Capacity costs are expenditures made to provide a certain volume of goods or services to customers. For example, a company may operate a production line on three shifts in order to provide goods to its customers in a timely manner. Each successive shift constitutes an incremental capacity cost. If the company wishes to reduce its cost structure, it can eliminate a shift, though doing so reduces its capacity.
A wide range of costs can be included in the capacity cost concept. For example, if an organization constructs a manufacturing facility to expand its capacity, the following fixed costs will be incurred:
- Building and equipment depreciation
- Building and equipment maintenance
- Insurance on the facility and equipment
- Property taxes
- Security for the building
Capacity costs tend to be largely fixed. This means that a business must incur them even in the absence of any sales activity. Given their fixed nature, capacity costs will increase the risk that a business will generate losses during a sales decline. Consequently, it is common for businesses to pare back their capacity levels during business cycle downturns, which may involve shuttering facilities.
It is possible to largely eliminate capacity costs by shifting work to third parties. However, the result is usually a higher cost per unit produced, since these third parties will include an overhead charge in their pricing. Also, the increased variable cost charged by third parties tends to reduce the overall profit earned by a business.
Another option is to cut back on capacity and also raise product prices. This combination reduces customer demand to match the reduced capacity level, while potentially enhancing company profits. However, this approach only works when customers are relatively insensitive to price increases, which is more likely to be the case if a company has strong product brands that customers perceive as having great value.