It’s been a long time since I’ve seen a significant company that could evidence more than a 75% utilization of productive capacity.
Due to very low or near zero interest rates and sky high liquidity, many companies struggle to reach a 50% utilization while some have entire production facilities running with utilization in the teens.
Most companies think little or nothing of these low utilization rates because the impact on interest expense and Profit is marginal. This low regard for idle capacity is a modern economic malaise that comes from distorting capital markets in order to buoy consumer spending and prop up the value of otherwise questionable assets with cheap debt.
In fact, the US Federal Reserve itself reports that average US Capacity Utilization for all major industry groups in 2015 fell to around 77%. This is lower than the average rate of utilization between 1972 and 2014, which was 80.1%. The corollary of this is that there are hundreds of billions of dollars lying idle on company balance sheets…literally doing nothing. There are additionally hundreds of billions of dollar loaded into prices through the accompanying idle Fixed Costs required to maintain idle capacity.
There is now a huge opportunity to lift capacity utilization and use the recovered capital to retire debt (or swap debt for equity), and to reduce Fixed and Variable Costs in order to lift Operating Profits.
The Fed is now going to squeeze the excess capital from the financial system, including the public balance sheet. Companies will be forced to recover idle capital as the price of debt rises and the Fed ‘normalizes’ monetary policy. Debt will be extinguished…one way or the other.
So, we can ask ourselves; How much capital is locked in a Balance Sheet if 25% of all operating assets are effectively idle? Not forgetting the Fixed Costs associated with maintaining all that idle capacity, we can also ask; What would be the impact on prices or Profit if idle assets and the associated Fixed Costs were shed?
How does one tell how much production capacity is idle?
Capital/Debt has been so cheap for so long that no company would fail to deliver goods and services for the reason of holding insufficient capacity….certainly since 2009. Buying production capacity has never been cheaper and companies have been busy buying and merging capacity through thousands of significant deals. Paring down the excess capacity acquired as a result is usually represented as a ‘future synergy’ which is never fully realized. Almost all businesses have been externally constrained by a lack of consumer demand.
However, don’t look for evidence of this excess capacity in financial statements. There is no line on the Balance Sheet titled ‘Idle Property Plant & Equipment’. There is no line on the Income Statement titled ‘Idle Fixed Costs’. There is no tag on excessive costs of labor due to chronically low efficiency and productivity outcomes.
The black magic of financial reporting is that idle Costs and Expenses relating to Property, Plant & Equipment are fully allocated to whatever units of output are generated over a reporting period…whether the assets were actually used or not.
The value of excess inventories (another form of excess production capacity) are often ‘written off’ in subsequent reporting periods by simply dumping the asset from the balance sheet and folding its cost back into the Cost of Goods (COGS) in some later reporting period. This results in utilization being overstated in one reporting period and the excess production capacity being disguised as lower Gross Margins in another reporting period.
Some Accountants will argue that the ‘Asset Turnover Ratio’ provides insight into capacity utilization. Alas, this is a ratio between the average value of Total Assets and Revenue which can be distorted by various means.
If an organization doesn’t like the sound of a big public ‘Write Off’ of inventory value, they may opt for selling the inventory for next to nothing…again, booking the fall in the Contribution Margin and lost profit to a lower Gross Margin. This way, Sales can take care of the inventory problem and production can keep generating output at a higher ‘utilization’. The consumer will gorge at lower prices.
The mechanism for obscuring excess capacity and taking losses associated with paying too much for assets, is the ‘goodwill impairment’ mechanism. This will get the capital off the balance sheet and express the loss as a non cash expense. The total value of assets is reduced, yet the idle assets remain, as do the inflated Fixed Costs. Evidence of low utilization is expunged from the Balance Sheet by reducing the value of Goodwill.
So, don’t hold your breath waiting for the CFO to come running into the CEO’s office shouting “we have to do something about our utilization problem!”
If the Accounting and Sales people don’t use price to obscure the low utilization level, it may have already been obscured by Operations when setting Efficiency Standards low in the production process or by accommodating high quality defect levels or terrible levels of downtime. Again, at the end of the reporting period, excess capacity which is masked in these ways looks like lower Gross Margins, Operating Margins and Contribution Margins. It doesn’t look like excess production capacity.
Many companies hold significant excess capacity which has accumulated over two decades of weak controls over capital spending and ubiquitous mergers and acquisitions which cumulatively build excess capacity. The irony is that low capacity utilization drives low operational performance. These two go hand in hand.
Monetary policy has fueled the creation of excess capacity and funded consumption in a variety of markets. These include the technology ‘innovation’ bubble (look at companies now struggling to make profits, including Twitter, LinkedIn, Yahoo, GoPro and Uber), the Fed balance sheet, the stock and bond markets and the commodities markets (oil, paper, edible oils and iron ore/steel to name just a few).
Would you see excess production capacity if you were looking straight at it?
Productivity Step Change (PSC) is a global Management Consulting Group based in the US dedicated to maximizing Capacity Utilization, improving Return on Invested Capital (ROIC), and increasing productivity for its clients across industry. Our enterprise-level, data-led, cross-functional business analysis typically requires 4-6 calendar weeks and is designed to provide evidence of your opportunities for overall growth. Please contact us if you would like to schedule time for a discussion and presentation.