Excess Capacity

It is a situation where a firm produces at a lower output scale than it has been designed for.

Author: Adrian de Vernou
Adrian de Vernou
Adrian de Vernou
Adrian is a student at Colgate University pursuing a double major in economics and political science. During his gap year, Adrian interned with Wall Street Oasis and Tokenized Commodities Council where he published pieces on a variety of business, economic, and financial topics. He is a member of the Colgate Investment Group, Scholars of Finance, and Real Estate Club.
Reviewed By: Osman Ahmed
Osman Ahmed
Osman Ahmed
Investment Banking | Private Equity

Osman started his career as an investment banking analyst at Thomas Weisel Partners where he spent just over two years before moving into a growth equity investing role at Scale Venture Partners, focused on technology. He's currently a VP at KCK Group, the private equity arm of a middle eastern family office. Osman has a generalist industry focus on lower middle market growth equity and buyout transactions.

Osman holds a Bachelor of Science in Computer Science from the University of Southern California and a Master of Business Administration with concentrations in Finance, Entrepreneurship, and Economics from the University of Chicago Booth School of Business.

Last Updated:October 25, 2023

What Is Excess Capacity?

Excess capacity is a business phenomenon when a company cannot sell a product as quickly as it produces. A situation is created where the business operates and creates more product supply when demand is severely behind. 

There are many reasons why a company may be operating in this way. One is that the broader economy is in recession. Recessions reduce consumer sentiments and their willingness to buy the products. This reduces the demand in a broader economy. 

Additionally, increased competition in an industry tends to upend the demand that once was there for other companies. If a new competitor begins taking other companies' customers, that will decrease their demand and create excess capacity. 

Whether through increased competition, recession, or both, this capacity negatively impacts businesses. Businesses are forced to reduce their production capacity to cut costs if it becomes too severe or prolonged. 

The term typically refers to the overproduction of a tangible good. However, the situation also occurs in the service sector. This is because the phenomenon revolves around an imbalance between supply and demand rather than just an abundance of goods. 

Having it can certainly sink a company, meaning that it is essential for businesses to find ways to resolve the issue. For example, a basic way to increase demand for a product is to decrease its price to attract new customers. But, unfortunately, it is not a short-run occurrence.

Key Takeaways

  • Excess capacity is a business condition where the total production capacity for a factory or business is greater than the actual output. 
  • In nearly all cases, this condition can cripple a company and make them go out of business.
  • The primary cause for this phenomenon is a low demand for the product, typically created by economic downturn or new competitors entering the market.
  • The equation used to calculate it is total capacity - actual output.
  • Aside from attempting to resolve the issue of low product demand with strong ad campaigns, businesses can revive the demand for their product by decreasing its price to make it seem more attractive. 

Excess Capacity Advantages and Disadvantages

While it may initially seem as though excess capacity can only be bad for a business, that is only partially true. There are some societal benefits to businesses operating in this fashion as they begin producing the optimum output. 

Advantages

1. Consumers often gain from this capacity as businesses are forced to discount their prices to sell more.

2. For companies, it can force them to innovate to reduce manufacturing costs.

3. It can provide insight into how business owners manage capital and financial resources.

While the above examples of advantages to either consumers or businesses are real and significant, this capacity can only be maintained for a short period. After that, doing so will bankrupt and take the company down as it reduces potential profits. 

Disadvantages

1. Resources are wasted. When the capacity is full, and companies keep producing, the new products that will not be sold are disposed of or destroyed. This has a financial cost to the business and often an environmental cost.

If a factory or plant overproduces and generates excessive supply for a product with little demand, the losing company will close the production site. As a result, people lose their jobs leading to excess capacity with social costs for societies and macroeconomics.

2. Businesses that can no longer cut costs and generate demand for their product will shut down after closing production sites and wasting resources. 

Causes and Solutions of Excess Capacity

To understand what causes this phenomenon, it is important to know how it is calculated. First, it is determined by using the following formula: 

Excess capacity = total capacity - actual output

Total capacity is the maximum amount of goods and services the business can supply without increasing costs or reducing profits during a specific period. Actual output is how much of the product or service is being provided to the market over that same time.

With that in mind, below are the key causes:

  • At its core, the event occurs when supply outpaces demand. This means that one cause is that a business spends too much on production because it expects that demand will rise more than it does.
  • New competitors in the industry can still get customers from the business. This means that supply suddenly decreases for a business's product or service at a rate its production cannot follow. 

Given the causes and equation for calculating this capacity, businesses need to be well-equipped with the solutions to this phenomenon. Below are the key solutions to it:

  • The key, long-term solution to excess capacity is to increase demand for the product or service causing the phenomenon. While this may not be possible if the cause of low demand is an economic recession, strong ad campaigns could bolster demand. 
  • Decreasing prices can help increase demand. However, decreasing prices too much could cut into profits. This is why businesses are bound to experience excess capacity and attempt to reduce production costs by innovating production techniques or firing employees.

Excess Capacity Manufacturing Example

It is important to note that this business condition is primarily prevalent in manufacturing companies. While there are examples and instances where it is present in other industries, it is most noticeable and widespread in manufacturing.

Given the commonness of this event within the manufacturing industry, it is important to solidify your knowledge on this topic with an example from this field.

A manufacturing plant is tasked with producing lamps. They can produce 1,000 lamps in one day. But, unfortunately, only 750 lamps are being produced. There may be many reasons why the plant needs to produce.

One of these reasons may be the low demand for lamps. An external factor may reduce people's need for lamps, or at least for these specific lamps. If a new lamp company has entered the industry, it may take some customers.

Suppose the manufacturing process requires human labor, which is becoming increasingly common. In that case, the factory workers must work efficiently to produce at their total capacity.

Note

To re-emphasize the point, however, most cases of this business condition are created because of low demand for the products produced.

The above example shows that the total capacity for the lamp manufacturing plant is 1,000 lamps a day, and the actual output is only 750 lamps in one day. 

If we look at the equation to calculate this capacity, we can see that in this specific example, it is 1000 lamps (total capacity) - 750 lamps (actual output) = 250 lamps (excess capacity). 

Excess capacity Non-manufacturing Example

While this piece has focused significantly on manufacturing businesses and companies, countries, cities, industries, non-manufacturing companies, and other economic players can also experience this condition. 

However, an excellent way to understand it is to look at it from an individual business perspective.

The following example will look at how a business began, what they sell, the factors that created excess capacity, and the steps taken to reduce it and return closer to optimum output. 

The recent construction of a sizable public university in a small town has resulted in an influx of new students. Now that there is a demand for someone to play music at parties, John, a former DJ, started a DJ business company.

As a one-person company, there is high demand for John's DJ skills, but there is only a limited supply of how much he can DJ. John is in a strong position right now, given that his service is in high demand, and he can set his prices because he is the only one providing this service.

John's absolute control over the DJ market is quickly challenged. Seeing the potential in this market, students in the entrepreneur society create their own DJ business and act as a direct competition against John. 

After spending more on flyers around campus, the new DJ business from the entrepreneur society is now hired for every party around campus. John's DJ business is now experiencing excess capacity; he has the time and music to DJ at parties; however, he needs to be hired.

Seeing his profits dwindle, John knows he will be put out of business if he regains market share quickly. So to build more demand for his service, John lowers prices by investing in new technologies that make producing popular party music cheaper. 

With lower prices, the demand for John's service increases to match his supply. As a result, he is no longer operating at excess capacity.    

Researched & authored by Adrian de Vernou | LinkedIn

Reviewed & Edited by Purva Arora | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: