Corporate Finance & Accounting

Overcapacity

What is overcapacity?

Overcapacity is a condition that occurs when the demand for a product is less than the amount of product a business can possibly supply to the market. Overcapacity occurs when a company produces at a scale that is lower than its designed output.

The term overcapacity is often used in manufacturing. If you see idle workers at a production plant, it probably means the plant is overcapacity. However, excess capacity may also apply to services. For example, in the restaurant industry, there are establishments where tables remain empty for long periods of time and employees appear inefficient. This inefficiency indicates that the venue can accommodate more guests, but the demand for the restaurant does not equal its capacity.

key takeaways

  • Overcapacity occurs when market demand for a product is less than the amount a company can possibly supply.
  • The term overcapacity is primarily associated with manufacturing, but is also used in services.
  • Excess capacity can indicate healthy growth, but too much excess capacity can damage the economy.

What causes excess capacity?

Some of the factors that can lead to excess capacity include over-investment, suppressed demand, technological progress, and external shocks (such as the financial crisis). Overcapacity can also stem from mispredictions of the market or inefficient allocation of resources. To stay healthy and financially balanced, a company’s management needs to align with supply and demand realities.

Why is overcapacity important?

While excess capacity can portend healthy growth, too much excess capacity can damage the economy. If a company cannot sell a product at or above its cost of production, the company may lose money by selling the product for less than it was produced, or the product may simply be sitting on a shelf.

If a company needs to close factories because of excess capacity, it will lose jobs and waste resources.

Companies with excess capacity can lose significant amounts of money if they are unable to pay the high fixed costs associated with production. On the other hand, excess capacity can benefit consumers as companies can use their excess capacity to offer customers special discounts.

As part of a competitive strategy, a company may also choose to deliberately maintain excess capacity in order to prevent or prevent new companies from entering its market.

Example of excess capacity: China

Since 2009, China’s economy has fallen into the third round of overcapacity. Early periods of overcapacity occurred between 1998 and 2001, and again between 2003 and 2006.Although China became the world’s second largest economy in 2010, it still faces internal and external economic challenges. Overcapacity in China’s manufacturing sector, including steel, cement, aluminum, flat glass, and especially automobiles, is one of its biggest challenges.

Overcapacity = potential output – actual output

China’s overcapacity remains rampant

The Chinese government has taken many steps to address this problem, but it continues. In industrial economies, excess capacity is usually a short-term condition that can self-correct.

However, the severity and persistence of China’s manufacturing overcapacity shows that there are deeper and more fundamental problems in the Chinese economy. These issues also have major implications for international trade, given China’s growing influence in global markets.

Overcapacity in China’s auto market

Often, car assembly plants have large fixed costs. In addition, most new factories in China rely on economic incentives from local governments, so there is pressure to keep factories open and employees employed — whether or not they can sell excess output. Plus, all those extra cars need to find a home, which could mean price wars and lower profits in China’s domestic market, as well as massive exports to the U.S. and elsewhere. That’s not good news for companies like General Motors (GM), which are now generating significant sales and earnings from China.

How long can it last?

One problem is that there is no incentive to remove excess capacity from the Chinese market. No one wants to close a relatively new factory in China and risk harsh criticism from the local government. Moreover, nearly two decades later, China’s overcapacity trend seems unlikely to abate anytime soon.

Then came COVID-19

The coronavirus (COVID-19) has hit the auto industry hard. During the outbreak, car sales in China fell by more than 80% in February 2020. But with more than 80 percent of the world’s auto supply chain connected to China, production shortages caused by disruptions to China’s auto industry have affected automakers around the world. Most of the world’s automotive and related companies believe that the COVID-19 pandemic will have a direct impact on their 2020 revenue.

Since COVID-19 originated in China, China may also start recovering from the pandemic earlier than Europe and North America. However, it is too early to determine not only what the long-term economic impact of COVID-19 will be, but also how much this latest setback will affect China’s historically troubled relationship with excess capacity.

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