether companies or economies are operating at their full potential.

Author: Adin Lykken
Adin Lykken
Adin Lykken
Consulting | Private Equity

Currently, Adin is an associate at Berkshire Partners, an $16B middle-market private equity fund. Prior to joining Berkshire Partners, Adin worked for just over three years at The Boston Consulting Group as an associate and consultant and previously interned for the Federal Reserve Board and the U.S. Senate.

Adin graduated from Yale University, Magna Cum Claude, with a Bachelor of Arts Degree in Economics.

Reviewed By: Christopher Haynes
Christopher Haynes
Christopher Haynes
Asset Management | Investment Banking

Chris currently works as an investment associate with Ascension Ventures, a strategic healthcare venture fund that invests on behalf of thirteen of the nation's leading health systems with $88 billion in combined operating revenue. Previously, Chris served as an investment analyst with New Holland Capital, a hedge fund-of-funds asset management firm with $20 billion under management, and as an investment banking analyst in SunTrust Robinson Humphrey's Financial Sponsor Group.

Chris graduated Magna Cum Laude from the University of Florida with a Bachelor of Arts in Economics and earned a Master of Finance (MSF) from the Olin School of Business at Washington University in St. Louis.

Last Updated:November 2, 2023

What is Capacity Utilization?

Capacity utilization assesses whether companies or economies are operating at their full potential.

An economy or corporation's production or manufacturing capabilities to create output are referred to as capacity utilization. It is an extremely crucial ratio that determines the percentage of potential output to actual output. 

The ratio yields a percentage that reflects a company's operational efficiency and varies depending on the consumer and the market demand.

Professionals and economists use capacity utilization to determine how efficiently enterprises, organizations, and economic entities employ the resources to produce outputs. The rate at which it is calculated might reveal a lot about a company's operational efficiency.

National economists use these rates to track an industry's performance in the present economic climate. Since the 1960s, the Federal Reserve of the United States has released rates for the US economy. 

Leaders may change their monetary or fiscal policies in response to these results and findings.

Key Takeaways

  • The capacity utilization ratio tells if a company or an economy is operating at their respective maximum potential or not. 

  • The formula for calculating the rate and/or ratio is (actual output/potential output) * 100. 

  • It is required to first determine the actual production level, then figure out what is the maximum production level. Then, multiply the answer by 100 and interpret it. 

  • A ratio lower than 85% essentially means that the company is not utilizing its resources properly or to its fullest capabilities. 

  • Understanding how this ratio works is critical for businesses because it provides a framework for planning resource allocation and discloses how effective a company is in optimizing its revenues and profits.

  • It can also help gauge inflationary pressures and market patterns as far as economists and government officials are concerned. They can then devise appropriate monetary and fiscal policies to aid in improving the economy's performance. 

  • Subcontracting, which is outsourcing a part of the obligations and tasks under a production process to a third party, helps to improve a company's performance. 

  • Other ways to improve a company's resource utilization ratio are

    • promotional efforts to get the company's products to the public & building a loyal customer base, 
    • sharing resources and profits equally, 
    • taking production decisions strategically. 
  • Many companies like to operate at 100% potential, but many choose not to because of several underlying risks. 

  • For example, to reach 100%, overtime payments may have to become mandatory, and this would drive up the labor costs of the company. 

  • Operating at full potential will also leave no room for flexibility if there are any unforeseen changes in demand for the company's products, services, etc. 

Formula for Capacity Utilization

The formula for calculating the ratio is: 

(Actual Output Level/Potential Output Level) * 100

The actual output level in the calculation represents the number of units a company or economy produces over a given period. The highest capacity at which businesses and economies may run without incurring any additional operating cost is referred to as potential output.

Example of Capacity Utilization

A company is required to follow the underlying steps: 

1. Calculate the actual output level: A company should record the number of goods it produces throughout the specified accounting and reporting periods. The entire number of completed inventories is included in this value, representing the degree of real output.

For example, a pen manufacturer can compute the total output by determining the number of pens the company manufactured and sold during a certain period. If the company produces 10,000 pens, the actual production level in the formula would be: 

CU = (10,000 / Potential Output) * 100

2. Determine the potential output level: When a company's resources are thoroughly utilized, the potential output represents the maximum level of operational potential. 

Operating at full capacity sustainably can have a favorable impact on output, sales, and revenue. 

Determine the potential output by assessing sales targets and evaluating the number of products required to meet those targets. This is most likely the maximum output level of the company.

Assume that the potential output level for the preceding example is 22,000. This indicates that the company believes it can produce more than double its current output if all of its resources are put to use. 

CU = (10,000 / 22000) * 100

3. Divide actual output by potential output: Once the calculation of actual output and estimation of potential output level is done, divide the two. 

CU = (10,000 / 22000) * 100 = 0.45 * 100

4. Multiply the result by 100: A decimal value is obtained after dividing the output data, which is multiplied by 100 to convert it into a percentage value. This percentage represents the CU rate.

CU = (10,000 / 22000) * 100 = 0.45 * 100 = 45%

5. Interpret the final result: One can interpret the CU rate using the assumption that 100 percent represents full operating capacity. 

Businesses are not working at their maximum potential if the CU rate is less than 100%. Conversely, overcapacity is indicated by rates greater than 100 percent.

For most economic and corporate operations, a CU rate of 85 percent to 100 percent is considered appropriate. 

The example rate of 45% indicates that the company is functioning at less than full capacity due to underutilization of resources, improper resource allocation, or a need to boost productivity.

Economic Significance of Capacity Utilization

The significance of capital utilization to an economy are as follows:

1. Understanding the capital utilization rate is critical for businesses and entire economies because it provides a solid framework for planning resource allocation to generate high-quality commodities.

