The mechanics of making a capacity expansion decision in the traditional capital budgeting sense are quite straightforward—any finance textbook will supply the details. Future cash flows resulting from the new capacity are forecasted and discounted to weigh them against the cash outflows required for the investment. The resulting net present value ranks the capacity addition against the other invest–ment projects available to the firm.
However, this simplicity masks an extremely subtle decision-making problem. The firm usually has a number of options for add-ing capacity which must be compared. In addition, to determine fu-ture cash inflow from the new capacity the firm must predict future profits. These will depend crucially on the size and timing of capa-city decisions by each and every one of its competitors, as well as on any number of other factors. There is also usually uncertainty about future trends in technology, as well as about what future demand will be.
The essence of the capacity decision, then, is not the discounted cash flow calculation but the numbers that go into it, including prob-ability assessments about the future. Estimating these is in turn a subtle problem in industry and competitor analysis (not financial analysis).
The simple calculation presented in finance textbooks does not allow for uncertainty and alternate assumptions about competitors’ behavior. In view of the complexity of the discounted cash flow cal-culation that properly includes these elements, it is useful to model the capacity decision with as high a precision as possible. The steps in Figure 15-1 describe the elements of the modeling process.
FIGURE 15-1. Elements of the Capacity Expansion Decision
The steps in Figure 15-1 must be analyzed in an interactive fash-ion. The first step is to determine the realistic options available to the firm in adding capacity. Usually the size of the additions can vary, and the degree of vertical integration of the new capacity may be a variable as well. The addition of unintegrated capacity can be a hedge against risk. Since the firm‘s own decision about how much capacity to add can influence what its competitors do, each of its op–tions must be analyzed separately in conjunction with competitor behavior.
Having developed the options, the firm then must make predic-tions about future demand, input costs, and technology. Future tech-nology is important because it is necessary to forecast the likelihood that present additions to capacity will be made obsolete or that de-sign changes will allow effective increases in capacity from in-place facilities. Forecasting input prices must account for the possibility that increased demand due to new capacity may increase input prices. These predictions about demand, technology, and input costs will be subject to uncertainty, and scenarios (Chapter 10) may be used as a device for coping with this uncertainty for analytical purposes.
The firm must next forecast how and when each and every one of its competitors will add capacity. This is a subtle problem in com-petitor analysis, which must draw on the full range of techniques presented in Chapters 3, 4, and 5. Competitors’ capacity moves will, of course, be determined by their expectations about future demand, costs and technology. Thus, predicting their behavior involves un-covering (or guessing) what these expectations are likely to be.
Predicting competitors’ behavior is also an iterative process, be-cause what one competitor does will influence the others, particular-ly if that competitor is an industry leader. Therefore, competitors’ capacity additions must be played against each other to predict a probable sequence of actions and resulting responses. There is a bandwagon process in capacity expansion, to be discussed later, which is important to try to forecast.
The next step in the analysis is adding competitors’ and the firm‘s behavior to yield aggregate industry capacity and individual market shares, which can be balanced against expected demand. This step will allow the firm to estimate industry prices, and in turn, expected cash flows from the investment.
The whole process must be scrutinized for inconsistencies. If the result of the predictions is that one competitor fares poorly by not adding capacity, for example, the analysis may have to be adjusted to allow that competitor to see the error of its ways and add capacity late. Or if the entire process of predicted expansion leads to condi-tions that violate most firms’ predicted expectations, it may have to be adjusted. The modeling of the capacity expansion process is com-plex and will involve a great deal of estimation. However, the proc-ess gives a firm a great deal of insight into what will drive expansion in the industry, as well as possible ways to influence it in its favor.’
A model of the capacity expansion process reveals that the degree of uncertainty about the future is one of the central determi-nants of the way the process proceeds. Where there is great uncer-tainty about future demand any differences in risk aversion and fi-nancial capabilities of firms will usually lead to an orderly expansion process. Risk taking firms, those loaded with cash or with high stra-tegic stakes in the industry, will jump in, whereas most firms will wait and see what the future actually brings. However, if future de-mand is perceived to be fairly certain, the capacity expansion process becomes a game of preemption. With known future demand, firms will race to get the capacity on stream to supply that demand, and once they do so it will not be rational for others to add still more ca-pacity. This game of preemption will generally be accompanied by heavy market signaling to try to deter other firms from investing. The problem occurs when too many firms try to preempt, and capacity is overbuilt because firms mistake each others’ intentions, misread sig-nals, or misjudge their relative strengths and staying power. Such a situation is one major cause of the overbuilding of industry capaci–ty, which I will explore further.
