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In Business, what is Excess Capacity?

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  • Last Modified Date: 15 September 2016
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Excess capacity refers to a production capacity which falls below the potential capacity available to the producer. For example, if a widget factory can make 100 widgets per hour and it is only making 70 widgets per hour, this would be a case of excess capacity, because the firm is producing below its capacity. There are several ways to assess capacity utilization, and many governments track this metric of performance because it can provide useful information about the state of an industry.

When a firm is producing below capacity, it means that demand for the products it produces is low. For consumers, this can be a good thing, because the price of the product will remain relatively low as well. Low demand can also be a sign that the economy is experiencing turbulence and that consumers are reluctant to buy new products. Thus, excess capacity may sometimes be a warning notice that consumers are reluctant to buy because they are worried about the economy.

For the producer, excess capacity can be a problem. Many costs of production are fixed; whether someone makes 100 units or 1000 units, the cost will be the same. One example is the cost of purchasing or renting facilities in which to produce products. When a producer makes products below capacity, the per product costs of production average high. The producer may be reluctant to raise prices in order to avoid depressing consumer demand, and as a result its profit margins shrink.

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One way to look at capacity utilization is to examine the technical limitations on product production. If a factory line is capable of making, for example, 1,000 units per hour, the technical capacity of the factory would be 1,000 units per hour. Production of less than this number of units would indicate excess capacity and suggest that the company is throttling back production because it does not want to end up with an excess of unsold inventory.

Economic analysis can also be used. In this case, the analyst looks for the point at which average per unit production costs cannot be brought any lower. This is the production capacity. When firms produce below this level, per unit costs are higher than they could be and the company is in a state of excess capacity. Remaining at this level of production could end up costing the company money because it may have difficulty meeting fixed overhead costs.

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bythewell
Post 3

@pastanaga - But in that case and in the case of a lot of specialist companies, I would think they could simply rent the capacity they need.

I mean, people who make Christmas food could just rent the bakeries and things during the few months that they need them.

Or they could own it outright and just use it for other things at that time.

The game companies could have all the capacity for crowds and just use the servers for something else when they aren't needed. There's never a lack of people who could use extra server space, after all.

pastanaga
Post 2

@irontoenail - I would argue that it's just as important to work out what your ideal capacity is before you set up your production lines, than to try and figure out new ways to use the product afterwards.

One example I can think of is the online game companies. Whenever they roll out a new, popular game, there are inevitably crashes because they don't have the server capacity to cater for as many people as want to play.

But, they do this on purpose. If they had so many servers that everyone could play in comfort even after a new release, those servers would go to waste whenever there wasn't a huge number of extra people trying to get online.

They've worked out how many computers they need to keep their regular customers happy and they keep it at that number.

irontoenail
Post 1

The difficulty is when the product you produce is not wanted in the same numbers throughout the year. For example, if you make rain jackets, they are obviously going to be more popular in the spring time, or whenever rainfall is highest. So you can either make your production capacity match one season or the other, or perhaps an average of the two.

There are a couple of ways to deal with this problem. If you do choose to average out the production, you can store the excess products to be sold when they are back in demand.

This doesn't work so well if the products you're making are perishable or perhaps not worth the cost for storing them.

In

that case, you might be able to find a market for them in other countries where the seasons or traditional uses for a product are different.

For example, Christmas fruit pies might not be as popular at other times of the year in the UK, but in other countries they might be considered a year round snack.

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