IB Docs (2) Team
Capacity utilization rate
The capacity utilization rate (AO2, AO4)
Capacity utilization refers to the extent to which an organization operates at its maximum level (known as the firm’s productive capacity). The capacity utilization rate measures the organization’s actual output as a percentage of its capacity (maximum potential output), at a particular point in time.
Capacity utilization is calculated using the formula:
A firm with 0% capacity utilization means it is not producing any output. Hence, there is a lot of spare capacity. By contrast, a firm that has 100% capacity utilization means it is operating at full capacity, with all of its resources being used.
As an example, suppose that a producer has the capacity to operate for up to twelves hours per day during a five-day working week. This means the maximum number of hours it can operate (the capacity) is 12 × 5 = 60 hours per week. So, if it is operational for 45 hours during a given week, the producer's capacity utilization rate is (45 / 60) × 100 = 75%. This tells managers that the firm was working at only three quarters of its maximum capacity.
As a real-world example, the capacity at Arsenal Football Club’s Emirates Stadium is 60,432. If on a match day the football club sells 54,389 tickets, this means the organization has a capacity utilization rate of 90% (i.e., 54,389 expressed as a percentage of 60,432).
Football clubs rely on operating at full capacity on match days
Capacity utilization is used as an indicator of productive efficiency as it measures the extent to which an organization is operating at its maximum level. For instance, when workers are required to work overtime, the capacity utilization rate rises. Capacity utilization is likely to fall when the level of demand falls or when there are insufficient resources to operate at a high level.
Advantages of high capacity utilization
Advantages of operating at or near full capacity include the following reasons:
In general, higher capacity utilization is required to achieve economies of scale. Average costs of production tend to fall when the level of output rises. So, as the capacity utilization rate increases there are more opportunities to experience economies of scale.
Hence, higher capacity utilization can help to reduce a firm’s unit costs, making it more competitive.
Lower average costs of production from economies of scale is also likely to lead to higher profits for the business.
Higher capacity utilization also means the firm is more productively efficient, as it makes the most out of the use of its resources. By contrast, if capacity utilization is low, resources are idle.
Disadvantages of high capacity utilization
Disadvantages of full capacity utilization include the following arguments:
Workers can become overworked, so become exhausted, stressed and demotivated as they work flat out.
Machinery and capital equipment are likely to become wear out and depreciate at a fast pace. This can result in higher costs for maintenance and replacement or repairs.
Improving capacity utilization may involve upgrading IT systems and technologies. However, this can be extremely costly.
As workers focus on the quantity or volume of output, it is possible that the overall quality will suffer.
At times, a business needs to operate below its full capacity in order to improve the overall experience of customers. Watch this video which shows why operating at full capacity is not good for customers at Tokyo Summerland:
This video shows that it is possible, but not necessarily sensible, to operate at above 100%:
Top tip!
For a business operating at full capacity, capacity utilization can be improved by outsourcing (subcontracting) the work. This also applies to organizations experiencing high growth rates.
To test your understanding of this topic about the capacity utilization rate, have a go at the following exam practice questions.
Exam Practice Question 1 - Sharma Fabrics
Urvashi Sharma runs a textiles factory located in the outskirts of Mumbai, India. The firm’s total costs amount to $98,000 per month, with labour costs totalling $52,000 per month. Rental costs and other overheads are $11,500 per month, and the rest of the costs are paid for the cost of hiring the latest capital equipment used at the factory. On an average day, the factory produces 261,000 units of output, but has a maximum capacity of 300,000 units.
| (a) | Calculate the capacity utilization rate for Sharma Fabrics. | [2 marks] |
| (b) | Calculate the cost of labour as a proportion of the firm's total costs, and comment on your results. | [4 marks] |
| (c ) | Calculate the cost of capital as a proportion of the firm's total costs, and comment on your results. | [4 marks] |
Teacher only boxAnswers
(a) Calculate the capacity utilization rate for Sharma Fabrics. [2 marks]
Capacity utilization rate = 261,000 / 300,000 = 87%
Award [1 mark] for the correct answer, and a further [1 mark] for showing appropriate working out.
(b) Calculate the cost of labour as a proportion of the firm's total costs, and comment on your results. [4 marks]
Labour intensity rate = (Labour costs / Total costs) × 100
($52,000 / $98,000) × 100 = 53.06%
This means that labour costs account for more than half of all costs for Sharma Fabrics. In this case, for every $100 of total costs, $53.06 comes from labour costs. This suggest the firm is labour intensive rather than capital intensive.
