Explain capacity, capacity utilisation and the management of demand-capacity mismatches, and evaluate strategies for adjusting capacity

What this dot point is asking

SEAB wants you to explain how much a business can produce (capacity), how fully it is using that ability (utilisation), and how it copes when demand and capacity do not match. The central link is between utilisation and unit cost - low utilisation means fixed costs spread over few units, raising unit cost - and the exam rewards sequencing the response to a mismatch and matching capacity decisions to how reliable the demand forecast is.

The answer

Capacity and capacity utilisation

Capacity is the maximum output a business can produce in a given period with its current resources. Capacity utilisation is the proportion of that maximum actually being used:

Why utilisation matters: unit cost

Fixed costs (rent, salaries, machinery, depreciation) must be paid regardless of output. At low utilisation, those fixed costs are spread over few units, so fixed cost per unit - and total unit cost - is high. As output rises toward full capacity, the same fixed costs spread over more units, lowering unit cost. This is why high utilisation generally improves efficiency and competitiveness.

Problems of under- and over-utilisation

• Under-utilisation (too much spare capacity). High unit costs, idle resources, and possible signals of weak demand. Some spare capacity is useful (room to grow, to handle surges, for maintenance), but persistent low utilisation is costly.
• Over-utilisation (operating at or beyond full capacity). Lowest unit costs, but no slack to handle surges, machinery and staff under strain, maintenance squeezed, quality and delivery at risk, and no room for new orders. Running flat out continuously is unsustainable.

The aim is usually high utilisation with a sensible buffer, not 100% all the time.

Managing demand-capacity mismatches

When demand exceeds capacity, the firm can increase capacity (invest in new plant - costly, slow, raises fixed costs; add shifts or overtime - flexible but dearer per unit; outsource the excess - avoids capital outlay but cedes margin and control) or manage demand (raise price, ration, lengthen lead times). When capacity exceeds demand, it can raise demand (marketing, lower price, new markets) or reduce capacity (rationalisation - mothball, sublet or sell idle plant, redeploy or release staff).

Evaluating capacity decisions

Capacity decisions hinge on the reliability and durability of the demand forecast. If a demand rise is confident and sustained, capital investment is justified; if it is uncertain or temporary, flexible options (overtime, temporary shifts, outsourcing) are safer because over-investing leaves the firm with low utilisation and high unit costs. A strong answer sequences the response - use existing capacity first, then add flexibly, then invest - and conditions the verdict on forecast certainty.

Examples in context

Example 1. Airlines and load factor. Airlines obsess over "load factor" - the proportion of seats filled, their version of capacity utilisation - because the cost of flying a plane is largely fixed regardless of how many seats sell. A half-empty flight spreads those fixed costs over few passengers, so carriers like Singapore Airlines use dynamic pricing and yield management to push load factors high, illustrating utilisation as the central driver of unit cost in a high-fixed-cost business.

Example 2. Manufacturers adding shifts before building plants. When demand rises, manufacturers typically add overtime or extra shifts first - a flexible, reversible way to lift output from existing plant - before committing to a costly new factory. Only when demand growth is proven and durable do they invest in new capacity, because a new plant that runs under-utilised carries crippling fixed costs. This shows the sequenced, forecast-dependent response to a capacity shortfall.

Try this

Q1. A firm produces 18{,}000 units against a maximum capacity of 24{,}000. Calculate its capacity utilisation. [2 marks]

• Cue. $\frac{18{,}000}{24{,}000} \times 100 = 75\%$ capacity utilisation.

Q2. Explain one drawback of a firm consistently operating at 100% capacity utilisation. [4 marks]

• Cue. At 100% there is no slack to absorb a surge in demand or to schedule maintenance, so the firm cannot take on new orders, machinery and staff are under constant strain, breakdowns and quality problems become more likely, and delivery reliability suffers. A small buffer below full capacity gives flexibility and protects quality and service.

Q3. Analyse why a firm facing rising demand might choose to outsource production rather than build new capacity. [6 marks]

• Cue. Outsourcing the extra output avoids the large capital outlay and the rise in fixed costs that building a new plant brings, and it is flexible and reversible - valuable if the demand rise is uncertain or temporary, since the firm is not left with under-utilised capacity if demand falls back. The trade-offs are lower margin (paying the contractor's profit), less control over quality and scheduling, and dependence on a supplier. So outsourcing suits an uncertain or short-term demand increase, while building capacity suits confident, sustained growth where the firm wants control and the volume to justify the investment.