Chapter 15: Capacity Expansion
Summary by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
Chapter 15: Capacity Expansion p. 324
Capacity expansion is a major strategic decision because of the capital required, and the complexity of the analysis. The question is how to add the capacity needed to support the firm's objectives without creating overcapacity in the industry. The purpose of this chapter is to examine the elements of the expansion decision, the causes of, and preventive approaches to overexpansion, and finally, various preemptive strategies for capacity expansion.
Elements of the Capacity Expansion Decision p. 325
The capacity expansion decision is presented as a capital budgeting decision in finance and accounting textbooks. However, the underlying complexity of the decision to expand capacity is not the financial analysis, or simple discounted cash flow calculation. The essence of the capacity decision is the underlying uncertainty, and the interactive forecasts, predictions, and estimates that go into the modeling process. The steps in this process are illustrated in the adaptation of Porter's Figure 15-1.
The first step is to determine the realistic options related to the size and nature of the expansion including the degree of vertical integration.
The next steps include making predictions about future demand, input costs, and the technology involved. Predictions about future technology are important because of the possibility of obsolescence. The scenario approach described in Chapter 10 can be used as a way of coping with the uncertainty related to these predictions.
Forecasting the capacity expansions of competitors requires all of the techniques discussed in Chapter's 3, 4, and 5, and involves an iterative process because the behavior of each competitor influences the behavior of other competitors.
Adding all competitors' expected capacity additions provides the industry's capacity. This prediction of industry capacity is compared with expected industry demand to estimate industry prices, costs, and cash flows from the investment.
The last step is to scrutinize the entire process for inconsistencies. Although there is a lot of uncertainty involved, the capacity modeling process can provide considerable insight about the industry's future, and how it can be influenced to improve the firm's competitive position.
Causes of Overbuilding Capacity p. 328
Overcapacity is a problem in many industries, particularly in commodity businesses where demand is generally cyclical, and products are not differentiated. Conditions that lead to overbuilding capacity in all industries include the following:
Technological p. 326
Adding Capacity in Large Lumps - The necessity to add capacity in large units increases the potential for overcapacity.
Economies of Scale or a Significant Learning Curve - The cost advantage obtained by firm's that add capacity early will motivate other firms to add capacity.
Long Lead Times in Adding Capacity - Long lead times penalize the firms that are left behind and motivates them to add more capacity.
Increased Minimum Efficient Scale - As larger size plants are built, the minimum efficient size plant increases to motivate firms to keep building larger capacity. (See my description of Economies of Scale).
Changes in Production Technology - New production technology attracts investment in new plant capacity, but the older facilities tend to remain in service because of exit barriers.
Structural p. 330
Significant Exit Barriers - Exit barriers tend to keep excess capacity in an industry regardless of the reason for its existence.
Forcing by Suppliers - Behavior by suppliers can force overcapacity on to customers through subsidies, easy financing, and price cuts.
Building Credibility - Overcapacity is sometimes needed in industries to motivate buyers to switch to a new product when buyers believe they would otherwise be vulnerable to a few suppliers.
Integrated Competitors - If competitors are integrated (downstream or upstream) there will be pressure on them to build capacity to protect these operations.
Capacity Share Affects Demand - In some industries (e.g., airline), the firm with the most capacity may get more than its proportionate share of business. The desire for capacity leadership promotes overcapacity.
Age and Type of Capacity Affects Demand - In some industries (e.g., fast-food) the newest, most modern food service outlet may get the most business. This adds pressure to build new capacity.
Competitive p. 331
Large Number of Firms - Many large firms who are all trying to gain market position and preempt the market contributes to the overcapacity problem.
Lack of Credible Market Leader(s) - A strong market leader, or group of leaders may be able to manage an orderly expansion. Lack of leadership adds to the instability of capacity building.
New Entry - New firms that enter the industry, particularly in industries with low entry barriers add to the problem of overcapacity.
First Mover Advantages - Advantages from adding capacity early (e.g., short lead times) motivates firms to build more capacity when future prospects appear favorable.
Information Flow p. 332
Inflation of Future Expectations - The tendency to be optimistic along with overinflated demand expectations promotes overexpansion.
Divergent Assumptions or Perceptions - Misestimates and perceptions related to competitors strengths may lead to over building capacity.
Breakdown of Market Signaling - Signals that are credible promote orderly expansion, while distrust of market signals causes instability in the process.
Structural Change - Changes in the structure of the industry can promote over building because firms need to invest in new types of capacity or misestimate their relative position.
Financial Community Pressure - Security analysts may put pressure on firms to expand by asking questions related to competitors' expansions. Questions about the firm's position tend to cause managers to respond with positive statements.
Managerial p. 333
Production Orientation of Management - The tendency to overbuild is greater where management is oriented towards production, rather than finance or marketing.
Asymmetric Aversion to Risk - The cost to the firm that is left behind because of a lack of capacity is greater than the cost of overbuilding capacity.
Governmental p. 334
Perverse Tax Incentives - Tax incentives that tax uninvested profits, or that allow tax-free retention of earnings by U.S. subsidiaries can encourage overinvestment.
Desire for Indigenous Industry - Where the minimum efficient scale is large relative to the world market, the desire by many countries to establish a position in an industry will lead to overcapacity.
Pressure to Increase or Maintain Employment - Governments may pressure firms to invest in capacity expansion to add jobs and reduce unemployment.
Limits to Capacity Expansion p. 334
Some checks on capacity expansion include: financing constraints, a desire to diversify rather than continue to invest in a single industry, a change in management who see things differently, additional cost of new capacity such as pollution control, uncertainly about the future, and previous problems in the industry related to overcapacity such as poor earnings.
Some firms may discourage expansion in various ways. For example they may announce a large addition, or release discouraging messages about future demand, or predict technological obsolescence of the current capacity in the industry.
Preemptive Strategies p. 335
A preemptive strategy involves an attempt to lock up a major share of the industry market to discourage entry or expansion by competitors. The early commitment of resources required and the disastrous warfare that may result if it doesn't work makes it a risky strategy. Certain conditions must be present for a preemptive strategy to be successful.
Large Capacity Expansion Relative to Expected Market Size
The firm initiating a preemptive strategy must add a large amount of capacity relative to the expected size of the market, and either be confident that competitors believe that their own expansion would not be beneficial, or make it known to competitors that the firm will quickly add more capacity if future demand exceeds expectations.
Large Economies of Scale Relative to Total Market Demand or Significant Experience Curve
The firm initiating a preemptive strategy may gain a significant cost advantage if economies of scale are obtained by their initial investment that are unattainable by firms entering or adding capacity later. For example, the unit cost of the preemptive firm (CP) may be well below the unit cost that could be obtained by any firm left with the residual demand (CR). See the adaption of Porter's Figure 15-2. The firm pursuing a preemptive strategy might obtain a similar cost advantage from a significant experience curve.
Credibility of Preempting Firm
A firm pursuing a preemptive strategy must show the commitment, resources, technological capacity etc. to be a credible preempting firm.
Ability to Signal Preemptive Motive before Competitors Act
The firm must act on a preemptive strategy before other firms consider adding capacity, and/or credibly communicate its intentions to prevent other firms from expanding.
Willingness of Competitors to Back Down
Competitors must be willing to back off. Certain types of firms might not back down. These include competitors with a historical or emotional attachment to the industry, competitors that need a position in the industry as part of an overall strategy, or competitors that have equal strength, a longer time horizon, or a reason to trade profits for a market position.
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