Page 165 - Operations Strategy

140 CHAPTER 4 • CAPACiTy sTRATEgy

example Why industries have more capacity than they need 5

There are few industries where the total demand for products and services matches the cumula-
tive capacity of all the firms in the industry. In many industries, capacity far exceeds demand.
The automotive, computer chips, steel, chemicals, oil and hotel industries all have significant
over-capacity because of over-investment and/or a collapse in demand. Take the automo-
bile industry, for example. One estimate claimed that the industry worldwide was wasting
$70 billion a year because of over-capacity. By the year 2000 around 30 per cent of all car-making
capacity was unused. The lost profit amounted to around $2,000 per car, which is more than the
combined industry profits worldwide. This is partly bad news for those firms with the higher
level of over-capacity because most car plants can only make significant profits when operat-
ing at over 80 per cent of capacity. However, over-capacity may not be viewed with too much
alarm. Many of the well-known Western hotel chains in Asia, such as Westin and Sheraton, do
not own the properties but confine themselves to managing them. The owners may be local
property developers or business people who invested for prestige or tax purposes. Many of the
management contracts of this type, put together in the boom times, included fees based on a
percentage of total revenue as well as a percentage of gross operating profits. So, even with no
profit, the management company could make healthy returns. By contrast, other hotel chains,
such as Shangri-La Asia, Mandarin-Oriental and Peninsular Hotels, both owned and managed
their hotels. Because of this they were far more exposed to the consequences of over-capacity
because it hit profits directly.
So why do companies invest, even when there is a high risk of industry over-capacity and
thus under-utilised operations? One reason, of course, is optimistic forecasting. The risks of
mis-forecasting are high, especially when there is a long gap between deciding to build extra
capacity and the capacity coming on-stream. A second reason is that all capacity is not the
same. Newer operations are generally more efficient and may have other operations advan-
tages compared to older operations using less state-of-the-art technologies. Thus, there is
always the chance that a new operation coming on-stream will attract business at the expense
of older capacity. A third reason is that individual firms usually make investment decisions,
whereas industry over-capacity is a result of all their decisions taken together. So a firm might
be able to reduce its costs by investing in new capacity but the prices it receives for its prod-
ucts and services are partly determined by the cumulative decisions of its competitors. This
also explains why it is not always easy to reduce over-capacity in an industry. Often it is in
nobody’s interest to be the first mover to shut down capacity. Its owner pays the costs of clos-
ing down capacity. The benefits, however, in terms of higher prices and margins, are spread
across the industry as a whole. So every firm wants capacity to be reduced as long as it is not
its own capacity.

Balancing capacity change
During 2006 the price of oil (and therefore gasoline) shot up to unprecedented levels
(in dollar terms). Why was this? Well, there was uncertainty in the supply of crude
oil and demand from developing economies was growing, but the reason that these
elements of supply and market uncertainty had such a dramatic effect was because
there was a shortage of refining capacity. The oil companies had failed to plan for suf-
ficient refinery capacity and the bottleneck in the supply chain had increased the fear
of shortages. So, planning for capacity change must take into account that the lowest
capacity, or ‘bottleneck’, part of the chain will limit the capacity of a whole chain of

M04 Operations Strategy 62492.indd 140 02/03/2017 13:02