Capacity utilization is the amount of manufacturing capability a company is using at any given time. If a company has the ability to run three manufacturing shifts per day and is only operating two shifts per day, it has a capacity utilization rate of 66.66 percent. This rate can also be calculated in number of units, so a company that can produce 10,000 pieces per day, but is only producing 8,000, has a capacity utilization rate of 80 percent.
The production capacity takes into account fixed costs, such as factories and equipment. It does not include variable costs such as labor and materials. Once a company reaches full capacity, it will have to increase its fixed costs by buying more equipment or building new factories in order to produce more goods.
Capacity utilization is expressed mathematically as actual output divided by potential output. This rate is expressed as a percentage. Companies rarely operate at 100 percent of installed productive capacity, because there will often be downtime due to equipment malfunctions and various other causes. A consistent rate of about 85 percent is considered optimal in most industries.
When the capacity utilization rate is low, it means that companies are able to increase production without incurring additional fixed costs. If demand for the company’s products increases, they can produce more goods at the same cost per unit. If the rate is high, companies cannot increase their output without incurring additional fixed costs to purchase new machinery or build new facilities.
Capacity utilization can be an economic indicator, as economists will consider the industry’s or the country’s overall capacity utilization rate when determining whether there is a risk of inflation. Inflation 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 remains the same, prices will go up, causing inflation.
The amount of capacity a company has beyond what it is using is excess capacity. Excess capacity can be thought of as the difference between the amount of goods that a company is capable of producing with its current infrastructure and the amount that it is actually producing. It can also be thought of as the incremental amount of product that a company can produce at the current cost. If the company wants to produce more units beyond full capacity, it will have to incur additional costs.