What is capacity utilization?
Capacity utilization is the amount of manufacturing capacity a company is using at any given time. If a company has the capacity to run three manufacturing shifts a day and operates only two shifts a day, it has a capacity utilization rate of 66.66%. This rate can also be calculated in number of units, so a company that can produce 10,000 pieces a day, but only produces 8,000, has an 80% capacity utilization rate.
Production capacity takes into account fixed costs such as factories and equipment. It does not include variable costs such as labor and materials. When a company reaches full capacity, it will have to increase its fixed costs by buying more equipment or building new factories to produce more goods.
Capacity utilization is expressed mathematically as actual output minus potential output, divided by potential output. The capacity utilization rate is expressed as a percentage. Companies rarely operate at 100% installed production capacity as there will often be downtime due to equipment malfunction and other causes. A constant rate of around 85% is considered ideal in most industries.
When the capacity utilization rate is low, it means that companies can increase production without incurring additional fixed costs. If demand for the firm's products increases, it can produce more goods at the same cost per unit. If the rate is high, companies cannot increase production without incurring additional fixed costs to buy new machines or build new facilities.
Capacity utilization can be an economic indicator, as economists will consider the overall capacity utilization rate of the industry or country when determining whether there is a risk of inflation. Inflationary pressures occur when companies are at or near full capacity and there is additional demand for goods. As demand for the product increases and production stays the same, prices rise, causing inflation.
The amount of capacity a company has in addition to what it is using is excess capacity. Overcapacity can be thought of as the difference between the amount of goods a company is able to produce with its current infrastructure and the amount it is actually producing. It can also be thought of as the incremental amount of product a company can produce at current cost. If the company wants to produce more units beyond its full capacity, it will have to incur additional costs.