Capacity utilization typically refers to the amount of manufacturing/productive capabilities that are being used by a company at a certain point in time. It can also be defined as a company’s metric for computing the rates at which the prospective output levels are either being met or availed. For instance, if the company has the resources and infrastructure to run three manufacturing shifts every day but is only operating with two shifts, it’s rate of capacity utilization will be 66.66%. This rate can be mathematically deduced when the actual level of output is divided by the potential levels of output, and the deduced value is further multiplied by hundred. The final value is expressed in the form of a percentage. So, mathematically the formula of capacity utilization is;
Capacity utilization = (Actual level of Output / Potential level of output) x 100
Nowadays, the majority of the companies do not operate at a productive capacity of 100%. This is because, most of the times, they experience various hurdles in the production process due to malfunctioning equipment, lower demands, employee disruption and other relevant reasons. So, a rate of 85% is consistently considered to be an optimal rate for most businesses. When a startup business does not operate at a productive capacity of hundred percent, it is considered to have ‘spare capacity’.
Why is capacity utilization important?
Capacity utilization is considered to be a highly important and relevant concept as;
- It is often used as a determinant of the productive efficiency of a company.
- With the rise in output, the average cost of production is likely to fall. This means, more capacity utilization can drastically reduce unit costs thereby helping the business to stand an edge ahead of its competitors.
Due to these reasons, all firms and entrepreneurial bigwigs aim to produce close to a full, (about 100%) utilization of capacity.
How can a company increase its capacity utilization rate?
Although reaching the maximum capacity rate of 100% is quite difficult, yet, companies can incorporate the following guidelines to increase their current capacity utilization rate and enjoy more profits from the business. They can;
- Employ staffs on a contractual basis, encourage overtime and ensure extra shifts to increase the overall workforce hours.
- Spend less time on maintaining the equipment/infrastructure that are necessary for production
- Subcontract a couple of production activities.
What happens when the rate of capacity utilization is low?
When the rate of capacity utilization is low or moderate, it means that the firms are being able to expedite their rate of production without incurring any recurring costs. In simpler words, when, a company enjoys high demand of its products, it can easily produce greater (or the required) number of those products at the same rate-per-unit. Also, with relatively higher rates, the companies cannot maximize their output levels without paying additional recurring costs for new resources and better infrastructure.
Thus, a company should try to ensure maximum capacity utilization to buck up their productive efficiency and enjoy greater profits in the long run.