Capacity Utilization and Effects on Product and Profit

Capacity utilization is an important concept for any business and plays a big role in the cost of production for any given product as well as the profit that can be made on the sale of that product. Just about any business has a capacity, whether it is for manufacturing products, serving customers or completing projects. It is how this capacity can be utilized or maximized that is ultimately most important to making a business more profitable.

Capacity utilization can be as simple as a restaurant or factory having a particular capacity to serve customers or produce products. It is difficult to operate a business at full capacity on a consistent basis, because problems can arise and the product might suffer. Capacity utilization is about utilizing most of this capacity, which typically gives a business the best opportunity to turn a profit and the most efficient use of resources, equipment, space and staffing.

Capacity utilization can have an effect on every product a business produces. Any capacity utilization rate below 50-70 percent is inefficient and is often a sign of weak demand for the product or service the business produces. This leads to an inefficient use of space, resources, equipment and staffing, which can put pressure on the ability to make a profit. Since many costs that go into producing a product are fixed, the cost of producing each individual product will increase, which shrinks the profit margin.

Low capacity utilization will more often than not lead to lower prices, which in turn will stimulate demand and increase the capacity utilization. Many businesses increase prices in an attempt to increase profit margins; however, this kind of move only acts to lower the demand for the products and can then lower capacity utilization even more. It is often a wiser move to lower prices and increase production to lower production costs and stimulate demand at the same time, which will increase capacity utilization.

Running above an 80-85 percent capacity utilization rate can signal high demand for the products being produced and that capacity is about to be maxed out. When capacity utilization rates get close to 100 percent product, consistency can suffer and the business can lose some control over production or customer service. This can damage the business's reputation and lower the demand for the products by turning customers away. This is a better problem to have than low demand, but it does present some challenges.

There are two main ways most businesses react to combat high capacity utilization. One course of action would be to raise prices to lower demand and enjoy a higher profit margin and more profit. The other way to approach this problem is to expand the business or increase the capacity to keep up with the demand. This is when it is the right time to grow the business and enjoy more profitability by increasing volume and enjoying savings from economies of scale.