Excess capacity refers to the situation where a firm is producing at a lower scale of output than it has been designed for. It is essentially the difference between what a business could potentially produce with the current resources and infrastructure it has available (maximum capacity), and what it is currently producing (actual output).
Here are a couple of key points to keep in mind about excess capacity:
- Causes: Excess capacity can arise due to several reasons, such as a decrease in demand for the company’s products or services, inefficient use of resources, seasonal changes affecting production, or economic downturns.
- Impact: While a certain degree of excess capacity can provide a buffer for unexpected increases in demand or problems with production, sustained excess capacity can be problematic as it represents wasted resources and costs. It can also lead to lower prices in the market if companies with excess capacity reduce prices in an attempt to increase sales.
- Management: Businesses often try to manage their excess capacity by finding ways to increase demand (like through marketing and sales efforts), diversifying their product offerings, or reducing capacity (which may involve steps like closing factories, laying off workers, or selling off equipment).
For instance, if a car manufacturing plant has the equipment and labor necessary to produce 10,000 cars a month, but due to decreased demand it is only producing 7,000 cars a month, it has an excess capacity of 3,000 cars a month. This means the company has the potential to produce more than it currently does without incurring additional fixed costs for new equipment or facilities.
Example of Excess Capacity
Let’s consider a company called “FastThreads Clothing Co.” that manufactures shirts. Their factory has the capacity to produce 50,000 shirts per month, working in two shifts with their current machinery and labor force. However, due to a recent decline in market demand, they are currently only producing 30,000 shirts per month.
In this case, FastThreads Clothing Co. has an excess capacity of 20,000 shirts per month. This means they could potentially produce 20,000 more shirts each month without needing to invest in new machinery or hire additional workers.
However, because they are not utilizing their capacity fully, they are not maximizing their potential revenue, and their per-unit cost might be higher because the fixed costs (like rent for the factory, salaries of permanent staff, depreciation of machinery, etc.) are distributed among fewer units of output.
To manage this excess capacity, FastThreads Clothing Co. might look for ways to stimulate demand, such as launching a new marketing campaign or offering discounts. Alternatively, they might explore other options like producing a different product that has higher demand or leasing their excess capacity to another business. If these measures aren’t feasible or successful, they might ultimately need to consider reducing their capacity, for example, by selling off some of their machinery.