Part 1: Industry Price Outlook

Future Capacity From Current Competition

Capsule: The current industry has many different forms of capacity that it can make available or withdraw from the market. Each of these forms has a separate cost that affects market prices. The various forms of capacity enter or withdraw from the market depending on the price.

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Symptoms and Implications:

With a reasonable forecast of future demand in hand, the Company estimates the local market’s current and expected future capacity to produce product for that demand. Normally, only companies in low marketing and sales industries would devote the time required to forecast future capacity in detail. The analysis requires a calculation of the cash costs of operating each increment of current industry capacity plus any new capacity likely to come on-stream in the next three to five years.

The Company makes this capacity estimate in order to check the balance between capacity and demand during the coming few years. The Company can see some new capacity coming from expansions announced by current competition. In capital intensive industries, these additions will usually come on stream within the next five years. At the opposite end of the spectrum, the Company might expect some withdrawals of currently operating capacity. The expansions of capacity influence the future price while the future price controls the withdrawals of current capacity in operation.

Examples of Capacity »

The cash costs of operating the highest cost capacity the industry requires effectively project what industry prices would be at any given level of demand. At a given level of demand, a low marketing and sales industry should realize a price just below the cash costs of the next increment of capacity that could be brought on stream. If demand is rising, prices must rise to bring the next higher cost addition to capacity into production but not high enough to bring more than that. If demand is falling, prices must fall low enough to discourage some currently producing capacity from continuing to turn out product.

The Company projects its future capacity by evaluating the announced and probable capacity expansions and withdrawals by the industry’s current competitors. As part of this projection, the Company must also consider any constraints on current capacity or potential expansions.

Additions to Capacity

Prices in an industry rise as industries exhaust available capacity and reach high utilization rates on existing capacity. Industry prices tend to rise before the industry reaches its full capacity utilization. This happens for two reasons. First, theoretical capacity utilization rates are often optimistic and do not allow for normal disruptions in operations. Second, the best industry competitors are the first suppliers to run out of capacity. Their customers tend to be willing to pay higher prices in order to ensure continuing supply of product from those suppliers. As these customers begin to pay a premium price, the rest of the industry experiences price increases as well. This price increase sets the stage for some capacity expansions.

New industry capacity comes in several forms. The amount of capital invested per dollar of sale defines these forms. Beginning with the most costly in capital investment and moving, generally, to the least costly, these forms include:

  • Greenfield expansion: the building of an entirely new production facility.
  • New line expansion: the building of a new production line inside of an existing facility.
  • Line conversion: the conversion of a production line or facility from a related product to the current product.
  • New shift: the addition of another work shift on an existing production line.
  • Debottleneck investment: the investment of capital to increase the capacity of one portion of the production line that limits the capacity of the entire line.
  • Capacity creep: the natural addition of capacity to an existing facility due to the “learning curve” effect, where the facility produces more using the same assets and work force as the company makes incremental improvements in work processes. The rate that this form of new capacity adds to industry capacity depends on the growth of the industry. In a relatively slow growing market, capacity creep adds 1/2% to 1-1/2% a year to industry capacity. The faster an industry grows the more capacity creep adds to the annual capacity of the industry. For example, capacity creep may add as little as two-tenths of a percent of total industry capacity in a market where demand is growing at less than 2% a year to as much as 6% in industries where demand is growing in excess of 30% a year.

These various forms of expansion require significantly different industry prices to be attractive to the company. As a rough set of rules:

  • Greenfield expansion requires average industry prices, through the industry cycle, sufficient to pay the company’s cost of capital. This is normally the industry’s highest price level.
  • New line expansions, line conversions and new shifts require prices in the top third of the industry’s pricing cycle. Times must be relatively good for the industry to bring this capacity on-stream.
  • Debottleneck investments require relatively low prices to be economically attractive. They will occur in any facility requiring more capacity in virtually any price environment.
  • Audio Tip #104: Where is the “Profit” in Expansion?
  • Capacity creep requires only that the production line or facility be open and operating. A Hostile industry, with very low prices and returns on investment, will still see capacity creep adding to industry capacity.

