It’s common for business owners and managers to focus on revenue and revenue growth. After all, without revenue, you have no business. And most of us don’t want a shrinking business.
But focusing too much on revenue is dangerous. If you want to build a profitable and sustainable business, you should monitor your capacity utilization as well as revenue.
Capacity utilization is simply the ratio of your capacity you are selling and delivering to your customers. The more of your capacity you use, the more profitable your company should be.
A few years ago I had a client whose capacity ranged from $2.8 million to $4.1 million in annual revenue. And they could produce either revenue amount with the same fixed cost base and only a slight difference in variable cost per unit. (So their profitability would go up significantly.)
By looking at their capacity compared to their actual revenue, they found they could increase revenue by over 62% without increasing their fixed costs.
Their plan for doing this was based on two changes:
1. Improved product mix
They increased the percentage of higher revenue and higher margin products they sold.
2. Increased pricing per unit
They maximized their pricing by selling products that were in greater demand by their customers and for which they had a competitive advantage.
They stopped focusing primarily on gross revenue and started looking at how they built their revenue.
This is important because as you grow your business you will eventually run out of capacity. But you need to know when you’ve actually run out of capacity and when you’re simply not using it well.
Because these are two vastly different situations.
For example, a company might have a growing backlog. The manager could assume this is because they have run out of capacity. So, his decision might be to borrow money and expand.
This is fine if their capacity utilization is very high and they are truly bumping up against their capacity ceiling. It probably means they are operating well so growing this model makes sense.
But if their capacity utilization is low, then a decision to invest and grow capacity could cause more trouble. It probably means they are not operating effectively as a business. So, adding capacity in this case means growing a poorly performing model.
And one simple metric can tell us the difference: Capacity utilization.