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OVERCAPACITY: THREAT OR OPPORTUNITY?

by Donald V. Potter

We studied 25 industries in overcapacity. The study showed how companies like Hewlett Packard, Anheuser-Busch and Procter & Gamble not only survive overcapacity, but flourish in spite of it, while others, like General Electric, have had to withdraw from overcapacity industries.

Overcapacity arises in two ways: demand falls or high costs lead to high prices and expansion of low cost competition. Most industries that go into overcapacity do so because they have high costs. Ultimately, all costs break down to three types: the cost of outside purchases, the carrying costs of capital (i.e. profits and debt payments), and the cost of people. Anyone of the three costs can drive an industry into overcapacity by setting a price umbrella under which new lower-cost entrants can shelter.

Thus the real economic reason for a price is not to make profit, it's to discourage the next competitor ready to come into the market from producing. In fast growing markets, prices are set at replacement value levels because demand growth often requires new capacity. The market price must pay for all capital, and purchase costs, at rates high enough to meet their present replacement levels.

In overcapacity, the market goes to marginal pricing, since the next increment of supply comes from someone with productive capacity in place. Now the market price must discourage a supplier already in the market, so prices fall to the marginal costs of the least efficient company. Surprisingly, prices usually do not rise after a shake-out. More often, they fall. Capacity usually doesn't go away. It just changes ownership.

In the vast majority of cases, either the high-cost company, or its capacity, is bought by a more efficient, lower-cost producer. Then the marginal costs of the least efficient company fall, so prices continue to fall until demand grows faster than the industry survivors can supply from their current capacity. Industries do not usually come out of overcapacity until the industry has seen real growth in demand.

The corollary of all this is that senior management has just two primary tools to deal with overcapacity: price to discourage somebody from producing when there is excess capacity; or expand when the industry is short of capacity. Consider the already oversupplied US auto industry. While U.S. industry has been enjoying the advantage of a tremendous appreciation of the yen versus the dollar, it has been raising prices, thus encouraging the Japanese to transplant to the U.S.. Three to five years from now, there will be more automobile overcapacity. Those high domestic prices have brought more new capacity on shore. The 1990's will see the big three US auto producers paying for the profits of the late 1980's.

On the other hand, many industries with high current capacity utilization rates are declining to add more capacity for fear of driving prices back down. But if they don't add capacity, the demand will not go away; someone else will meet it. And that somebody will be around for a long time, since it takes very low prices to get rid of capacity after it has been created.

How does a firm survive overcapacity? There are five survival imperatives. The five all come down to one sentence. You have to offer features, reliability, and convenience for a price that no one else can match. In doing this, a company also wants to avoid draining resources to fight losing battles so it can spend less than its competitors in offering high performance for attractive prices.

First, withdraw from areas of weakness. Fully half the game in overcapacity is to spend less than the other guy. The first way to do that is to lose less than he does by withdrawing from areas where you are weak - earlier rather than later. History says that the third of the industry with the highest costs will be forced out. The high-cost company's odds of long-term survival are higher if it withdraws early, rather than hold on only to become progressively weaker in a falling price environment and be pushed out later.

The next thing is to discourage competition. A company should price low enough or expand aggressively enough so that it grows faster than anyone else in its market. The company must control more of the customers' minds than any of its competitors to win in today's economy.

The third imperative: copy success as soon as it becomes apparent in product development and cost structure - especially in cost structure. In the early 1980's, domestic companies came under great pressure from lower-cost companies from the Pacific Rim. Some domestic companies quickly decided to switch rather than fight, and began moving production to lower-cost manufacturers, at home and abroad. Others decided to keep production in-house. Those who did not copy suffered and became much weaker long-term players. If, as history suggests, a company is going to have to copy a successful product innovation or successful cost structure change, it should do so early rather than late. The longer the company waits, the stronger the initiator gets, and the weaker the late follower becomes. It may hurt to copy, but it's going to hurt a lot less early on than it will a few years down the road.

The fourth survival imperative is to focus product or service innovations on improving reliability and convenience rather than on features and price. Managers naturally tend to emphasize new features. The problem is that features, like lower prices, are relatively easy for a competitor to duplicate.

If a competitor can duplicate the innovation easily, the company should rather invest in becoming a fast copier. Spend money, time and effort on reliability and convenience - the really tough aspect of performance for other people to duplicate.

There's a new way to consider economies of scale today. The old model - big plants, lots of throughput, and relatively high utilization of labor and equipment per unit of product produced - is less convincing than it used to be. Capital is readily available today, so that many companies can achieve maximum economies of scale.

The new economies of scale come in marketing and sales. Many companies spend an average of 20% of revenues to bring customers in the door. But that's average. The real cost of getting a new customer is closer to 100% of the revenues he produces in the first year. A company that wants to spend less than competitors should worry more about customer turnover and selling cost than manufacturing economies of scale. The real economies of scale of today rest with satisfied customers. So if a company does not satisfy a customer by having very high reliability, convenience, and reasonable pricing, it can lose him. And then the cost of getting him back is far greater than the cost of getting him in the first place.

The fifth survival imperative: focus cost management on people productivity, especially in overhead. To control cost, you can: 1) reduce customers benefits, and thus cut the price of the product; 2) reduce the units of people, purchase, or capital used to produce the customers benefits; or 3) change the rate that you pay for the people, the capital and the purchases.

History suggests that a reduction in the units is far more effective than a reduction in the rate the company pays. The most important unit reduction to stress is people, but not direct labor. Most of the cost savings in period of overcapacity come by improving the productivity of middle and upper management - this is overhead. Acquisition are one very effective means of reducing overhead. There is more potential still in tying overhead back to specific customer benefits.

A summing up? The five survival imperatives boil down to one sentence. In overcapacity, a company must offer performance - features, convenience, and reliability - for a price no one else can match or withdraw from the market earlier rather than later.

(Note: This Perspective was written in the context of the economy in 1988. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)

 

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