Capacity Cost

Capacity Cost

Investopedia / Jessica Olah

What Is a Capacity Cost?

A capacity cost is an expense incurred by a company or organization in order to provide for or increase its ability to conduct business operations at larger scale. Capacity costs are therefore associated with things that allow a business to increase its production above a set point or reach markets beyond their current distribution network.

Capacity costs are a given in business if the business wishes to grow beyond its current production capacity and generally can be reduced or avoided only by reducing staff or shutting down business locations, both of which may reduce capacity or outsourcing.

Key Takeaways

  • A capacity cost is incurred when a business or other organization spends money in order to expand operations or increase production capacity.
  • Capacity costs are a necessary part of doing business, and are especially relevant for new and emerging companies that are oriented toward rapid growth.
  • These costs may include items such as lease agreements on larger facilities, purchase and depreciation of new equipment, as well as increased costs to operate and maintain those larger or newer assets.

Understanding Capacity Costs

Capacity refers to the maximum level of output that a company can sustain to make a product or provide a service. Planning for capacity requires management to accept limitations on the production process. Capacity requirements planning (CRP) is the process of discerning a firm's available production capacity and whether it can meet its production goals. Capacity requirements planning weighs the costs of increasing capacity against the company's actual production capabilities to see if the current capacity can successfully meet the existing production schedule and at budget.

Capacity costs include a wide range of cost types. Some are fixed and are not affected by small shifts in business productivity. Typical examples of this nature are items such as rent or lease payments, depreciation on equipment or machinery, property taxes, insurance, and basic utilities such as heating. If a company dramatically increases its sales and needs to increase its production to make sure products are available to its new customers, the business may need to add additional manufacturing facilities. That would raise all of the mentioned capacity costs.

Other Considerations

Capacity costs can also be more closely related to consumer demand. If a distribution center is experiencing a period of high volume due to increased sales productivity, they might add additional workers or additional shifts to keep up with the high demand. These increases in personnel are also capacity costs, as they allow the business to increase its production capacity. Once the high volume period passes, the company can scale back on personnel to reduce their costs.