2. The rate or ratio also reveals how well businesses and economies optimize revenue and profits while fulfilling the rising demand for goods. 

3. It can also be used to evaluate operational efficiency and provide information about a company's cost structure. It can be used to calculate the rate at which unit costs rise or fall. When production increases, the average cost of manufacturing decreases.

It indicates that the higher the ratio, the cheaper the cost per unit, giving a company a competitive advantage.

4. Furthermore, the level of planning required for capital utilization calculations necessitates an understanding of market demand and how it affects the operational capabilities and present procedures.

5. It is also worth noting that the capacity utilization rate can tell us a lot about how efficient a company's or an economy's operations are. 

A rate less than 85%, for example, may indicate that manufacturing procedures, staffing, or another component of business applications need improvement. 

On the other hand, if a corporation or business performs at or near-maximum potential, it risks depleting its resources too quickly. 

6. The ratio can be used to gauge inflationary pressures. It can help researchers and economists to gauge market patterns and inflationary pressures and, accordingly, devise rectifying measures. 

If the market demand rises, the rate will rise, and if the demand falls, the rate will fall. Because there is the extra scope and insufficient demand for the output produced, a low CU rate will result in a price fall.

7. It can be extremely helpful when government officials and economists have to devise appropriate monetary and fiscal policies to improve the economy's performance.

Improving capital utilization Ratio

Some of the ways to improve the ratio are

a) Subcontracting

One takes orders and produces for other businesses when they subcontract. In this manner, one can make the most of their potential and make it available to other firms. 

Subcontracting, in a sense, allows maximizing capacity utilization and profit simultaneously.

In a nutshell, it has a significant impact on corporate profitability and vice versa. Every manufacturer or business should pay special attention to increasing capacity utilization. 

This ratio can be improved through proper planning, disciplined strategy, and strategic decision-making.

b) Promotion works best 

Product demand and resource utilization go hand in hand. Any firm, whether a start-up or a large corporation, should strive to improve the quality of its products and raise consumer demand. 

Participating in promotional efforts and introducing innovative techniques to boost product value lead to a rise in production rate and maximum capacity utilization.

c) Structured Approach

To manage a budget, one starts with tiny capacities. With an increase in product demand, one can extend their performance. 

Paying too much for less production would reduce profit margins, seeing how the company always has the option of expanding facilities in response to rising demand. The company should be adaptable to demand swings.

d) Boost Planned Manufacturing

It is not always easy to raise the financing as per the need to get the firm off the ground. Raising funds from the market is a time-consuming procedure that requires careful planning. Planning always aids in making the greatest use of the resources. 

Many would-be entrepreneurs have difficulties adapting to rapid changes in production, demand, manufacturing, and so on. However, efficiency at every level is always the final result when done from the ground up.

Planning and scheduling are two cornerstones of good operations, including capacity utilization

e) Sharing resources

Sharing resources is becoming more popular as a means of maximizing resource use. It is a win-win situation for both sides because they profit equally. It improves their chances of remaining in the market with little funds. 

One can obtain desired industrial resources from an owner, benefiting both the owner and the seeker. This not only improves utilization and prevents investment duplication but also improves profitability and cash flow

Sharing resources not only solves challenges for aspiring entrepreneurs but also contributes to creating an ecosystem in which owners and seekers can connect smoothly for greater capacity utilization.

f) Increasing profits

Entrepreneurs should come up with unique concepts to make the most of the existing resources. A person's potential should always be thoroughly examined to discover how it might be effectively exploited from a certain perspective. 

They say that before starting a business, one should know everything about the product; similarly, one should know everything about its capacities. 

Consider various scenarios and come up with creative solutions to increase usage and, as a result, earnings.

More importantly, the owner should make every effort to expand the reach of their potential. Their industrial capacity's context and competence may be important to business demand in another part of the country or the world.

g) Strategic Decision Making

Strategic advancement is critical for business development whenever one seeks to start something new. 

Successful investors seek out companies with well-defined plans and strategic decisions that significantly impact the company's future. 

The plan should be centered on growing a firm with modest production rates for maximum capital gain, making the business more consistent, and creating a larger customer base.

Optimizing Capital Utilization

Lower unit costs have numerous ramifications for a company's price and profit. As a result, it tends to be safer to expect that businesses will always want to run at full potential if at all possible. 

Most businesses, on the other hand, will want to function at or near their full capability, but not at 100%, as this poses several risks:

1. All forms of machinery and equipment require some downtime for routine maintenance; otherwise, problems may occur. 

Would you prefer to travel in an aircraft, for example, that had not been maintained in months but had been cleaned, refueled, and re-entered the air? Breakdowns will very certainly be more costly than accepting decreased capabilities.

2. Furthermore, working at their maximum potential can cause workers and managers to become stressed, leading to more mistakes, accidents, reduced motivation and productivity, absenteeism, and more labor turnover.

3. A small amount of spare room is acknowledged as necessary to give flexibility if it is required. 

Sudden spikes in demand can be satisfied in the near term by raising output without disturbing potential customers whose demands could not be supplied otherwise.

4. Payments may be required over time to maximize resource use, raising labor costs. 

5. High capacity utilization in service businesses, particularly those that provide personal services such as hairdressing or restaurants, can contribute to longer wait times and poorer customer service. 

6. Overcrowding in vacation resorts and amusement parks lowers customer satisfaction. 

7. A congested production environment may be less efficient because people get in each other's way and have to wait for equipment and other things. 'Too many cooks spoil the broth,' as the adage goes.

Researched and Authored by Sara Malwiya  | LinkedIn

Reviewed and Edited by Parul Gupta | LinkedIn

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