Mark as a 2 + 2
Award [1 mark] for the correct answer, and a further [1 mark] for showing appropriate working out.
Award [1 mark] for a vague commentary that shows limited understanding, and [2 marks] for a clear response that shows understanding of the calculated figure.
(c) Calculate the cost of capital as a proportion of the firm's total costs, and comment on your results. [4 marks]
Capital (Capital costs / Total costs) × 100
Capital expenditure = $98,000 – $52,000 – $11,500 = $34,500
Capital intensity rate = ($34,500 / $98,000) × 100 = 35.2%
This means that capital costs account for about a third of all costs for Sharma Fabrics. In this case, for every $100 of total costs, $35.20 comes from the costs of capital. Despite being a textiles manufacturing that uses the "latest capital equipment", it is not capital intensive.
Mark as a 2 + 2
Award [1 mark] for the correct answer, and a further [1 mark] for showing appropriate working out.
Award [1 mark] for a vague commentary that shows limited understanding, and [2 marks] for a clear response that shows understanding of the calculated figure.
Exam Practice Question 2 - Fortune Shoes
Veronica Fortune owns and runs Fortune Shoes as a sole trader. The firm has fixed costs of $6,000 a month and can produce a maximum of 2,000 pairs of shoes per month when operating at full capacity. The variable costs are $20 per unit, and the shoes are sold for an average price of $80. The average sales volume is 1,600 pairs of shoes per month.
| (a) | Define the term sole trader. | [2 marks] |
| (b) | Calculate the capacity utilization rate for Fortune Shoes. | [2 marks] |
| (c) | Calculate the fixed costs per unit for Fortune Shoes at 1,600 units of output and at its maximum capacity. | [3 marks] |
| (d) | Calculate the profit margin at 1,600 units of output for Fortune Shoes and at its maximum capacity. | [3 marks] |
| (e) | Calculate the difference in profit if Fortune Shoes could operate and sell all of its shoes at its level of productive capacity. | [3 marks] |
Teacher only boxAnswers
(a) Define the term sole trader. [2 marks]
A sole trader (or sole proprietor) is a type of business structure that is owned and run (controlled) by one person, although s/he can employ staff. Hence, all profits made by the business (if any) belongs to the owner (Veronica Fortune in this case). There is no legal distinction between the owner and the business itself, so the owner has unlimited liability (legal and financial responsibility for all losses and debts).
Award [1 mark] for an answer that shows some understanding of the term sole trader.
Award [2 marks] for an answer that shows good understanding of the term sole trader, similar to the example above.
(b) Calculate the capacity utilization rate for Fortune Shoes. [2 marks]
Capacity utilization rate = (1,600 / 2,000) × 100 = 80%
Award [1 mark] for the correct answer, and a further [1 mark] for showing appropriate working out.
(c) Calculate the fixed costs per unit for Fortune Shoes at 1,600 units of output and at its maximum capacity. [3 marks]
Fixed cost per unit = Total fixed cost / Output
At 1,600 units, the fixed cost per unit = $6,000 / 1,600 = $3.75
At 2,000 units, the fixed cost per unit = $6,000 / 2,000 = $3.00
Award [1 mark] for each correct answer, and a further [1 mark] for showing appropriate working out, up to the maximum of [3 marks].
(d) Calculate the profit margin at 1,600 units of output for Fortune Shoes and at its maximum capacity. [3 marks]
Profit margin = Price – Average cost
At 1,600 units, AC = $3.75 + $20 = $23.75
At 1,600 units, profit margin = $80 – $23.75 = $56.25
At 2,000 units, AC = $3.00 + $20 = $23
At 2,000 units, profit margin = $80 – $23 = $57.00
Award [1 mark] for each correct answer, and a further [1 mark] for showing appropriate working out, up to the maximum of [3 marks].
(e) Calculate the difference in profit if Fortune Shoes could operate and sell all of its shoes at its level of productive capacity. [3 marks]
Profit = Total contribution – Total fixed costs
At the current 1,600 units, profit = [(80 – 20) × 1,600] – $6,000 = $90,000
At the maximum 2,000 units, profit = [(80 – 20) × 2,000] – $6,000 = $114,000
Hence, the difference in profit = $114,000 – $90,000 = $24,000
Award [1 mark] for the correct answer. Award a further [2 marks] for showing appropriate working out, up to the maximum of [3 marks].
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