CAPACITY UTILISATION – SUMMARY

Introduction
Definition of capacity utilization: The proportion of maximum output capacity being
achieved.
Formula: current output level X 100
Maximum output level
The degree of total capacity being used by a business can identify its operational efficiency.
Maximum capacity is the total level of output that can be achieved over a certain time
period by the business. For a hotel, monthly total capacity would be the total room nights
available and for a factory, it would be the amount of the resources they had – land, capital
equipment, labour -can produce. If a firm is working at full capacity, it is achieving 100%
capacity utilization as there is no spare capacity.

Capacity utilization – impact on average fixed cost

Basic concept
When the utilization is at a high rate, the average fixed cost is being spread over a large
number of units hence, the unit fixed cost would be lower.
Example: The hotel bedrooms are occupied: (100% of capacity)
Hotel fixed costs per day (ex: rent and salaries): $2500
Average fixed costs per room per day: $25
This means that utilization is at a high rate as 100% of capacity is being used, meaning that
there’s a lot of people that bought a room in the hotel (average fixed cost is being spread
over a large number of units aka the customers) hence, the unit fixed cost would be lower
($25 per day).

However, if the utilization is at a low rate, the average fixed cost is spread over a lower
number of units hence, the unit fixed cost would be higher.
Example: The hotel bedrooms are occupied (50% of capacity)
Hotel fixed costs per day $2500
Average fixed costs $50
This means that utilization is at a low rate (50% of capacity only), meaning that lesser people
are purchasing hotel rooms so the average fixed cost is spread over a lower number of unit
(aka customers) hence, the unit fixed cost is higher (the price charged to each customer).

Further explanation:
-The hotel fixed cost per day itu $2500 kan so if there’s a lot of customers which results in
the hotel being 100% occupied so, each of them bayarnya gausa mahal2 because at the end
of the day klo di totalin, it’ll be more than $2500 jg probably unlike klo customersnya lg dikit
during that day. Klo lg dikit and only 50% of the hotel rooms are occupied then each
customer di chargenya lebih tinggi biar at the end of the day klo di totalin itu masih dpt
$2500. Klo cmn di charge the same kaya pas hotelnya lg rame (which is $25) yg ada hotelnya
gabisa reach $2500 makanya dimahalin.

Advantage & Disadvantage of reaching 100% capacity utilization

Advantage
It can be assumed that most firms wish to reach 100% capacity utilization as it would mean
lower unit fixed cost and this would be profitable for the business. The business would be
able to claim how successful they are to the point where it has no spare capacity. As an
example, hotels would put up a ‘no vacancy’ sign in front or in airplane tickets, they would
put up a ‘sold out’ sign. It would also bring a sense of job security to the workers there as
they believe that the company they’re working for is successful and this would then give
them a feeling of pride.

Disadvantages
1. The workers may feel under pressure to put out their best foot forward at every task
they’re responsible for and this could lead to stress. The operations manager cannot afford
to make any production scheduling mistakes as there is no room for mistakes or time to
make up for it.
2. Regular customers need to be turned away as there is no spare capacity left and this will
lead them to find other suppliers. This would lead the business to lose long term clients.
3. Machineries will be working flat out and there’s no time for maintenance, this would lead
to increased unreliability in the future. That is why some businesses kept spare capacity for
the unforeseen future while still reaching 100% capacity utilization.

Excess capacity (means ada sisa ex: sisa hotel rooms yg blm ke occupy) –
what are the options?
Low levels of capacity utilization lead to higher unit fixed costs. Some business has
attempted to reduce the excess fixed cost but before that, we need to consider the time
factor first:
1. If it’s just a seasonal problem and short-term, such as for ice cream businesses that are
only highly demanded during the summer, then the business might want to:
a) Maintain high output levels and add to stocks. However, this might be expensive and
risky if the sales do not recover. Maintaining high output means keep producing at the same
production rate despite the high spare capacity/low capacity utilization and add to stocks
means that decision will automatically increase the inventory of semi-finished / finished
goods because of the low capacity utilization. It is costly as sales may not be achieved.
b) Adopt a more flexible production system wherein a machinery is needed to be more
flexible to produce a product that is highly demanded by customers during that season to
generate more profit, instead of producing the same products all throughout the
year/season. However, this requires more machineries, workers and resources to be more
flexible enough to produce different products.
c) Give employees / workers a flexible contract so that if there is excess / spare capacity, the
workers can be laid off first and this will save costs for the business. However, this might
bring in negative impact as the workers will have bad morale and motivation.

2. If it’s a long-term issue such as a change in fashion trend or technological development

and economic recession, the business might want to consider cutting down the production
capacity if the business can’t earn back the customer’s demand by means of promotion
anymore. This is often referred to as rationalization and this will have both cost and industry
related implications.

DEFINITION:
Rationalization – Reducing capacity by means of cutting overheads to increase the
business’ operation efficiency, for example cutting off factories and office departments
that often include redundancies (means not needed anymore)

Disadvantage of rationalization
Even though this might be the best thing to do for the business right now, the business
might face a problem wherein a sudden upturn or sudden increase in demands by customers
happens for whatever reason. If this happens, the business will not be able to satisfy their
demands as a lot of capacity has been cut off and this will leave the customers disappointed.
Staff redundancies (that are not needed) will also feel like they’ve lost the job security and
motivation, this will lead to bad publicity in the media.

Excess Capacity – evaluating the options (brief ideas only, detailed one below this)
1. Excess capacity in the short term
This might be caused by seasonal demands therefore the business might consider marketing
their solutions or entering overseas market and cutting down prices, in effort to increase
their sales.

2. Excess capacity in the long term

This might be caused by economic recession and technological developments in the recent
times that caused a certain business’ past technologies to be less competitive in the market.
With this, the business might want to identify the precise reason to the cause of their excess
capacity, and by this it will help to identify which products need improvement or updating
rather than the general recession in demand.

Dealing with short-term and long-term excess capacity (yg table itu)
Dealing with short-term excess capacity
Option 1: Maintain high output and produce for stocks
Advantages
1. A sense of job security for staff because they’ll keep working everyday
2. No part-time working for staff as they need to maintain high output
3. Production schedule doesn’t need to be changed or orders from suppliers as continuous
production rate remains
4. Goods may be sold at a season or time where it’s most demanded.

Disadvantages:
1. Doesn’t apply for goods that may go out of date quickly since it’ll build up in the
inventories and quality may be reduced
2. Stock holding cost may be substantial as stocks may pile up therefore the cost of holding
it will be more expensive too.
3. Demands may not increase as expected therefore, the goods need to be sold at a
substantial discount.
Option 2: Introduce greater flexibility into the production process
-By having flexible contracts for the employees
-By having flexible machineries that can produce different products
-Short-term working for employees ex: all staff on 3 day week

Advantages
1. Production can be stopped during slack periods and increased again when the demands
increase.
2. Other products can be produced, following a different demand pattern
-for ex: during a certain season like summer, ice cream is highly demanded so the business
should produce more ice cream
3. Avoids stock build-up
-Stock build up usually happens when the workers keeps on producing products everyday
which aren’t even demanded currently, because they have full time contract perhaps so
they have to do something or else the business are just paying them for nothing. Therefore,
now that they have flexible contracts, they may be laid off when demands are low to avoid
stock build up because if it builds up and no one wants to buy it, it has to be sold on a lower
price which is not profitable for the business at all and it has now reduce in quality anyways.

Disadvantages
1. Staff may be demotivated due to not having full-time, permanent contracts.
-Because, this might make them feel like their job security is on the line and can be laid off
any time so what’s the purpose of putting their best foot forward every time when they
know they can be laid off suddenly.
2. Staff needs to be trained in order to be able to produce different kinds of products. This
will add extra costs to the business.
-Might add extra costs to the business because more training for the staff is needed.
3. Flexible and adaptable machineries that can produce different kinds of products are
expensive.

Dealing with a long-term excess capacity

Option 1: Rationalizing existing operations and cut capacity by means of closing factories or
office
Advantages:
1. Higher capacity utilization
-By rationalizing through closing factories that aren’t needed, it would mean that there will
be lesser factories. The focus will be on the essential factories only and there will be more
pressure for that factory as the rest of the backup factories are now being cut off. Hence,
the business will be able to achieve high capacity utilization then since there is no spare
capacity now.
2. Reduced overheads
-Overheads means a cost or expense incurred in the general upkeep or running of a
business. Overheads is being reduced because factories are being cut off so there is no more
need for the business to spend any costs in running that factory as it has just been cut off
recently.

