Why Capacity Utilization Rates are Key to Understanding Profitability

Capacity utilization rates are a great way to understand the efficiency and productivity of a project or workplace. Understanding how much of your potential capacity you are using is key to evaluating the profitability of your business.  

Whether it’s monitoring physical output or employee productivity, tracking capacity utilization is vital for pinpointing opportunities to improve performance and grow your bottom line. 

What is capacity utilization?

Capacity is the maximum amount of something that can be produced, contained, stored, or accommodated. In business, capacity can refer to any asset associated with creating products or services. 

It can be a measure of production facilities and machinery (i.e., how many products can a plant output in a day, week, or month?) Or, it can assess employee capacity (i.e., how many labor hours does your team have available to work on billable projects?) 

Capacity utilization determines the percentage of capacity that is being used over a set period. By monitoring capacity utilization, companies can tell how efficiently they are operating. For instance, if a company is consistently operating at roughly 50% capacity then, on average, half of its resources are sitting around idle. 

How to calculate capacity utilization

Capacity utilization is calculated and expressed using the capacity utilization rate formula:

(Actual Capacity Being Used/ Total Capacity) x 100

Or

(Actual Output / Potential Output ) x 100

Let’s assume that the potential output for your team is 30 billable hours per day. After tracking actual billable hours, you discovered only 24 hours were charged to client work yesterday. Therefore, your team’s capacity utilization rate yesterday was 80% (24/30 x 100.)

You can also do an employee utilization calculation for each member of your team to see if specific people are underperforming or outperforming the rest. 

Generally, you need to track utilization over an extended period of time to make sure you’re not just assessing performance based on a bad day or week. One way to do this is to take the totals for the period. For instance, if you want to calculate potential capacity for the month, you multiply possible billable hours per day by the number of workdays in a month. 

To find the average rate for all employees, you can calculate the total potential and actual billable hours for everyone for a set period (i.e., six employees x five hours per day x 20 days per month). Or you can find all of their individual utilization rates and use this formula:

Total employee utilization rates/ Total number of employees

For example, if you had two employees, one with an 80% utilization rate and one with a 90% rate, then the formula would be:

(80% + 90%)/2 = 85%

What is the ideal capacity utilization rate?

A 100% capacity utilization rate would represent full capacity. However, this is not generally a realistic target. Some research indicates 100% utilization is harmful, as it can lead to burnout and lower quality work. 

So what is an ideal capacity utilization rate? 

One way to answer this question is to research trends and benchmarks for your industry and set the average as your goal. Another option is to look at your business’ historical performance. For instance, let’s say your highest monthly utilization rate in the past twelve months was 85% — you may choose this as your ideal rate. A final option is to calculate your ideal rate based on your business costs, product or service pricing, and profit targets. 

The formula is:

(Costs + Profit) / Potential capacity x Billable rate) x 100

It is also sometimes expressed as: 

((Resource costs + overhead + profit margin) / Potential capacity x Billable rate) x 100

Suppose you have an employee who costs $60,000/year, and you allocate overhead costs at 2.5% of labor costs. Now assume your target is a 20% profit margin, and your billable rate is $65/hour. 

If their potential capacity is five billable hours per day for 260 workdays per year, or 1300 hours total, the formula would be:

((60,000 + (60,000 x 2.5%) + (0.20 x 61,500)) / 1,300 hours x $65/hour) x 100

(73,800/ 84,500) x 100

87.3%

In this scenario, their ideal capacity utilization is 87.3%. 

How to improve capacity utilization in business

If your ideal capacity utilization rate seems to be a stretch goal, you can change one of the other variables in the formula to achieve a more attainable rate.

Some options for lowering your target capacity utilization rate are:

  1. Lower the employee’s cost (potentially by replacing with a lower-paid employee)
  2. Decrease your overhead costs 
  3. Reduce your profit margin goals
  4. Increase the employee’s potential capacity (by limiting non-billable work or through unpaid overtime)
  5. Increasing the rate you charge clients for this employee’s effort

Many of these options come with negative side effects. For instance, if you use a cheaper employee, you may have lower quality work. But if you increase the employee’s billable rate, you may lose clients. So, before lowering your targets, it’s worth focusing on improving capacity utilization. 

Here are some ways to improve the capacity utilization rate of your business:

  • Pinpoint the weak links. By analyzing the utilization of each resource separately, you can discover who is underperforming and identify any bottlenecks in your process. For instance, if you have one employee who’s only at 60% capacity, you can focus on coaching, training, or other options to help them improve. 
  • Reduce non-billable work. If your employees only have the capacity for five billable hours in an eight-hour workday, what is taking up the other three hours? You may be able to remove these distractions and increase their overall potential capacity.
  • Take on more clients/ billable work. Maybe utilization is low simply because there isn’t enough billable work to keep your team busy. If this is the case, attracting new business and taking on new projects will boost your capacity utilization rate.   

Monitoring capacity utilization

Understanding your capacity utilization rate is a critical component of evaluating the profitability of your team and business. With Wrike Resource, our resource planning and scheduling solution, you gain the visibility and flexibility needed to balance your teams’ workloads and optimize your resource utilization. Want to learn more about how Wrike Resource can benefit your business? Contact us today

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