In manufacturing, efficiency is everything. But what happens when production slows, and excess capacity emerges? For manufacturers, optimal capacity is typically in the range of 80-85% of “maximum” production, and this range accounts for normal downtime such as repairs, tooling changes, shift changes, etc.
Excess capacity occurs when a manufacturer operates below its optimal production level—often due to economic downturns, increased competition, or shifts in demand.
While this can pose financial challenges, understanding how to account for excess capacity properly can help manufacturers maintain stability and position themselves for future growth.
From an accounting perspective, it’s critical to monitor overhead rates and ensure that excess capacity costs are not improperly allocated to inventory.
- Establishing a Standard Overhead Rate Manufacturers should determine their optimal production levels and apply a standard overhead rate, allowing for a reasonable growth factor rather than adjusting rates based on lower production levels. This prevents excessive costs from being incorrectly assigned to inventory.
- Allocating Costs Properly – Excess capacity costs should be charged to the cost of goods sold in the period they occur. If costs are allocated based solely on production, lower output can significantly inflate the per-unit cost of goods, leading to potential mispricing.
Potential Consequences of Excess Capacity
Excess capacity can put pressure on profit margins and force manufacturers to lower prices. Without strategic management, companies may struggle to remain competitive in a market where demand has softened.
Example
Consider a company whose normal production is 1,000,000 units with $1,000,000 in overhead costs. Under normal conditions, each unit carries $1 of overhead. However, if production drops to just one unit while overhead remains the same, that unit would absorb the full $1,000,000 in cost—a clear distortion of financial reality. This misallocation can result in overpricing inventory and further weakening demand.
Short-term Excess Capacity
Short-term excess capacity doesn’t have to be purely negative—it can be a time for strategic investment:
- Workforce Development – Investing in employee training can improve skill levels and efficiency, preparing the team for increased production when demand rebounds.
- Facility Upgrades – Use this period to complete maintenance, upgrade equipment, or implement automation that may have been postponed during busier times.
- Process Improvements – Assess current workflows and identify opportunities for optimization, including new technologies that can enhance productivity.
In general, periods of short-term excess capacity should be used to better position your business for the eventual turnaround.
Long-Term Excess Capacity
For long-term excess capacity, deeper strategic shifts may be necessary:
- Business Restructuring – Companies may need to explore downsizing, consolidating operations, or even selling off underperforming business units.
- Mergers and Acquisitions – Combining operations with another entity can help achieve efficiency gains and strengthen market position.
Moving Forward with Confidence
Excess capacity is a challenge, but with the right approach, it can also be an opportunity for manufacturers to refine their operations and build resilience. By proactively managing overhead allocation, reinvesting in efficiencies, and considering strategic adjustments, companies can navigate slow periods and emerge stronger.
If your business is facing excess capacity concerns, now is the time to assess your financial strategy and operational efficiencies. Thoughtful planning today can set the stage for long-term success. Reach out to the Wegner CPAs manufacturing advisors for strategic guidance.