What Is Capacity Utilization Rate?
Capacity utilization rate measures the percentage of an organization's potential output that is actually being realized. The capacity utilization rate of a company or a national economy may be measured in order to provide insight into how well it is reaching its potential.
The formula for finding the rate is:
(Actual Output / Potential Output ) x 100 = Capacity Utilization Rate
A number under 100% indicates that the organization is producing at less than its full potential.
- Calculating the capacity utilization rate pinpoints the degree to which an organization is achieving its full production potential.
- Business executives can use the rate to decide how much production can be ramped up without the cost of investing in new equipment.
- A nation's economists use it to track how its industries are performing given the current economic environment. Fiscal and monetary policy may be adjusted based on the number.
- Capacity utilization is most relevant to industries that produce physical products rather than services.
- In the U.S., the Federal Reserve tracks capacity utilization rates in 89 industries within the mining, manufacturing, and utility sectors.
Understanding Capacity Utilization Rate
Capacity utilization rate is a key metric for a business or a national economy. It indicates the slack in the organization at a given point in time.
A company that has a utilization rate of less than 100% can, at least theoretically, increase its production without incurring the additional expensive overhead costs that are associated with purchasing new equipment or property.
A national economy with a ratio of under 100% can pinpoint areas in which its production levels can be increased without significant costs or disruption.
The concept of capacity utilization is best applied to the production of physical goods, which are simpler to quantify.
Corporate Capacity Utilization Rates
The capacity utilization rate is used by companies to assess their current operating efficiency.
It also provides insight into the cost structure of the business in the short term or long term because it can be used to determine the point at which unit costs will rise as it increases production.
Imagine, for instance, that Company XYZ currently produces 10,000 widgets at a cost of $0.50 per unit. It determines that it can produce up to 15,000 widgets without costs rising above $0.50 per unit. Therefore, the company is running at a capacity utilization rate of 67% (10,000/15,000).
In this case, company executives may conclude that they can safely increase production to 15,000 without investing in additional equipment.
Capacity utilization rates for the U.S. economy have been published by the Federal Reserve since the 1960s. Its deepest decline occurred in 2009 when capacity utilization fell to 66.7%. In the fourth quarter of 2020, it was at 73.4%.
Historical Capacity Utilization Rates
The Federal Reserve gathers and publishes data on capacity utilization in the U.S. economy.
In fact, the Fed calculates capacity utilization rates for 89 industry sub-sectors including 71 in manufacturing, 16 in mining, and two in gas and electric utilities.
In the fourth quarter of 2020, deep in the COVID-19 pandemic, the Fed calculated a revised capacity utilization rate for all U.S. industry at 73.4%
Capacity Utilization and the Business Cycle
Capacity utilization overall fluctuates with the business cycle.
Companies adjust their production volumes in response to changes in demand. Demand declines sharply during recessions as unemployment rises, wages fall, consumer confidence decreases, and business investment dips.
The Fed has published capacity utilization figures since the 1960s, spanning a number of economic cycles. All-time-high levels approaching 90% were achieved in the late 1960s and early 1970s. The deepest declines occurred in 1982 and 2009 when capacity utilization fell to 70.9% and 66.7%, respectively.
The Fed's numbers are published monthly in mid-month for the previous month but may later be revised.
Effects of Low Capacity Utilization
Low capacity utilization is a concern for fiscal and monetary policymakers. In 2015 and 2016, several European economies, including those of France and Spain, were struggling with the effects of low capacity utilization.
Despite monetary stimulus leading to historically low-interest rates, inflation remained below target levels for extended periods, and the threat of deflation loomed.
Low capacity utilization and high unemployment created so much slack in those economies that prices were slow to react to stimulative efforts. With so much excess capacity, rising product activity did not require significant capital investment.
Capacity Utilization Rate FAQs
Here are the answers to some commonly asked questions about the capacity utilization rate.
How Is Capacity Utilization Measured?
The formula for calculating the rate is:
(Actual Output / Potential Output ) x 100 = Capacity Utilization Rate
A number less than 100% indicates the degree to which production can be increased without additional investment. That is, the cost per unit will be the same.
How Does a Business Increase Capacity Utilization?
A business may choose not to increase its capacity utilization rate.
Businesses respond to the current business cycle. If demand for their products is low, they will decrease production. Their capacity utilization rates will decline as a result.
But in times when demand is strong, the capacity utilization rate informs them how much they can step up production without incurring additional per-unit costs.
What Is a Good Capacity Utilization Rate?
Ideally, 100% is a perfect score in an organization's capacity utilization rate.
However, a company wouldn't want to keep its production at 100% for long. It would want to expand its production capacity in order to increase its revenues. That would hurt its perfect utilization rate score but it would improve the company's prospects in the long run.
Does Investment Go Up When the Capacity Utilization Rate Is High?
Investment should go up when the capacity utilization rate is high. It indicates that an organization is producing as much as it can, based on the resources it has in place. If its leaders don't anticipate greater demand in the future and invest accordingly, its competitors will fill the gap.
What Is Manufacturing Capacity Utilization?
Manufacturing capacity utilization is a somewhat narrower term than capacity utilization.
The capacity utilization rate is most relevant to manufacturing businesses. The bulk of their costs may be found on the assembly line. But they have other costs, such as storage and shipping. All of these costs are factored in to determine a manufacturer's capacity utilization rate.
Nevertheless, manufacturing capacity utilization is the key factor. If a business's current equipment can only handle 1,000 units per day, the number can't be increased to 1,200 without business additional equipment.