Causes of Overbuilding Capacity
There seems to be a strong tendency toward overbuilding of ca-pacity, particularly in commodity businesses, that goes far beyond that due to mistaken attempts at preemption. Since overbuilding is a key problem in capacity expansion, we must explore its causes in some detail.
The risk of overbuilding is most severe in commodity businesses for two reasons.
- Demand is generally cyclical. Cyclical demand not only guarantees overcapacity in downturns but also seems to lead to excessively optimistic expectations in upturns.
- Products are not differentiat This factor makes costs crucial to competition, since the buyers’ choice is heavily based on price. Also, the absence of brand loyalty means that firms’ sales are closely tied to the amount of capacity they have. Thus, firms are under great pressure to have large, modern plants to be competitive and adequate capaci–ty to achieve their target market share.2
A number of conditions lead to overbuilding in industries, both in commodity businesses and other businesses, which can be divided into the following categories. If one or more factors are present in an industry the risks of overbuilding can be severe.
Adding Capacity in Large Lumps. The necessity to add capac-ity in large units increases the risk that bunching of capacity deci-sions will lead to serious overcapacity. This was a major factor in the overcapacity of color picture tubes that developed in the late 1960s. Many firms producing television sets perceived the need to assure a supply of tubes, but the size of an efficient tube plant was very large relative to that of a television set assembly plant. Demand did not grow rapidly enough to absorb the massive color tube capacity put on stream all at once.
Economies of Scale or a Significant Learning Curve. This fac-tor makes it more likely that attempts at preemptive behavior like that previously described will occur. The firm with the largest capa-city or which adds capacity early will have a cost advantage, putting pressure on all firms to move quickly and aggressively.
Long Lead Times in Adding Capacity. Long lead times re-quire firms to base their decisions on projections of demand and competitive behavior far into the future or pay a penalty in not capi-talizing on opportunity if demand materializes.3 Long lead times in-crease the penalty to the firm who is left behind without capacity, and hence may cause risk-averse firms to be more prone to invest even though the capacity decision itself is risky.
Increased Minimum Efficient Scale (MES). Where MES is in-creasing and the new larger plants being built are significantly more efficient, unless demand is growing rapidly the number of plants in the industry must shrink or there will be overcapacity. Unless every firm has several plants and can consolidate them, some firms will necessarily have to reduce market share, something they may loathe to do. More likely every firm will build the larger new facilities, creating overcapacity.
A variation of this situation has been occurring in the oil tanker shipping industry, where the new Supertankers are many times the size of the older vessels. The capacity of Supertankers ordered in the early 1970s far exceeded the market demand.
Changes in Production Technology. Changes in production technology have the effect of attracting investment in the new tech-nology, though plants using the old technology are left operating. The higher the exit barriers for the old facilities, the less likely will they be withdrawn from the market in an orderly way. This situation is occurring in the production of chemicals, in which there is a changeover from natural gas to oil as a feedstock. When the oil-fed plants come on stream, serious excess capacity is expected to occur, which will slowly be eliminated as gas prices rise and gas-fed plants are shut down.
Significant Exit Barriers. Where exit barriers are significant, inefficient excess capacity does not leave the market smoothly. This factor accentuates and elongates periods of overcapacity.
Forcing by Suppliers. Equipment suppliers, through sub-sidies, easy financing, price cuts, and the like, can increase over-building of capacity in their customers’ industries. In a scramble for orders, suppliers can also make it possible for marginal competitors to build capacity who would be unable to under normal circum-stances. Shipbuilders have forced capacity increases in the shipping industry, aided by heavy government subsidies, to maintain employ-ment. Lenders for new capacity can also accentuate the overbuilding problem by providing capital to all comers. Aggressive real estate in-vestment trusts (REITs) are partially to blame for overbuilding in the U.S. hotel industry in the late 1960s and early 1970s, for example.”
