What’s it: Capacity utilization refers to the extent to which existing production capacity is used. It may refer to a company’s machinery or production facilities. Or, we might find it to describe an industry or an economy aggregate.
What is production capacity? It is the potential, or maximum output a machine or production facility can achieve. And to get the capacity utilization rate, we divide the actual output by the potential output, expressed as a percentage.
Capacity utilization is closely related to demand prospects. For example, when demand is strong, companies increase production to sell more products and make more profits. As a result, they will maximize the existing capacity.
However, if production is near full capacity, the existing facilities will no longer be able to increase further. Thus, businesses need to expand production to meet demand. Finally, they invest in new physical capital to increase production capacity.
Conversely, when demand deteriorates, companies face excess capacity. As a result, capacity utilization is low, and some resources are idle. And the pressure on their profitability increases. They incur high fixed costs and can only spread them to less output.
Because profitability is pained, businesses have no incentive to invest in capital goods. Instead, they optimize their existing production capacity while taking efficiency measures.
Why is capacity utilization an important indicator in the economy?
There are several reasons why capacity utilization is an important economic indicator. First, it becomes an indicator of the ongoing economic conditions. For example, high capacity utilization indicates strong demand. This condition usually occurs during a prosperous economy (economic expansion), where households see strong prospects for their income and employment. So, they are willing to spend more money on consumption expenditure.
Strong consumption spending increases the demand for goods and services. This situation provides an incentive for businesses to increase their production. Therefore, they try to maximize the existing capacity to increase profits before investing in capital goods.
Second, the capacity utilization rate signals operating efficiency. For example, when companies operate close to their potential output, they can spread high fixed costs over more output. Thus, the cost per unit is lower, enabling them to obtain higher profitability.
Third, when the utilization rate increases, we expect an increase in employment. Companies will usually increase capital expenditures to increase production as demand grows. They buy capital goods such as machinery or build new production facilities.
Such investments increase the demand for labor because businesses also need them to operate machines or production facilities. As a result, more jobs are available, lowering the unemployment rate.
Fourth, capacity utilization signals inflationary pressures in the economy. As explained earlier, high capacity utilization leads to an increase in labor demand. Consequently, the labor market is tighter, and wages are pushed up.
An increase in wages increases the cost of production, which the company passes on to the selling price. As a result, inflationary pressures increased.
How do we calculate the capacity utilization rate?
Calculating the capacity utilization rate requires only arithmetic operations. First, we need actual output data – the output realized by a machine or production facility over, say, a year. Then, we need potential output, the maximum output the production facility can achieve in a year. Finally, we divide the actual output by the potential output, expressed as a percentage. Here is the formula for the capacity utilization rate:
- Capacity utilization rate = (Actual output / Potential output) x 100%
For example, a company has a production facility with 3,000 units per year. However, in reality, the facility only produces 2,000 units a year. Thus, applying the above formula, we get a capacity utilization rate of 73.3% (2,000 / 3,000).
Ideally, companies produce maximum capacity (100% capacity utilization rate). Thus, if utilization is less than 100%, theoretically, they can increase production without incurring the expensive overhead costs associated with purchasing new production equipment. And in aggregate, the utilization rate below 100% allows the economy to increase output without driving inflation.
Nevertheless, the actual output often does not reach the maximum. Several reasons explain why it happened. First, machines and equipment have worn out. Second, the company performs routine maintenance and repairs. As a result, the machine can not produce as much as when it was purchased and used throughout the day.
How do capacity utilization impact companies, aggregate demand, and the economy?
At the micro level, the capacity utilization rate affects the company’s profitability because it impacts the cost per unit. In addition, it also affects the business decision to invest in capital goods.
Meanwhile, at the macro level, it could indicate general economic conditions. For example, it gives us insight into aggregate demand, the unemployment rate, and inflation.
Impact on profitability
Higher utilization lowers the cost per unit. This is because businesses can spread high fixed costs over more output. So, while the variable cost per unit increases with an increase in output, a lower fixed cost per unit decreases average cost. Thus, the company can earn a higher profit for each unit sold, assuming its selling price remains constant.
On the other hand, lower utilization rates reduce profitability. Companies incur high fixed costs and spread them over less output. Consequently, the cost per unit is higher.
Increased utilization also contributes to the company’s competitiveness. For example, lower unit costs allow them to lower selling prices while maintaining adequate profitability. Furthermore, as the selling price is lower, their products become more attractive, boosting consumer demand. Finally, although the profit margin per unit is lower, they can profit more by selling more output.
Conversely, high unit costs reduce competitiveness. For example, a company keeps constant its selling price to support profit margins even when unit costs rise. While the margin per unit remains unchanged, their products are becoming less competitive than competitors. Their products become less attractive because consumers have to buy at higher prices, reducing demand.
Maintaining high utilization rates is crucial in some industries, such as energy. This is because they have substantial fixed costs in their cost structure. As a result, they have to produce at a significant scale to break even and make a profit. Thus, if their utilization rate is low, they face significant pressure on profitability.
Typically, companies in such an industry will try to sell as much output as possible to maintain utilization at a favorable level, including by lowering selling prices. However, it has other consequences. For example, a price war arises because other companies will also do so, sending market prices falling and leading to profitability pressures for all companies in the market.
