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

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.