What is {term}? Excess Capacity

Excess capacity occurs when the actual production of a firm is less than the amount that is achievable or optimal. This can indicate that the demand for the product is below the amount that 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 toward 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 beneficial for consumers because full capacity can lead to 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.

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 must 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.

Capacity and Special Orders

Excess capacity is a factor when a business manager is pricing a special order received at the end of a production month. In this context, prior production and sales have already paid for the company’s fixed costs for the month such as the 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 the firm receives a customer request for a price quote toward the end of June. XYZ's normal sale price is $10 per towel. However, only the variable costs need to be covered because the fixed costs have already 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. Thus, if the special order price is $8, a profit is generated, but the price is 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.