Disadvantages:
1. Redundancies costs for staff payments
2. The business may be criticized due to lack of social responsibility
-If the business suddenly lay off employees without finding them a solution, they will be
heavily criticized as they are seen as not responsible. This might affect people especially
who are already in their 40’s or 50’s because businesses are more likely to hire employees
who are at their 20’s and 30’s (younger ones with a more modern mind).
3. The business might be in trouble if the demands suddenly spiked up again due to new
products being released perhaps, but they don’t have enough capacity hence, customers are
disappointed.
4. Workers may feel like their job security is on the line / uncertain about their job
security.
-This is because a factory or office department might be closed at any time all of the sudden
and this means, the workers there might be laid off too

Option 2: Research and Development into new products

Advantages
1. It will replace existing products and make the business more competitive
2. If introduced quickly enough it might prevent the business from rationalization

Disadvantages
1. Research and Development is expensive
2. If introduced very quickly into the market without having a clear marketing strategy, it
might be unsuccessful
-With marketing strategy, the business will be able to have a clearer idea on how to
promote the product and through which medium (ex: billboards, magazines, or social
media)
3. Research and Development takes a long time to do and might take too long to prevent
the business from cutbacks in capacity and rationalization.
-By the time research and development is finished, the business might have already
rationalized already.

-The final decision will depend on many factors – such as cost of expansion. The time factor
also plays an important part here, wherein it has been proven to be quicker to put work
contracts with outside firms who could produce components that used to be made within
the factory, than to actually build a brand new production facility which takes years to
complete and by the time it has been completed, the demand might have fallen anyways
probably due to an economic downturn.

Working at full capacity

The potential problems of working at full capacity has been identified. When a business is
working close to or at full capacity, other decisions needs to be taken.
DEFINITION:
Full capacity: When a business produces at a maximum output

Capacity Shortage
DEFINITION:
Capacity Shortage – When the demand for a business’ products exceed the production
capacity.
-This is the opposite of excess capacity. Capacity shortage is when the demands are higher
compared to the output the business could produce. It is essential to identify the cause to
the spike of demand and estimate how long will it last. If the shortage of output is caused by
a faulty machine that’ll be fixed next month, it is unlikely the business would be able to cope
with the increase in demand currently and drastic action to raise capacity is unlikely.
However, if the business has been operating at 100% capacity and the demand doesn’t
seem to be falling, this will be considered as long-term capacity shortage and, two options
could be taken (see the options below)

How to overcome long-term capacity shortage problems (table yg bawah itu):

Option 1: Use subcontractors or outsource the finished goods, supplies, components.
Advantages
1. No major capital investment is required
2. It offers great flexibility because if the demands fall back, the contracts with other firms
can be ended right away.
-Unlike if the business do rapid expansion, if demands fall back they have to shut it down
and it will be a waste of capital.
3. It is easy to arrange

Disadvantages
1. Lesser control over the quality of output
-This is because some outsourced factories are quite far hence, the manager perhaps, can’t
control it.
2. There is uncertainty over delivery time as it may take some time and the reliability of
the delivery may be questioned too.
3. More administration and delivery cost as the output has to be transported from far
away (the outsourced factory) to the main area where the business operates.
4. Unit cost may be higher than ‘in-house’ production due to the supplier’s profit margin.

Option 2: Capital investment in expansion of facilities

Advantages:
1. Increase in capacity since the business has invested in expansion of facilities
2. The new facilities should be able to use the latest equipment and methods.
3. More control of the quality and final delivery times
4. Other economies of scale should be possible too.

Disadvantages:
1. It does increase the capacity however, should the business experience a fall in demand
for a long period of time, it may put the business at risk because now they are left with
excess capacity (as no one is purchasing)
2. Capital cost may be high
3. It takes time to build and equip a new facility
-Customers may be impatient to wait and decides to move on eventually.
4. Raising capital may be a challenge / problem for the business.
-These decisions should not be taken lightly as the rapid expansion of a business could
determine its profitability. If the business fails to expand, they might be left with a shrinking
market share and become increasingly dependent on external contractors. Rapid expansion
that takes place before doing a proper estimation of when the demand will last is also a
problem because if the business finally expands and the demands fall suddenly for a long
period of time, it will put the business at risk as they are now left with excess capacity if
demand trends change.

