The capacity utilization rate is the proportion of the production capacity of a business or economy that is currently in use. For example, when an organization has a capacity utilization rate of 80%, it means that the firm is currently operating at 80% of its theoretical capacity. The concept can be misleading from several perspectives. First, a firm should only produce as many products as are immediately needed; any additional use of capacity is only going to result in unneeded products that will be stored as inventory, resulting in unnecessary inventory holding costs and the risk of obsolete inventory. Second, the measure is based on a theoretical capacity level that is unsustainable over the long term, since downtime is needed for repairs and maintenance.
A better view of the capacity utilization rate is to focus it solely on the bottleneck operation of a business. The firm cannot generate any additional throughput unless this one operation is properly managed to achieve the highest possible utilization rate. Focusing on the capacity utilization of any other work center in a business is actually counterproductive, since doing so creates an inherent incentive to increase its usage, even when it is not necessary to do so.
When viewed from the perspective of an entire economy, the capacity utilization rate measures the potential amount of slack in the economy. When the utilization rate is low, it implies that the economy can easily absorb significant increases in growth. The economy must grow enough to absorb this slack before there is any incentive for capital investments to be made.