69-Industry Capacity Expansion Despite Overcapacity

Over the years, I have had several senior managers ask me: “When will these stupid competitors stop adding capacity in this lousy market we face?” The answer is usually “not soon” and “maybe never.” Industry capacity reduction does not end a Hostile market in overcapacity. Here is an explanation why and an illustration of this phenomenon.

Posted 12/29/08

The global automobile industry is in world-wide overcapacity. In 2006, the industry had the capacity to build 80 million vehicles. It produced just under 65 million vehicles that year. The industry breaks even on factory output at about an 80% utilization ratio, roughly where the industry was in 2006. And with demand falling globally by 3% or so in 2008, you would think that the industry would not be adding capacity, but it is. Capacity is increasing rapidly. By 2011, the global auto industry is likely to be able to produce 100 million vehicles in a year.

Why would this be happening? There are three reasons that capacity might expand in an industry despite overcapacity. The first reason is that some geographic segments are growing faster than average. India and China, in particular, are growing faster than the average world-wide demand and will add capacity to meet local needs. (See the Symptom & Implication, “Both new entrants as well as existing competitors have added capacity” on StrategyStreet.com.) Second, some industry competitors can afford to add capacity under the pricing umbrella of other competitors. This is going on today in North America. Honda is just opening a new assembly plant in Indiana. Honda is operating under the pricing umbrella set by the UAW and its big three auto plants. Third, virtually all industries see capacity expansion through what we call the “learning curve” effect. A plant in operation can become more productive each year simply by learning to do things more efficiently. This increase in productivity causes the plant capacity and, therefore, the industry capacity to increase.

We have studied over fifty industries in overcapacity. In each of those industries where we had the opportunity to measure plant productivity, capacity increased every year due to the “learning curve” effect. This effect works even in slow-growing industries, such as newsprint. Its effect on capacity grows as the pace of growth in the industry increases. A high-tech plant would have a greater growth in productivity and capacity from the “learning curve” effect than would a newsprint facility.

Industries that appear to be in severe overcapacity may still be adding capacity. This growth in capacity adds to the pressure on industry prices and margins. It prolongs the industry’s pain from overcapacity. (See the Symptom & Implication, “The company believes the industry will be more diplomatic about adding capacity” on StrategyStreet.com.)

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Update 2022:

2019 was the last normal year before Covid for light vehicle worldwide production. The industry was shrinking at about 2% a year in total production in 2019. Still, the industry continued to add capacity despite the fact that it was already in overcapacity.  2019 saw 50 new light vehicle plants opened compared to 14 plant closures, for a net increase of 36 new plants. This brings the total to 758 light vehicle plants worldwide. 2019 added 3.6 million units of new capacity on top of the already existing 45 million units of idle capacity. This produces a plant utilization ratio of 63%. Most of the new capacity went to China where the rate of capacity expansion was running at more than twice the pace of market growth. Other regions witnessing significant plant capacity expansion include the US, India and Mexico.

The light vehicle industry continues to add capacity, even the most expensive form of capacity, greenfield capacity. In addition to this new greenfield capacity coming on stream, it is likely that the industry’s existing plants are becoming more productive every year. This is a form of capacity addition we call “capacity creep”.  This latter form of capacity addition occurs in virtually all markets, even the most hostile. See HERE for descriptions of alternatives to add capacity and their implications for industry margins.

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Update 2/26

The profit pressure is sure to continue on the industry’s marginal production plants. The light vehicle manufacturing market has continued to add capacity somewhat faster than the market demand has grown. The drivers of this capacity addition have been China, India and worldwide investments in electric vehicle production.

The sources for the following estimates are varied. Please view them as directional rather than specific and highly accurate.

By 2024, the industry had not recovered from its Covid shakeup. Before Covid struck, the industry was producing more units than it did in 2024. 2024’s total light vehicle production came in at something over 79 units worldwide.

The worldwide light vehicle manufacturing industry comprises 900 plants and roughly 115 million units of capacity. The industry’s implied average capacity utilization ratio was just under 70%, high enough for the better manufacturers to make a decent return on investment.

The industry continues to add bricks and mortar capacity, especially due to particularly strong regions and the advent of electric vehicles. The regions of China and South Asia (including India) along with the investments required to develop and produce electric vehicles drove most of the industry’s bricks and mortar capacity expansion. From 2019 through 2024, China added 10 million units of new or upgraded capacity. South Asia added 4 million units, while North America added 3 million. Europe’s light vehicle productive capacity shrank by roughly 2 million units. Overall, the industry added about 15 million units during that time.

Of course, the industry also added hidden capacity in the form of the learning curve effect, which we have called capacity creep. Plants become more productive year-by-year as they fine tune their operations. A rough estimate of capacity added to the industry by capacity creep calculates that the industry adds 1.5 to 1.75% to each year’s capacity.

The industry continues to be challenging for even the good producers. That does not promise to change soon. The biggest producers do not show signs of easing up their capacity additions anytime soon. As in most industries facing Hostility, demand growth is the exit ramp.

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