In addition to the six forms of capacity expansion above, there is one other source of capacity for the Company to support its Core customers. The Company may withdraw from some or all of its relationships with Non-core and Near-core customers. This action frees some Company capacity to serve its better customers. In this form, the Company gradually raises the prices for its least attractive customers in order to encourage them to seek other suppliers, or to turn them into attractive customers. Those less-attractive customers who reduce their purchases from the Company release capacity to serve other, more profitable, customers.

Future Capacity Questions

Analysis 61:
Unit Equivalent Sales Price Needed to Justify Marginal Capacity Addition
Analysis 62:
Sources of New Capacity
  • How does the Company define “capacity” to produce a product?
  • How does current industry capacity to produce the product compare to current industry demand for the product within the Company’s practical economic service area?
  • How does current industry capacity to produce the product compare to current industry demand in areas immediately adjacent to the Company’s area of practical economic reach?
  • How does current industry capacity compare to current industry demand in areas beyond those above? ·
  • Where is capacity out of balance with demand?
  • Do the differences in industry capacity compared to industry demand in other areas have an impact on the balance in the Company’s area?

The Company reviews the alternatives the industry has to bring additional capacity on stream in the market and the prices necessary to incite this capacity.

  • If capacity is greater than demand today, what prevents the companies with the excess capacity from reducing their prices to sell the excess capacity?
  • In what amounts, over what period of time and at what price levels, can future industry capacity change, using each of the following methods of increase:
    1. Capacity creep: where increases in operating efficiencies increase the effective capacity of a facility.
    2. Debottlenecking: where an industry competitor increases the practical capacity of a section of the facility that defines the facility’s limits on the current unit output.
    3. Marginal expansion: where an industry competitor increases the capacity of a facility by converting another line, by adding a new production line or by adding an additional labor shift.
    4. Greenfield expansion: where an industry competitor builds a new facility.
  • How much physical capacity could the industry add to the market over the next few years? In capital intensive industries, companies announce major capacity additions three to five years before they come on stream.
  • At what price would the industry be willing to add these increments of capacity? (Analysis 61 and Analysis 62)

The Company would expect that these additions to capacity will not take place unless industry prices reach levels to support them. These capacity additions determine minimum industry prices to provide each increment of new capacity. In an expanding demand market, capacity requirements determine minimum prices.

Withdrawal of Capacity

Of course, industry demand may be falling or low cost competitors may expand their capacity faster than demand grows. In these events, some of the industry’s currently producing capacity must close down, stop producing. Roughly speaking, there are three levels of capacity withdrawal. The withdrawals take place as industry prices fall, with the following order:

  • Reallocation: where an industry competitor shifts capacity away from the current product to other, more profitable products. In some industries, companies who face low prices or margins in one part of the market are able to shift the productive capacity to other products with better prices and margins. This decision has the effect of reducing the capacity available in the current market
  • Curtailment: where an industry competitor reduces a shift or shuts down a part of its capacity at a facility.
  • Shutdown: where an industry competitor closes down a facility.

The Company would expect that these withdrawals will not occur unless industry prices fall far enough to force them. In a Hostile market, industry prices determine the maximum industry capacity that can operate.

There are two events we see in Hostile markets that many believe would cause a withdrawal of currently producing capacity: acquisitions and industry leaders’ voluntary capacity withdrawal. Each event usually leaves more capacity producing than many assume.

An acquired facility will usually continue to produce, perhaps with a lower cash cost structure. Acquisitions in the industry combine two former rivals into one company. There is an opportunity, as a result of this combination, for the acquiring company to close the highest cost capacity of the combined companies. In practice, this rarely happens. Industry prices before the combination were already high enough to cover the cash costs of all the acquired operating facilities. After the acquisition, the acquiring company normally keeps the high cost facilities operating in order to generate more cash. Further, the formerly high cost facility may have a new lower-cash-cost level due to cost improvements the acquiring company makes, including overhead reduction. The acquired facility remains in production, often at a lower cash cost. You would normally not assume that capacity that is sold or transferred from one owner in the industry to another will be shut down. If the new owner can produce a cash return by running this recycled capacity it will normally continue to operate in the industry.