Building Credibility. Some period of significant overcapacity is often virtually required in industries trying to sell new products to large buyers, particularly if a new product is an important input. Its buyers will not switch to the new product until sufficient capacity is on stream to meet their needs without making them vulnerable to a few suppliers. This has been the case with the high-fructose corn syrup industry.
A related, and very common, case is one in which buyers strong-ly encourage firms to invest in capacity with implied promises of fu-ture business. They may do so directly or indirectly through state-ments designed to indicate their feelings about the need for new capacity. Of course buyers are not required to actually place orders once the capacity is built; it is in their interest to insure that adequate capacity exists to serve their greatest possible needs even if putting that much capacity in place is not the most prudent decision for sup-pliers—since this level of demand is quite unlikely.
The pressure of buyers is strongest where the industry faces close substitutes. Here lack of capacity can help substitutes penetrate the industry, and firms are motivated to prevent it.
Integrated Competitors. If competitors in the industry are also integrated downstream, pressures for overbuilding may be in-creased because each firm wants to protect its ability to supply its downstream operations. Under these circumstances, if the firm has insufficient capacity to supply demand, it will lose not only market share in the industry but also possibly share (or greater risks of ob-taining input supplies) in its downstream unit. Therefore, it is more apt to insure it has enough capacity even if there is uncertainty about future demand. A similar argument holds if competitors are inte-grated upstream.
Capacity Share Affects Demand. In industries such as airlines the firm with the greatest capacity may get a disproportionate share of demand because buyers are prone to approach it first. This char-acteristic creates strong pressures for overbuilding capacity as sev-eral firms strive for capacity leadership.5
Age and Type of Capacity Affects Demand. In some indus-tries, such as many service businesses, capacity is marketed directly to buyers. Having the most modern, well-decorated fast-food outlet, for example, may yield competitive benefits. In industries where buyers choose among firms based solely or in part on the type of ca-pacity they have available, these pressures for overcapacity exist.
Large Number of Firms. The tendency toward overbuilding is most severe when many firms have the strengths and resources to add significant capacity to the market, and they are all trying to gain market position and possibly to preempt the market. Paper, fer-tilizer, corn milling, and shipping are industries in which large num-bers of firms have contributed to making overbuilding a severe problem.
Lack of Credible Market Leader(s). If a number of firms are vying for market leadership and no firm or firms have the credibility to enforce an orderly expansion process, the instability of the proc-ess is increased. A strong market leader, conversely, can credibly add sufficient capacity to meet a major portion of industry demand, if necessary, and can credibly retaliate against overaggressive build-ing by others. Thus a strong leader or small group of leaders can often orchestrate an orderly expansion through their announcements and actions. The conditions for credibility and the mechanisms used are discussed in Chapter 5.
New entry. New entrants often create or aggravate the prob-lem of overbuilding. They seek positions in the industry, often sig-nificant ones, and incumbent firms refuse to yield. Entry has been a major cause of overcapacity in such industries as fertilizer, gypsum, and nickel. Businesses with easy entry are also subject to overbuild–ing because entrants rush in in response to periods of favorable in-dustry conditions.
First Mover Advantages. Ordering and building capacity early may offer advantages that tempt many firms to commit early to ca-pacity when future prospects look favorable. Possible advantages from committing early include short lead times in ordering equip–ment, lower equipment costs, and the first opportunity to take ad-vantage of supply/demand imbalances.
4. INFORMATION FLOW
Inflation of Future Expectations. There seems to be a process by which expectations about future demand can become overinflated as competitors listen to each other’s public statements and to securi-ty analysts. This situation appears to have occurred, for example, in the ethylene and ethylene glycol industries. A related point is that managers may be optimists who prefer positive action to inaction or a negative posture.
Divergent Assumptions or Perceptions. If firms have differ-ing perceptions of each other’s relative strengths, resources, and staying power, they tend to destabilize the capacity expansion proc-ess. Firms may misestimate (under or over) the likelihood that their rivals will invest, leading them either to invest unwisely or not to in-vest initially at all. The former case leads directly to overbuilding, whereas in the latter case, the firm left behind may make a desperate attempt to catch up, triggering a sequence of excessive investments.
