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How Economically Significant Are Unused Capacity Costs? A Large-Scale Empirical Analysis

Author

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  • Merle Ederhof

    (Graduate School of Business and School of Medicine, Stanford University, Stanford, California 94305)

  • Venky Nagar

    (Ross School of Business, University of Michigan, Ann Arbor, Michigan 48109)

  • Madhav Rajan

    (Booth School of Business, University of Chicago, Chicago, Illinois 60637)

Abstract

This study uses a confidential Census sample of 151,900 U.S. manufacturing plant-years from 1974 to 2011 to investigate the impact of excluding the cost of unused capacity from key financial indicators, namely, product costs and gross margins. We estimate the magnitude of unused capacity cost as a percentage of sales to be about 4.8%, which for Compustat manufacturing firms in 2011 amounts to $142 billion (by comparison, the well-researched topic of research and development expenses totals to $223 billion). We find that excluding the cost of unused capacity decreases product costs by approximately 6% and increases gross margins by around 26%. These magnitudes are economically significant and pervasive across industries and over time. Excluding the cost of unused capacity also smooths the time-series variation in unitized product costs and gross margins, with the standard deviation of gross margins declining (significantly) by 5%. Additional analyses indicate the presence of congestion and other costs at high capacity utilization levels, as predicted by the operations literature. This paper was accepted by Suraj Srinivasan, accounting.

Suggested Citation

  • Merle Ederhof & Venky Nagar & Madhav Rajan, 2021. "How Economically Significant Are Unused Capacity Costs? A Large-Scale Empirical Analysis," Management Science, INFORMS, vol. 67(3), pages 1956-1974, March.
    • Handle: RePEc:inm:ormnsc:v:67:y:2021:i:3:p:1956-1974
    DOI: 10.1287/mnsc.2019.3502
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    References listed on IDEAS

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