Examples of Recycling Capacity »

While it does little to reduce current capacity, an acquisition may reduce the rate of future capacity expansion. The larger combined company can absorb larger increments of capacity expansion over its larger base of customers without putting itself into overcapacity. For example, a capacity addition might have added 5% to the previous company’s capacity in an industry growing at 1% per year. The previous company requires five years of growth to absorb that incremental capacity. An acquisition which combines the company with a rival might result in a combined firm where the same increment of capacity represents only a 2% addition to the combined company’s capacity. The new combined company would absorb this capacity addition with a mere two years of market growth.

In some Hostile markets, the industry leaders may voluntarily withdraw producing capacity in order to force industry prices to rise. This move carries real risk for those industry leaders and usually fails in its mission. While more than one industry leader may withdraw some capacity, there is no market referee to ensure that all the leaders participate, and do so in proportion to their sales in the market. Some company inevitably suffers and then refuses to participate in future curtailments. More importantly, smaller companies may, and often do, refuse to curtail production at all. In fact, these companies may expand their capacities to replace the leaders’ withdrawn capacity. Then the leaders see less of a price increase than they expected and they lose market share to the smaller firms who had refused to follow the leaders’ curtailment. This is the capacity form of the Leader’s Trap.

More Future Capacity Questions…

  • If industry capacity must decrease, what opportunities (with amounts and timing) does the industry have to reduce this capacity through:
    • Reallocation: where the Company shifts capacity away from the current product to other, more profitable products.
    • Curtailment: where the Company reduces a shift or shuts down a part of its capacity at a facility
    • Shutdown: where the Company closes down a facility.
  • In what order would physical capacity be withdrawn from the industry if demand were to fall?
  • At what price would the owners of each increment of capacity be forced to withdraw it? These prices would be the minimum cash costs needed to keep the capacity operating.

Constraints on Capacity Expansion and Substitute Products

As a final step in evaluating future capacity, the Company would consider constraints on future capacity expansion and substitute products.

In estimating the future capacity for your industry you should consider constraints on the ability of current or potential competitors to expand in your industry. These constraints include legal constraints, such as patents or government regulations, and control over critical information and materials. If these constraints are effective, they tend to raise prices in the industry.

External forces, especially the availability of critical raw materials and components, may effectively reduce the entire industry’s capacity. If the industry cannot obtain sufficient raw materials to produce the product at current demand, the industry’s capacity goes into shortfall. A shortage of the supply of asphalt reduces the capacity of the residential roofing industry, which uses asphalt as a raw material. A similar capacity constraint occurs with access to critical parts and components of the final product. If the heavy equipment industry cannot obtain a sufficient supply of their specialized tires from their tire suppliers, their capacity falls short of demand. Prices rise and lead times lengthen, producing a Reprieve market.

While constraints on capacity expansion tend to raise prices, substitute products dampen price increases. As prices in the industry rise because of an increase in demand or other factors, you may have to consider the impact of substitute products entering the market and effectively adding capacity to it. These substitute products become stronger economic forces in the industry only when the industry’s prices rise relative to the substitute product or when the substitute product itself improves in such a way that it reduces customer costs faster than does the current industry product.

More Future Capacity Questions…

  • Are there legal or regulatory constraints limiting competitive expansion?
  • Does the industry have adequate access to critical raw materials and components to meet current and projected demand?
  • Are there substitute products that effectively limit the high price that the industry may charge for its products?

The Company’s expectations of future capacity is a critical component in its forecast of future prices and margins, the subject of the next section.

Basic Strategy Guide Users Return to: Step 19

Summary PointsNext: Future Prices