Outsourcing
DEFINITION:
Outsourcing – Using another business such as a ‘third-party’ to undertake the production
process rather than doing it within the business, using the firm’s own employees.

DEFINITION
Business-process outsourcing (BPO) – A form of outsourcing that uses a third-party to take
responsibility for certain business functions such as the HR or finance department.
-Usually these third-party businesses are located in foreign countries with lower labor costs
and a less strict regulatory environment.
The growth of outsourcing in the recent years is not only caused by capacity shortage only
but there are other reasons to it.

Reasons to outsource:
1. Reduction and control of operating cost
-It would be cheaper for a business to just ‘buy-in’ specialists rather than employing them
which would be much expensive. Buying in specialists is cheaper because the business
would benefit from economies of scale as the specialists offer the same service to a large
number of other business. Much outsourcing also involves offshoring wherein the business
would buy in services, components or even finished goods from industrialized countries who
has a low wage economy, with the intention of reducing the cost of doing business.

2. Increased flexibility
-By removing departments from the staff payroll and ‘buy in’ specialists whenever they are
needed only, fixed costs are being converted into variable costs. Additional capacity can be
obtained by outsourcing and this is much beneficial for the business because if the demands
fall back, the business could just end the contract directly rather than expanding their own
facilities but end up closing down it down again when demands fall back. The benefits of
using subcontractors have been discussed which includes no greater capital investment
needed, it is easy to arrange and offers a flexibility wherein contracts with other firms can
be cancelled whenever demands falls back. (see how to overcome long term capacity
shortage).
Subcontractors: A business or person that carries out work for a company as part of a larger
project.

3. Improved company focus

-The business would outsource its ‘peripheral activity’ or the ones that are considered to be
less prioritized and focus on the ‘core activities’ instead which is the main goal and aim of
the business. For example, a hotel would just focus on the management time to improve
customer’s service rather than the accounting functions therefore the accounting functions
are being outsourced completely.

4. Access to quality and resources that are not available internally.

-Many outsourcing firms or companies employ quality specialists that small-medium sized
businesses cannot afford to employ.
Outsourcing companies: Those who provide the third-party services. They are contracted by
the client (or another business) to do tasks for them which prove to be too much for them
to handle.

5. Freed up internal resources for use in other areas

-If the HR department of an insurance company is being shut down along with the functions
of it, then the office space and computer facilities could be made available to improve
customer’s service.

Potential drawbacks to outsourcing

1. Loss of jobs within the business
-By outsourcing, it would mean that some workers need to be laid off. The employees would
feel demotivated and lose the sense of job security they once had. If the business employs a
low-wage employee at the same time of the job losses, the business might be questioned
for its ethical standards and also receive bad publicity.

2. Quality issues
-Internal processes would usually be monitored by the business’ own quality assurance
system however, since the business is planning to outsource some of its function out to a
third-party firm, then they need to send one of their own quality assurance staff out to
make sure quality and customer service standards are being met. Therefore, a clear contract
with minimum service level agreement needs to be arranged.

3. Customer’s resistance
-Overseas telephone calls have been criticized for not being able to understand foreign
operators. The customers sometimes may object to dealing with overseas outsourced
operations. Bought in components are being questioned as well by the customer’s mind in
terms of their quality and reliability.

4. Security
-Using outside businesses to perform important IT functions could have security risks
because if the important data are lost, no one knows who should take responsibility for this.

Outsourcing Evaluation
-The global trend towards outsourcing will continue as firms seek further ways on improving
its operational effectiveness especially now where opportunities can be found due to
globalization. Before outsourcing anything, the business needs to make a substantial cost-
benefit analysis of the decision first. Closing down or run down a whole department for its
functions to be outsourced would be time consuming and expensive. If the outsourcing has
failed, then re-establishing it and reopening it would be expensive.
-The business would also need to identify which activity is considered to be the ‘core
activities’ of the business and which one is the ‘peripheral activities. These varies from
business to business.