What is 'Excess Capacity'

Excess capacity is a situation in which actual production is less than what is achievable or optimal for a firm. This often means that the demand for the product is below what the business could potentially supply to the market. A company can use excess capacity to offer customers a special order price and generate more sales near the end of the month.

BREAKING DOWN 'Excess Capacity'

A firm's excess capacity is an indication of the demand for the products it produces. Excess capacity is also a good situation for consumers, because full capacity can lead to the price inflation. A company with sizable excess capacity can lose a considerable amount of money if the business cannot pay for the high fixed costs that are associated with production.

The Differences Between Types of Capacity

Theoretical capacity assumes that the production process works efficiently all the time and that nothing prevents maximum efficiency. This level of capacity is not realistic, because every business has plant workers who miss work or equipment that breaks down.

Practical capacity accounts for a certain amount of production stoppages due to staffing issues, vacations and holidays, and equipment repair and maintenance. Each business needs to determine the level of capacity that is practical. If the company has not reached practical capacity near the end of a month or year, the firm has excess capacity available.

Instances Where Capacity Impacts a Special Order

Excess capacity is a factor when a business manager is pricing a special order received at the end of a production month. This situation arises when prior production and sales have already paid for a company’s fixed costs for the month, such as a factory lease or insurance premiums on equipment. Because fixed costs are paid for, the special order price only needs to cover the variable cost of production and generate a profit.

Assume, for example, that XYZ Manufacturing produces hand towels, and that the firm receives a customer request for a price quote toward the end of June. XYZ's normal sale price is $10 per towel, and only the variable costs need to be covered, since all fixed costs have been paid for the month. If the variable cost of each hand towel is $7, for example, any sale price above $7 generates a profit, and any special order price quotes are far below the normal retail price. XYZ must explain to the customer that the special order price was unusual and not necessarily a price offered in the future.

  1. Capacity Requirements Planning ...

    An accounting method used to determine the available production ...
  2. Aggregate Capacity Management

    The process of planning and managing the overall capacity of ...
  3. Capacity Management

    The management of the limits of an organization's resources, ...
  4. Capacity Utilization Rate

    A metric used to measure the rate at which potential output levels ...
  5. Fiscal Capacity

    In economics, the ability of groups, institutions, etc. to generate ...
  6. Capacity

    The maximum level of output of goods and/or services that a given ...
Related Articles
  1. Investing

    Calculating the Capacity Utilization Rate

    Capacity utilization rate is a ratio used to compare a current usage level against a maximum potential level.
  2. Investing

    What is Capacity Utilization Rate?

    The capacity utilization rate shows how much a firm or economy is producing as a percentage of what it’s capable of producing.
  3. Insights

    Capacity Utilization: A Strike Against Rate Hikes

    Despite a recent jump in certain prices indices, capacity underutilization suggests inflation is not a threat, and a more dovish Fed should be welcomed.
  4. Investing

    Is It Time To Short This Industry Favorite?

    A combination of capacity growth, higher fuel prices and worries about the health of the global economy have sent airline stocks skidding this year. The US Global Jets ETF (NYSE:JETS) is down ...
  5. Investing

    3 Reasons Why XLE & USO's Performances Will Be Limited

    Discover the three reasons why the United States Oil Fund and the Energy Select Sector SPDR Fund will likely underperform after the first quarter of 2016.
  6. Investing

    One Airline Ready To Fly Higher And One Not Cleared For Takeoff

    A combination of capacity growth, higher fuel prices and worries about the health of the global economy have sent airline stocks skidding this year. The US Global Jets ETF (NYSE:JETS) is down ...
  7. Investing

    Brexit Fallout: Delta Cuts Capacity on U.K. Routes

    Delta Air Lines (NYSE: DAL) reported better-than-expected second-quarter results on Thursday morning, sending the stock up close to 4% in early trading. Planned cost cuts from reducing the capacity ...
  8. Financial Advisor

    Risk Tolerance Only Tells Half The Story

    Just because you're willing to accept a risk, doesn't mean you always should.
  9. Investing

    Understanding Marginal Cost of Production

    Marginal cost of production is an economics term that refers to the change in production costs resulting from producing one more unit.
  10. Investing

    3 Reasons Why U.S. Oil Imports Are Rising (PSX, BP)

    Explore the reasons behind increasing oil imports to the United States, despite production and inventory levels at or near all-time highs.
  1. Does the law of diminishing marginal returns only apply to labor?

    Learn more about how the law of diminishing returns is used by economists and businesses. Find out more about the laws of ... Read Answer >>
  2. How long should an expansionary economic policy be implemented?

    Finding the optimal time period to end expansionary economic policy is an urgent issue; the key is found with capacity utilization. Read Answer >>
  3. Is there any way to reverse the law of diminishing marginal returns?

    Learn more about how consumer spending, supply and demand impact production decisions. Find out more about the law of diminishing ... Read Answer >>
  4. How can you calculate diminishing marginal returns in Excel?

    Learn more about production costs and applying the law of diminishing marginal returns using Excel. Find out more about how ... Read Answer >>
  5. Do production costs include the marginal cost of production?

    Learn more about marginal costs of production and production costs. Find out how businesses can use marginal cost calculations ... Read Answer >>
Hot Definitions
  1. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
  2. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  3. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  4. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  5. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
  6. Job Market

    A market in which employers search for employees and employees search for jobs. The job market is not a physical place as ...
Trading Center