“We have plenty of capacity”. We hear that a lot in meeting prospective clients. Plenty of capacity usually means plenty of manufacturing capacity. If your top line is flat, you have a sales capacity situation. If managing the manufacturing capacity you have is troublesome, you may have a shortage of management capacity or systems capacity. Simply stated, having plenty of capacity means you are growing almost untethered!
Capacity has a massive impact on business valuation. While the results of unmanaged capacity show up in other places (like labor cost, asset utilization, sales growth through meeting service proposition), many businesses do not thoroughly measure capacity throughout the entire operation. Manufacturing capacity is only effective if you have enough capacity in your supply chain, systems, management, sales organization… You must have capacity that supports your strategic plan. You must understand the cost of capacity and the cost of being short of capacity. And you must understand the capacity cycle and its impact on enterprise value.
We use a simple graph to explain the basics of the capacity cycle. This graph is indicative of the capacity cycle in a particular manufacturing cell or line, an entire department, a plant, or an entire business. Within each of the layers of hierarchy, the given capacity is that of the constraint of that level. So, a plant that manufactures painted widgets may be able to paint 700 per hour but can only manufacture 400. That plant’s capacity is 400 units. We believe any level should have some protective capacity above that of the constraint. Managed protective capacity is cheaper and yields better total capacity than a balanced system, but that is another topic.
Our view of capacity is that any stated level is a range. For our painted widget plant, an eight-hour day yields 400 units. We could add an hour of overtime to get to 453 (paid breaks, so 7.5 productive hours in 8). A ten-hour day would yield over 500. But how long can you work your employees 50 hours without increasing the risk of injury or burnout? We could drop to 7 hours and get ~350 units. But the model for this business was designed to work 40-48 hours per week. To get more than that, we need to add a shift, add equipment, etc.
When new capacity is added, it is normally a step. In our painted widget plant, we can add a new widget manufacturing line. We move from about 480 units per day to 800, but the plant’s capacity is still 700 units, assuming they are all painted. Now we must add some paint capacity. Short term, we can move our paint line up to run some overtime. But each manufacturing line is now limited by paint capacity. While there are a lot of solutions here, we want to keep the conversation set on organizational capacity and the impact on enterprise value.
We have determined that capacity limits our ability to grow top line. We have determined that short-term increases are possible but can get expensive quickly. We know that adding fixed assets is expensive and can heavily impact many of the ratios used in valuing a company. And we have demonstrated how additional capacity is not linear but stepped as new capacity is brought online.
In our years of working with portfolio companies pre- and post-deal, we have found the below graph to be instrumental in simplifying the relationship between capacity and enterprise value.
While demand is not linear in more traditional businesses, with the onset of direct-to-consumer sales and other low-density sales many businesses have seen their demand curve become almost perfectly linear. If you can produce and ship one more unit, you can sell it. But for the purposes of this discussion, we will assume it to be linear.
As demand increases, any growth-minded business will try and fill that demand if the price is right. Depending on where a business is in its capacity cycle, that may not be a great approach. If early in the cycle, the business has added capacity that is not consumed yet. There is underutilized capacity that has increased fixed costs. Any unit that consumes that capacity has little incremental cost limited to what is traditionally referred to as variable cost.
But once that capacity is filled, the math changes. For additional sales, we have to determine if the incremental revenue of each unit is enough to cover the cost of being over-capacity. Each unit produced above capacity is costing overtime, increasing risk of burnout and injury, adding to management load, maybe even wearing out equipment faster and putting additional stress on maintenance. Again, if the overtime is reasonable, it is often a good decision, to a point.
But once you are outside that band of capacity, you risk major expense from running that way. If our painted widget plant needs 600 units per day, working 12-hour days indefinitely will eventually lead to failure. In the meantime, our labor expense is growing rapidly with all the overtime and our effective production rate is dropping.
Matched capacity is an academic target. If we could have perfectly variable capacity, we would match capacity to demand. That capacity would have to be as flexible as our demand, adding and shedding as our daily demand fluctuates. But, matching capacity to demand doesn’t work in most businesses. The first rush order means we are overconsumed. Disruptions in supply chain or worker illness throws us out of balance.
There is, however, a sweet spot. That sweet spot is a business running near capacity, but with some protective capacity to handle typical disruptions. It is where a company has the lowest per unit fixed costs, the ability to protect the hard-won reputation for meeting service proposition, some flexibility in near-term plans for changing out low-profit customers for ones with better pricing.
The sweet spot is where costs are the lowest per unit and volume is as high as practical before the next step of capacity is added starting the capacity cycle over again. The sweet spot happens by accident sometimes. And if so, is usually not recognized until the business is over-capacity. Contrary to the old cliché, it is not a good problem to have.
The key to maximizing enterprise value through capacity is to create your strategy to get into the sweet spot. We have gotten several companies there. With the EBITDA of a well-run, growing (top and bottom line) company and the multiples commanded by predictable financials, documented high performance, praiseworthy adherence to service proposition and a confident management group, enterprise values can be incredible. When potential buyers are looking at capacity, they have some room to grow before being oversold. But they also can see how well the business performs at its current capacity. This leaves both strategic and financial investors with some flexibility in their integrations. It is a deal that leaves many willing to bid up the price.
Capacity is not an operations-only problem. Capacity planning is a vital part of any strategic plan. Sales, supply chain, human resources, management, manufacturing…each has demands that need to be met with capacity.
Title 2 Business Services members have been working with clients for over 20 years to build capacity plans and implement them. We have saved clients from expanding prematurely by optimizing facilities for more capacity. We have helped clients roll capacity planning into their strategies and turnaround plans. We have dramatically increased capacity in businesses by adding small amounts of capacity to critical areas of a business. Contact us to find out more about how we can help your business with capacity and strategic planning.