Breakdown of Market Signaling. Where firms no longer trust market signals because of new entrants, changed conditions, recent outbreaks of warfare, or other causes, the instability of the capacity expansion process increases. Signaling that is credible, on the other hand, promotes an orderly expansion by allowing firms to warn others of planned moves, to plan for the expected starting and com-pletion of capacity expansions, and so forth.
Structural Change. Related to the preceding point, industry structural change can often promote overbuilding of capacity, either because it requires firms to invest in new types of capacity or because the turmoil of structural change makes firms prone to misestimate their relative strengths.
Financial Community Pressure. Although the financial com-munity can sometimes be a stabilizing force, often security analysts seem to accentuate pressures toward overbuilding of capacity by questioning managements who have not invested once their compet–itors have. Also, managements’ need to make positive statements to the financial community to improve stock prices may lead to state-ments that can be misinterpreted by competitors as aggressive, prompting retaliation.
Production Orientation of Management. Capacity overbuild-ing seems to be particularly liable to occur when production has been the traditional concern of management, as contrasted to marketing or finance. In such businesses, pride in having the shiniest new plants is high, and the perceived risk of being left behind in adding the newest and most efficient capacity is great. Thus pressures for overbuilding are compelling.
Asymmetric A version to Risk. A strong case can be made that managers lose more by being the only firm caught with insufficient capacity in a strong market than they do by having built too much capacity, along with all their competitors, if demand fails to materi-alize. In the latter case they can take safety in numbers and have not lost relative position. In the former case, their jobs as well as the company’s strategic position may well be in jeopardy. Such an asym-metry between the consequences of building and not building insures that there will be strong pressures for all companies to build capacity once a few have taken the plunge.
Perverse Tax Incentives. Tax structures and/or investment tax credits can sometimes encourage overinvestment. This is an acute problem in shipping, where Scandinavian tax laws shelter profits re-invested in capacity but tax uninvested profits. This motivates all shippers to reinvest in capacity when industry conditions are good. Overbuilding is also promoted by tax-free retention of earnings by U.S. subsidiaries abroad.
Desire for Indigenous Industry. Industries of such stature as to be subject to a nationalistic fervor to have an indigenous industry are prone to world overcapacity. Many countries will seek to estab-lish a home-based industry, hoping to sell excess supply on world markets. If minimum efficient scale is large relative to the world market, it is likely to lead to overcapacity.
Pressures to Increase or Maintain Employment. Governments sometimes exert great pressures on firms to invest (or not disinvest) to increase or maintain employment, a social goal. This factor ac-centuates problems of overcapacity.
7. LIMITS TO CAPACITY EXPANSION
There are some checks against the tendency for overbuilding, even when some of the conditions discussed are present. Some of the most common are the following:
- Financing constraints
- Company diversification, which raises the opportunity cost of capital and/or widens the horizons of management who may have been production-oriented or prone to overbuild to protect their position in their traditional industry
- Infusion of top management with finance background to re-place management with marketing or production backgrounds
- Pollution control costs and other increased costs of new ca-pacity
- Great uncertainty about the future that is widely shared
- Severe problems because of previous periods of overcapacity
Several of these conditions were present in the aluminum indus-try in 1979, and as a result the industry may break from its pattern of boom or bust in capacity utilization. Poor earnings resulting from overcapacity in the late 1960s and restricted profits in high demand years because of wage-price controls have left this industry financial–ly unable to make major investments until several good years swell the coffers. In addition the cost of constructing facilities has quad–rupled since 1968.6
A firm can sometimes influence the capacity expansion process in a number of ways, by using its own behavior to signal to competi-tors about its expectations or plans or by otherwise trying to influ-ence competitors’ expectations. For example, the following actions will tend to discourage capacity additions by competitors:
- a large announced capacity addition by the firm (see the next section of this chapter on preemptive strategies);
- announcements, other signals, or information that carries a discouraging message about future demand;announcements, other signals, or information that elevates the perceived likelihood of technological obsolescence of the current generation of capacity.
Source: Porter Michael E. (1998), Competitive Strategy_ Techniques for Analyzing Industries and Competitors, Free Press; Illustrated edition.