Excess Capacity

and finance Allah shmoop How do capacity constraints work on

the bottom line All right people you're the CEO of

Little Poker is a company that makes shrimp forks You

just received an order for twenty thousand forks from a

shrimp fest in Gulf Port Mississippi Big order Big revenue

It should be time to pop the champagne and celebrate

but there's a problem You currently make forty eight thousand

forks per month and you only have capacity for fifty

thousand a month Which means that your facility working at

full speed has a limit or a constraint of fifty

thousand units that it can produce in any given month

Well we've run into a problem known as capacity constraints

You just don't have enough capacity now to fulfill the

Gulf port order in a timely fashion They want delivery

in two months and it would take you ten months

to make it the additional twenty thousand You need to

fill the order right So why not just increased capacity

Well it might not be that easy Whether you can

take the order or not depends on the specific reason

you have a cap on your production Well there are

different kinds of capacity constraints In your case Well you

don't have enough machines to make more than fifty thousand

a month If you want to expand production you'LL have

to buy some additional equipment It's very expensive solution to

the problem here Well they already be worth that additional

costs Buying those machines In other words is your bottom

line hurt or helped by an attempt to break through

your capacity constraint Well before we tackle that question directly

let's look at some other potential reasons that company's capacity

might be constrained Some situations are easier to fix than

others For instance the company might not have enough workers

will If that's the case they could just hire extra

people pay him a little bit of overtime to increase

production or they can pay a lot of overtime to

their current workers The only thing to look out for

with additional labor is whether the increased costs are going

to cut into their profit margins Bringing in additional workers

shouldn't matter The gross profit and gross margin figures already

include the cost of direct labor The new workers will

make more products The additional cost come with additional revenue

gross margins stay the same But using overtime workers that

you have to pay a lot of overtime to could

get too costly to be worth it Well since the

company would pay more per hour in the overtime shift

the gross margins for the products made during that time

would decrease On the other hand getting more use out

of the machinery and overhead means that the company is

able to leverage its operating expenses Mohr And that's a

good thing The overtime costs might hurt gross margins but

operating margins might not be impacted as much they might

even improved while based on the situation Right lot of

moving parts here another potential capacity constraints Not enough raw

materials like say you make caviar ice cream and your

supplier can't provide enough caviar to make more than ten

thousand gallons of ice cream a month That raw material

constraint limits your production will The solution here involves finding

an additional source of product or caviar The main worry

though in terms of the bottom line would be well

what if the prices for that extra caviar are really

high Getting additional raw materials might force you to tap

into a way more expensive means of obtaining them like

to get more caviar You might have to await into

expensive Russian black markets Make more than ten thousand gallons

of the caviar ice cream in the class per gallon

might actually increase We'LL all that expensive black market caviar

then you know really cuts into your profits Is it

worth it Is it worth it That's what you're asking

all the time here Or the mere fact that you

need more raw materials could drive prices higher like you're

now a big buyer a big commander of a limited

supply product More demand for the caviar consent Caviar prices

higher across the board Well if your raw materials cost

more it'LL cut into your gross margin of fact That

could make the additional production less profitable and that might

not be worth the effort Remember that's what we're asking

here Is it worth it Is it worth it Okay

back to little pokers In your case that capacity constraint

comes from limits to the output of your machinery You

have two time slapping machines These things here each one

can bust out twenty five thousand marks a month There's

nothing you can do to get them to produce Maur

If you want to increase capacity your only choice is

to buy additional machine Well the first question you have

to ask Can we fit anymore machines in the warehouse

singing here Well if the answer is no and you're

probably s out of luck if you're out of physical

space you may need then a new factory in warehouse

and laborers and all that That's an extremely expensive proposition

Buying a new factory would only make sense if you

force a long term demand well above your current capacity

If you believe that you could make and sell double

your current output for example well then maybe it be

worth it Well luckily for you you don't have to

make that choice Your chief engineer says she can move

things around toe add an additional machine She says she

can do it in such a way that you don't

have to interrupt current production to install the new machine

Right Well the big worries here one Will you have

enough sustained demand justify buying a new machine into How

will the cost of the new machine impact your real

bottom line Well the reason you're considering buying a new

machine because he received a special order from the Gulf

Port Shrimp fest Another time sliding machine cost two million

dollars If you spend that amount just to fill the

one order well then it's a money losing proposition and

or fit Say you buy the machine for two million

dollars and use it to make the additional twenty thousand

additional units It brings in ninety grand in revenue But

then the machine sits idle while you go back to

your normal production levels You lost more than one point

nine million dollars on that deal for buying that machine

that now holds coats very nicely Better to just turn

down that special order not worth it But if that

special order is a sign of long term demand for

Shrimp Fork thing is well it might be worth the

expansion You have your salespeople call around you bring in

some outside consultants who produced a lot of fancy pretty

looking charts you don't really understand but they tell you

bottom line they think there's enough demand to expand capacity

long term So you take the plunge you spend two

million dollars to buy the new machine And yes you

could have leased it for a month or two or

something like that and much higher prices But we won't

get you all complicated here That machine is enough to

increase your capacity to seventy five thousand Shrimp fork Thing

is a month You easily get the special order in

on time The customers so impressed they tell all the

other regional shrimp fest about your company You start to

get tons of orders Literally Infact you become the official

shrimp fork provider for the entire Gulf Coast Enough demand

for seventy five thousand forks a month Additional revenue of

one hundred twelve thousand five hundred dollars a month to

well you're gross Margins on the forks remain steady at

sixty five percent Meaning you bring in gross profit of

seventy three grand from that new product Well you were

able to sign a long term lease for the time

slapping machine that cost you fifty grand a month Yeah

So instead of buying in fall the capital twenty three

thousand one hundred twenty five dollars in new monthly profit

from the expansion Good for you The visitors to all

the Gulf Region Shrimp fest Get a shrimp eating experience

that's a really great and you add to your bottom 00:06:33.635 --> [endTime] line the only real losers here and the shrimp