Capacity utilization? Isn’t that the province of the production scheduling crew, and what could that possibly have to do with the duties of a controller? This post reviews the reasons why paying proper attention to capacity utilization has a very direct impact on both profits and cash flow, both of which are primary responsibilities of the modern controller.
Capacity is made up of either human or machine resources. If those resources are not used to a sufficient degree, there are immediate grounds for eliminating them, either by a layoff [in the case of human capacity] or selling equipment [in the case of machines]:
- In the first case, a layoff usually has a short-term loss associated with it, which covers severance costs, followed by an upturn in profits, since there is no longer a long-term obligation to pay salaries.
- In the second case, the sale of a machine does not have much of an impact on profits, unless there is a gain or loss on sale of the asset, but it will result in an improvement in cash flow as sale proceeds come in; these funds can be used for a variety of purposes to increase corporate value, such as reinvestment in new machines, a loan payoff, a buyback of equity, and so on.
Consequently, a controller who keeps a close eye on capacity levels throughout a company, and who makes recommendations to keep capacity utilization close to current capacity levels, will have a significant impact on both profits and cash flows.
When making such analyses, the main issue to be aware of is that controllers tend to be conservative—they want to maximize the use of current capacity and get rid of everything not being used. This may not be a good thing when activity levels are projected to increase markedly in the near term. If management had followed a controller’s recommendation to eliminate excess capacity just prior to a large increase in production volumes, it would require some exceptional scrambling, possibly at high cost, to bring the newly necessary capacity back in house. This would probably result in a major drop in management confidence in the controller, and correspondingly less attention paid to future recommendations of any kind. Consequently, a controller must work with the sales staff to determine future sales [and therefore production] trends before recommending any cuts in capacity.
Capacity utilization also reveals the specific spots in a production process in which work is being held up. These bottleneck operations prevent a production line from attaining its true potential amount of revenue production.
A controller can use information about bottlenecks in two ways. One is to recommend improvements to bottleneck operations in order to increase the potential amount of revenue generation. The other is to point out that any capital improvements to other segments of a production operation are essentially a waste of money [from the perspective of increasing the flow of production], since all production is still going to create a logjam in front of the bottleneck operation. Of course, there may be other valid reasons for improving a non-bottleneck operation, such as using automation to eliminate direct labor costs, but at least any projects based on a proposed improvement in production flow through non-bottleneck operations could be canceled to save cash.
Another useful way for a controller to use capacity utilization information is in the determination of pricing levels. For example: if a company has a large amount of surplus excess capacity and does not intend to sell it off in the near term, it makes sense [and cents] to offer pricing deals on incremental sales that result in only small margins. This is because there is no other use for the equipment or production personnel. If low-margin jobs are not produced, the only alternative is no jobs at all, for which there is no margin at all.
However, if a controller knows that a production facility is running at maximum capacity, it is time to be choosy on incremental sales, so that only those sales involving large margins are accepted. It may also be possible to stop taking orders for low-margin products in the future, thereby flushing low-margin products out of the current production mix, in favor of newer, higher-margin sales. Although a highly profitable approach, this can also irritate customers who are faced with “take it or leave it” answers by a company that refuses new orders unless higher prices are accepted by the customer. Consequently, incremental pricing for new sales is closely tied not only to how much production capacity a company has left, but also to its long-term strategy for how it wants to treat its customers.
A final area in which capacity analysis can be used to alter profit levels is in mergers and acquisitions. If an acquisition team is looking at buying another company, but can justify it only if there are significant synergies [a rare occurrence], then a hard look at the target company’s capacity utilization may provide the needed profit increase. For example, if the target organization has a large amount of excess capacity, the acquiring company can assume that a large part of the excess equipment or production lines can be sold off, thereby garnering additional cash flow.
Another approach is to purchase a company in order to make immediate use of its excess capacity. For example: if a company has acquired new customers but does not expect to have the capacity on hand to service those customers for a long time [perhaps delayed by a long backlog at an equipment manufacturer or tight local labor markets], it can buy a competitor solely on the grounds that it needs that company’s capacity. This approach has the added benefit of allowing a company to closely review the product margins on sales by both companies, eliminate those customers yielding meager profit margins, and keep the remaining high-margin accounts from both organizations, along with a repositioning of the needed capacity to match the requirements of these most desirable customers.
Yet another reason for using capacity as the focus of a merger or acquisition is that building the needed capacity from scratch may be more expensive than acquiring a company that already has not only the facilities but also the expertise to run them. For all of these reasons, capacity utilization analysis should be a key part of any merger or acquisition strategy.
This post has revealed that a controller should be deeply interested in capacity utilization analysis, because it affects gross margins, profits, and cash flows, and can even justify the purchase of or merger with another company.
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