SELF TEST #19B: Future Capacity
When should a company undertake an extensive analysis of future capacity?
Normally, only companies in low marketing and sales industries should devote the time to forecast future capacity in detail. These are normally industries with gross margins on sales of 10% or less. Other companies should concern themselves primarily with the expansion of current competitors, especially low-cost competition, and with new entrants to the market.
In what forms can a company add capacity in an industry?
The companies in the industry may add capacity in at least six different ways. The most expensive is a Greenfield expansion, where an industry competitor builds an entirely new facility. Next is a new line expansion, where the Company builds a new production line inside an existing facility. Third would be a line conversion, where the Company converts a production line or facility from one related product to the current product. Fourth, the Company can add a new shift, which is the addition of another work shift to an already existing production line. Fifth, the Company may invest to debottleneck a part of the facility which is limiting the capacity of the entire facility. Sixth, the Company’s natural learning curve effect will cause Capacity Creep, which is the natural addition of capacity to an existing facility and workforce because the Company learns to operate the facility more efficiently. Finally, there is one other way for a company to expand capacity for its Core customers and that is to raise its prices for its least attractive customers and withdraw from some or all of its relationships with Non-core and Near-core customers.
Capacity Creep tends to add a very modest amount of capacity to an industry each year. The normal range is .5% to 1.5% increase in industry capacity every year due to Capacity Creep. The faster an industry grows, the more Capacity Creep adds to the annual capacity of the industry.
How high must prices be in order for the industry to be willing to add new capacity?
The type of new capacity added depends on prices that the industry sees. If the industry sees prices that would enable it to cover its cost of capital through the business cycle, it will add the more expensive forms of new capacity. These include Greenfield expansion, which usually comes only with the industry’s highest price levels, and such marginal expansions as new lines, line conversions and new shifts. Debottlenecking investments require relatively low prices because they are marginal investments to free up significant capacity. These occur in almost any price environment.
If an industry needs to reduce capacity, what alternatives are available to it?
There are three typical ways for a company in an industry to reduce its productive capacity. The first is reallocation, where the Company shifts capacity away from the current product to other more profitable products. The second is curtailment, where the Company reduces a shift or shuts down part of its capacity at a facility. The third is shut down, where the Company closes down a facility entirely.
The industry is consolidating with many mergers and acquisitions. Will this reduce industry capacity?
The odds are this merger and acquisition wave will not reduce current industry capacity. Before the mergers and acquisitions, prices were high enough to keep all the operating facilities of the two merged companies running. Each facility is likely to continue operating as long as it can produce cash for its owners. On the other hand, these mergers and acquisitions may slow the rate of future capacity expansion. The larger merged company can absorb a larger increment of capacity addition without going into overcapacity.
Should an industry leader voluntarily withdraw producing capacity in order to help the industry raise its prices?
This is a risky strategy for the industry leader. It must watch out for the other industry competitors. If those competitors add capacity that matches or exceeds the amount the industry leader withdrew, industry prices will stay the same or even fall, and the industry leader will have lost market share in the bargain.
Assume for the moment that an industry is currently in overcapacity, where there is more capacity than there is industry demand. Suddenly, it finds itself unable to secure enough raw materials to keep all its current capacity operating. What is likely to happen to industry prices?
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