In Business, what is Excess Capacity?

Excess capacity refers to a production capacity which falls below the potential capacity available to the producer. For example, if a widget factory can make 100 widgets per hour and it is only making 70 widgets per hour, this would be a case of excess capacity, because the firm is producing below its capacity. There are several ways to assess capacity utilization, and many governments track this metric of performance because it can provide useful information about the state of an industry.

When a firm is producing below capacity, it means that demand for the products it produces is low. For consumers, this can be a good thing, because the price of the product will remain relatively low as well. Low demand can also be a sign that the economy is experiencing turbulence and that consumers are reluctant to buy new products. Thus, excess capacity may sometimes be a warning notice that consumers are reluctant to buy because they are worried about the economy.

For the producer, excess capacity can be a problem. Many costs of production are fixed; whether someone makes 100 units or 1000 units, the cost will be the same. One example is the cost of purchasing or renting facilities in which to produce products. When a producer makes products below capacity, the per product costs of production average high. The producer may be reluctant to raise prices in order to avoid depressing consumer demand, and as a result its profit margins shrink.

One way to look at capacity utilization is to examine the technical limitations on product production. If a factory line is capable of making, for example, 1,000 units per hour, the technical capacity of the factory would be 1,000 units per hour. Production of less than this number of units would indicate excess capacity and suggest that the company is throttling back production because it does not want to end up with an excess of unsold inventory.

Economic analysis can also be used. In this case, the analyst looks for the point at which average per unit production costs cannot be brought any lower. This is the production capacity. When firms produce below this level, per unit costs are higher than they could be and the company is in a state of excess capacity. Remaining at this level of production could end up costing the company money because it may have difficulty meeting fixed overhead costs.