Capacity Utilization Rate

Capacity Utilization Rate

The capacity utilization rate, also known as the capacity utilization ratio, is a percentage-based ratio that applies to the actual productivity of a business or country. It specifically references the ratio between true output – what is actually produced, and potential output – what could be produced. In the United States, the overall capacity utilization rate is used as an economic indicator that the Federal Reserve publishes on a monthly basis and factors into its decisions regarding interest rates and whether or not they should be cut or increased. The capacity utilization ratio is also a useful indicator in predicting the rate of inflation.

On a more direct level, capacity utilization rates can be calculated by industry or sector as well as by individual business. By making note and graphing the capacity utilization rates of major industries, economists can gather cursory clues about how stressors on inflation and long-term interest rates will increase. These rates can further be used to give indications regarding whether or not the stock market will rise or fall.

The capacity utilization rate formula is expressed as a percentage and looks like this:

OR = (AO – PO)/PO x 100

OR is the operating rate. AO is Actual Output and PO is potential output. The final number is a percentage of the potential output of 100%.

In general, maximum actual output of a company is always going to be less than 100% due to the actual resources it possesses, human factors including employee output, machinery limitations and maintenance. A simplistic capacity utilization rate example would look something like this: XYZ Corp. makes widgets. Their machinery and the number of employees they have can potentially create 10,000 widgets over three, eight-hour shifts. However, their actual output is 7,900 widgets over those same three shifts. Using the formula, 7,900 – 10,000/10,000 x 100 = -21. Taken from 100%, the capacity utilization rate calculation of XYZ Corp. is 79%.

Capacity utilization ratios are also a quantitative way to estimate the gross domestic product of a country. However, there are times when specific categories might be dismissed. For instance, whenever a particular sector experiences an extreme change in its capacity utilization rate, economic analysts may eliminate that specific area of industrial production. A good example of this might be during a year that experiences unusually high temperatures that cause a summer drought. Water use may increase above the average that is usually associated with a particular geographical area. Because of the extreme change in average water use, this particular sector’s impact may need to be tempered or eliminated by economists to get a more accurate ratio.

One final thing to note is that capacity utilization rates that always come in above the normal trend can be considered inflationary. If this is the case in the U.S., the Federal Reserve may decide to raise short-term rates. On the opposite end of that spectrum, if a particular utilization rate or set of rates is below the average, the Fed may choose to lower rates.