Capacity utilization measures the extent to which a company, industry, or economy utilizes its production capacity. Production capacity is a potential output that can be produced by a company or economy. By dividing the actual output into potential output, we get a capacity utilization rate.
- Capacity utilization rate = (Actual output / Output potential) x 100%
Ideally, the company produces at its potential output (100% capacity utilization). But the actual output is often less than that. It occurs because of machine wear-out or routine maintenance and repairs.
Capacity utilization and investment in fixed capital
Capacity utilization is the primary determinant of investment expenditure. Declining capacity utilization rates signal a slowdown in demand. Usually, this happens during economic contractions. The company produces far below its potential output. This situation creates excess capacity. There is no incentive for companies to increase production or invest in new capital assets. They will usually struggle to liquidate the inventory of unsold products, for example, by offering discounts or lowering selling prices.
However, when consumer demand is higher than expected, companies will use their production capacity more intensively. Companies usually operate at or near full capacity. If consumer demand increases, these conditions encourage them to increase production and invest in new equipment. This situation often occurs during an economic expansion (real GDP grows).