Capacity costs, often referred to as fixed costs, encompass the expenditures necessary for a business to sustain its production capability, irrespective of the actual output or production volume. These expenses persist even in periods of zero production, as they pertain to essential infrastructure, facilities, and resources essential for maintaining production potential.
Capacity costs refer to the expenditures a business incurs to ensure it can produce a specified volume of goods or services for its customers. For instance, operating a production line across multiple shifts to meet customer demand increases capacity costs incrementally with each additional shift. Reducing the number of shifts can decrease a company's cost structure but also diminish its overall capacity.
Various costs are encompassed within the concept of capacity costs. For instance, the expenses related to constructing a manufacturing facility—such as depreciation and maintenance of buildings and equipment, facility and equipment insurance, property taxes, building security, and utilities—are all part of capacity costs.
Capacity costs are predominantly fixed, implying that they are incurred regardless of sales volume. Their fixed nature increases the risk of losses during periods of sales decline. To mitigate this risk, businesses often reduce their capacity levels in response to downturns in the business cycle, potentially involving facility closures. Capacity requirements planning is a strategic approach used to determine optimal capacity levels based on various sales and product mix scenarios.
Outsourcing work to third parties is one strategy for significantly reducing capacity costs, albeit with a likely increase in the cost per unit due to third-party overhead charges. This approach generally results in a higher variable cost and potentially lower overall profits. Another strategy involves reducing capacity while simultaneously increasing product prices to align customer demand with the new, lower capacity level, thereby potentially boosting profits. This method is most effective when the market is less sensitive to price increases, often due to strong brand loyalty and perceived product value.
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