Excess Capacity

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.