Capacity utilization is an important KPI for manufacturing companies. It represents the percentage of production capacity (or productivity) that a factory, enterprise, or economy is operating at compared to its maximum potential capacity.
You can also listen to this article:
What is capacity utilization?
Capacity utilization refers to the actual rate of production of a company with installed production capacity, compared to its potential maximum output. Also called capacity utilization rate or operating rate, finding this ratio of actual output to potential output allows enterprises to scope the efficiency of their manufacturing operations. It can also be used to assess the degree of utilization of other business assets like employee productivity.
Capacity utilization is a KPI that is mostly used in industries that produce physical products instead of services, as calculating the rate for the latter is hugely more complex. It is also used by governments to map the economic capacities of their industries. For example, the Fed has been calculating the capacity utilization rate for 89 of its industry sub-sectors in the U.S. economy for going on 60 years.
Capacity utilization is an important metric in production management, assisting greatly in the capacity planning of manufacturing operations. Next to considerations for more effective production planning, it helps to consider the average cost of production, the splitting point between fixed and variable costs, and to determine the right time to enter into new markets or exit old ones.
Calculating the capacity utilization rate
To calculate the capacity utilization rate, it is first necessary to determine the actual output level of a manufacturing operation. This involves gathering data related to the capacity of the existing workforce, equipment, and supplies from purchase reports, inventory movements, cycle times, etc. The maximum potential output, or production capacity, must be similarly corroborated. This can be achieved through analyzing metrics such as productive hours per day, the throughput time of products, etc. The data for the output levels should ideally come from a longer period of time in order to avoid assessing performance based on temporary fluctuations in business volumes or production conditions.
A few more technical KPIs to help determine the manufacturing capacity utilization rate are OEE or Overall Equipment Effectiveness, and TEEP or Total Effective Equipment Performance. OEE determines the true productive time of a manufacturing operation by multiplying workstation availability, workstation cycle time performance, and the quality of production or rate of defects. TEEP, meanwhile, extends this by adding in utilization (or loading) and multiplying it with OEE.
Once the data on real and potential utilization is obtained, it is possible to determine the capacity utilization rate. A simple formula is to divide the manufacturing operation’s actual output level with the potential maximum output level (at installed production capacity) and then multiply the product by one hundred in order to obtain a percentile figure.
Capacity utilization = (actual output level / potential output) x 100
For example, let us say a factory is outputting 100 bicycles a week but its potential maximum output is 140 bicycles. This makes the capacity utilization rate for the factory: (100 / 140) x 100 = 71.43 %. If the capacity utilization was closer to 100%, the average cost of goods produced would be lower. On the other hand, capacity overhead margin – potentially useful in case of a projected demand surge, for example, would be smaller as well.
Understanding potential output
It is good to bear in mind that potential output can be defined in two ways – technical and economic. The technical definition refers to the maximum amount of output in a set time-period with installed productive capacity. This expresses the production headroom of a manufacturer without increasing the average cost of production arising from having to hire additional workforce or purchasing new equipment.
Realistically though, the average cost of production might start to increase well before a manufacturing operation starts getting close to 100% capacity utilization rate. This is because, as productivity is stretched close to its limits, margins for error get smaller, equipment depreciation gets faster, extra shifts need to be implemented, equipment maintenance executed more often, etc. The economic potential output is therefore expressed as the level of output beyond which the average cost of production begins to rise realistically.
While a 100% capacity utilization rate might seem like a good idea on paper, it is usually not cost-effective in the long run. At maximum capacity, sudden increases in demand might leave the company at a production deficit in a crucial time of potential expansion, not to mention tensions arising from the workforce and equipment being stretched to their capacity limits day in, day out. For these reasons, a capacity utilization rate of around 85% is considered ideal in most cases.
Capacity utilization business considerations
Keeping the capacity utilization rate of a production operation in mind is important as the metric provides an invaluable insight into the company’s cost structure. It allows to determine the balancing point between the operation rate and average cost per unit. Many companies also shift their capacity utilization rates higher or lower strategically, depending on customer demands, raw material prices, phases in the business cycle, etc.
When the rate is constantly very high, it would probably be a good idea to invest in new manufacturing infrastructure to further increase production capacity. Among other considerations, this helps to avoid losing out on filling emerging or existing market caps. Conversely, if the rate is constantly low, the company should focus on increasing the efficiency of its manufacturing operation. There are a multitude of ways to do this. For example, by implementing new production systems (e.g., SMED), employing more staff, subcontracting parts of the production process, becoming a subcontractor yourself, optimizing production planning and scheduling, etc.
- Capacity utilization is a KPI that measures the actual production output of a company compared to its potential maximum output.
- The metric is used to determine available production overhead without need for investments into new manufacturing infrastructure.
- A 100% capacity utilization rate might seem ideal but is usually unsustainable in the long run. A rate of 85% is considered optimal in most cases.
- Capacity utilization has an inverse relationship with average cost of goods or cost per unit – the higher the utilization rate, the lower the average cost of goods and vice versa.
You might also like: Production Costs – A Simple Guide