For this reason, competition between companies tends to be intensive in industries with high fixed costs. Each company must achieve a high utilization rate to break even and profit. So, if demand falls, it could lead to a price war.
Effect on investment
Capacity utilization tends to fluctuate as companies attempt to adjust their production volumes in response to changing demands. For example, the utilization rate is also low if demand is weak. As a result, companies simply rely on existing facilities to meet demand. Consequently, there is no incentive to invest in capital goods.
On the other hand, if the utilization is high and close to its maximum capacity, the incentive to invest gets stronger. But before realizing the investment plan, the company will predict how strong the demand will be in the future.
Say future demand continues to grow strongly. That creates an incentive to invest because the business sees an opportunity to increase profits. Since the existing capacity is insufficient, they invest in doing so. They incur capital expenditures, for example buying new machines or building new production facilities. The investment adds to the existing production capacity. Thus, they can increase output and reap more profits.
The relationship between capacity utilization and investment decisions is strong, especially for companies in capital-intensive industries. They usually rely on heavy machinery or equipment with significant fixed costs. So if the utilization rate is already high, but future demand continues to grow, they will invest.
The relationship between capacity utilization and aggregate demand
Aggregate demand equals business investment plus household consumption, government spending, and net exports. Thus, when business investment increases, it will also boost aggregate demand.
- Aggregate demand = Household consumption + Business investment + Government spending + Net exports
Increased business investment creates more household jobs and income, prompting them to increase spending. Seeing strong demand, producers increase their output. They use production facilities more intensively, pushing up utilization rates.
If demand continues to grow strongly, businesses will invest in capital goods. In addition, they also recruit more workers to operate the new machine or facility. As a result, improvements in household income and employment prospects continue, leading to stronger household consumption. Ultimately, increased household consumption and business investment allowed the economy to sustain its expansion.
Conversely, a decline in investment weakens aggregate demand. Business lowers output. As a result, the utilization rate drops, leaving some resources idle. They also reduce the workforce, worsening household income prospects.
In this situation, there is no incentive to invest. Instead, businesses will only utilize existing facilities more efficiently. In addition, the deteriorating outlook for household incomes has resulted in a decline in consumption. Finally, aggregate demand fell further.
Relationship between utilization rate and business cycle
The utilization rate fluctuates throughout the business cycle. During a recession, the economic outlook deteriorates. Households view their income and employment prospects as bleaker. As a result, they reduce consumption spending, causing the demand for goods and services to decline.
Weaker demand forces companies to produce well below their maximum potential. As a result, they face excess capacity. And pressure on their profitability is also increasing. They have no incentive to invest in new capital assets in this situation. Instead, they leverage their existing capacity to meet demand. Or, they liquidate unsold inventory, for example, by offering a discount or lowering the selling price.
The opposite situation occurs during expansion. The economy is prospering. Businesses face strong consumer demand as income and employment prospects improve. Initially, they will use their production capacity more intensively and operate near full capacity. Then, if consumer demand continues to increase, they will increase investment.
Long story short, high utilization signifies a prosperous economy (economic expansion). On the other hand, low utility signals a difficult economy, such as a recession. Companies typically use about 80% of their available productive capacity in the United States. The percentage will be lower during a recession and higher during an expansion.
Correlation between utilization rate and the unemployment rate
The unemployment rate moves with the utilization rate. During strong demand, businesses will increase investment when existing capacity is insufficient (capacity utilization rate is near full). In addition, they will also recruit new workers to, for example, operate new machines or equipment.
On the other hand, a low utilization rate indicates some resources are idle. Jobs are hard to find due to decreased job creation. As a result, the unemployment rate increased.
Implications on inflation
Economists use the utilization rate as an indicator to measure inflationary pressures. They interpret it as a measure of the high excess demand pressure in the economy.
A higher utilization rate indicates businesses are more optimistic. They see a strong prospect of demand for their product. So, they try to increase production to reap more profits. However, it does not necessarily lead to high inflationary pressures as businesses may still operate at “natural” capacity utilization rates.
Then, when businesses increase production at a rate where their utilization exceeds the “natural” rate, it signals excess demand in the economy. The economy likely faces demand-pull inflation because aggregate demand exceeds aggregate supply. Businesses are highly confident in their demand, making them willing to increase production at more than natural utilization rates. And further production increases will result in stronger inflationary pressures.
What to read next
- Aggregate Demand Curve: Meaning, Sloping Reasons, Determinants
- Aggregate Demand: Formula, Components and Determinants
- Business Confidence: Its Effect on Aggregate Demand and the Economy
- Capacity Utilization: Its Relationship With Profitability, Aggregate Demand and the Economy
- Consumer Confidence: Its Effect on Aggregate Demand and the Economy
- Demand Shock: Definition and a Brief Explanation
- How Exchange Rates Affect Aggregate Demand and the Economy
- How Fiscal Policy Affects Aggregate Demand and the Economy
- How Household Wealth Affects Aggregate Demand and the Economy
- How Monetary Policy Works Affects Aggregate Demand and the Economy