the impact of outsourcing on a business

4.3 Capacity Utilisation and Outsourcing

Objective

To understand how capacity utilisation is measured, why it matters, the consequences of under‑ and over‑capacity, the range of methods (including outsourcing) that can improve utilisation, and the overall impact of outsourcing on a business.

---

1. Capacity Utilisation – Definition, Measurement & Why It Matters

• Definition: The proportion of a firm’s productive capacity that is actually used over a given period.
• Formula: \[ \text{Capacity Utilisation (\%)} = \frac{\text{Actual Output}}{\text{Maximum Possible Output}} \times 100 \]
• Worked example: A plant can produce a maximum of 200 000 units per year. In the current year it produces 150 000 units. \[ \text{Utilisation}= \frac{150\,000}{200\,000}\times100 = 75\% \]

Why Capacity Utilisation Matters

Utilisation directly influences unit cost and profitability:

• Higher utilisation spreads fixed costs over more units → lower fixed cost per unit.
• Economies of scale are realised when a larger proportion of capacity is used.
• It affects breakeven analysis – the higher the utilisation, the lower the sales volume needed to cover total costs.
• Very high utilisation can increase variable costs (overtime, wear‑and‑tear) and risk quality problems.

Capacity Cushion & Desired Range

Most firms aim for a capacity cushion of 10‑30 % to allow flexibility for demand spikes, maintenance and unexpected disruptions. Consequently, a “desired utilisation range” of **70 % – 90 %** is common in the Cambridge syllabus.

Effect of Different Utilisation Levels on Unit Cost

Utilisation (%)	Fixed Cost per Unit (FCU)	Variable Cost per Unit (VCU)	Total Cost per Unit (TCU)
60	£4.00	£6.00	£10.00
80	£3.00	£6.00	£9.00
95	£2.53	£7.00	£9.53

(Numbers are illustrative – they show how spreading fixed costs reduces the total unit cost, but very high utilisation may raise variable cost.)

---

2. Impact of Operating Under‑ or Over‑Capacity

Condition	Typical Consequences
Under‑utilisation (e.g., < 70 %)	Higher fixed cost per unit → reduced profitability. Idle plant, equipment and labour – waste of resources. Loss of economies of scale; unit cost rises. May indicate seasonal demand, poor forecasting or excess capacity.
Over‑utilisation (e.g., > 90 %)	Increased wear and tear → higher maintenance & breakdown risk. Overtime or extra shifts raise variable cost per unit (often 15‑25 % higher). Quality can deteriorate if equipment is pushed beyond design limits. Reduced flexibility to respond to sudden demand spikes.

---

3. Methods of Improving Capacity Utilisation

Outsourcing is one of several levers a firm can use. The table below summarises the main options.

Method	How It Improves Utilisation	When It Is Most Appropriate
Shift work / overtime	Increases output without new equipment.	Short‑term demand spikes; when labour costs are acceptable.
Equipment upgrades / additional machinery	Raises maximum possible output, reducing the gap between capacity and demand.	Long‑term growth forecasts; when capital is available.
Process re‑engineering / lean / JIT	Reduces bottlenecks and waste, allowing existing capacity to be used more efficiently.	When inefficiencies are identified in the production flow.
Product‑mix optimisation	Shifts production toward higher‑margin or higher‑demand items, making better use of plant.	When demand for different products varies widely.
Outsourcing of non‑core activities	Transfers low‑value or seasonal work to an external supplier, freeing internal capacity for core, higher‑value output.	When a function is not a competitive advantage, when external expertise is available, or when capacity is idle.

---

4. Outsourcing – Definition

Outsourcing is a contractual arrangement in which a business transfers responsibility for a specific activity or process to an external supplier, rather than performing it in‑house.

5. Why Companies Outsource (Key Drivers)

• Cost reduction – lower labour, overheads, or capital costs.
• Focus on core activities – free resources for strategic tasks that give competitive advantage.
• Access to specialised expertise – benefit from supplier’s experience, technology, and economies of scale.
• Improved capacity utilisation – avoid under‑utilised plant or over‑capacity in non‑core areas.
• Flexibility & scalability – adjust output quickly to demand changes without long‑term commitments.
• Risk sharing – transfer certain operational risks (e.g., technology obsolescence) to the supplier.

---

6. Impact of Outsourcing on Capacity Utilisation

When a non‑core activity is outsourced, internal capacity can be re‑allocated to higher‑value activities, leading to:

1. Higher utilisation of core production facilities.
2. Reduced idle time on equipment that would otherwise be under‑used.
3. Potential to expand output in core areas without additional capital investment.
4. Greater ability to respond to market opportunities because resources are focused on core competencies.

---

7. Financial Implications – Simple Make‑or‑Buy Model

The decision to outsource is often based on a cost‑benefit analysis. A basic model compares total in‑house cost (\(C_{in}\)) with total outsourcing cost (\(C_{out}\)).

\[ C_{in}=F_{in}+V_{in}\times Q \] \[ C_{out}=F_{out}+V_{out}\times Q + C_{trans} \]

• \(F\) = Fixed cost (e.g., plant, equipment, salaried staff).
• \(V\) = Variable cost per unit.
• \(Q\) = Quantity produced.
• \(C_{trans}\) = Transaction, monitoring and contract‑management costs.

If \(C_{out}

---

8. Advantages of Outsourcing

Advantage	Explanation
Cost Savings	Lower labour rates, economies of scale, reduced capital expenditure.
Focus on Core Competencies	Management can concentrate on activities that provide a competitive advantage.
Access to Expertise & Technology	Suppliers often possess specialised skills and up‑to‑date equipment not available internally.
Improved Capacity Utilisation	Internal resources are redeployed to higher‑value tasks, reducing idle capacity.
Flexibility & Scalability	Ability to increase or decrease output quickly without long‑term capital commitments.
Risk Sharing	Operational, technological and some market risks can be transferred to the supplier.

9. Disadvantages of Outsourcing

Disadvantage	Explanation
Loss of Control	Quality, delivery times and confidentiality depend on the supplier’s performance.
Hidden / Transaction Costs	Contract negotiation, monitoring, transition and possible renegotiation expenses.
Supplier Dependency	Risk of supplier failure, price increases, or reduced service levels.
Impact on Staff Morale	Redundancies or redeployment can lower motivation and increase turnover.
Strategic Risks	Outsourcing a function that later becomes a source of competitive advantage.
Potential Quality Issues	Differences in standards or lack of alignment with the firm’s brand values.

---

10. Make‑or‑Buy Decision Framework

Managers should evaluate both financial and strategic factors before deciding to outsource.

1. Is the activity a core competency or a source of competitive advantage?
2. Can the firm achieve a lower total cost by outsourcing? (Use the cost model.)
3. Will outsourcing improve capacity utilisation of core assets?
4. Are reliable suppliers available with the required quality, capacity and technology?
5. What are the risks of loss of control, supplier dependency and confidentiality?
6. How will outsourcing affect the firm’s brand, customer perception and employee morale?
7. Are the transaction and monitoring costs acceptable?

11. Decision‑Process Flowchart (Suggested Diagram)

Identify activity → Analyse cost & strategic importance → Assess supplier capability → Conduct risk assessment → Make‑or‑Buy decision → Draft & monitor contract.

---

12. Case Study – Company X (Electronics Manufacturer)

• Problem: 30 % of factory capacity was idle because of seasonal fluctuations in demand for a non‑core component.
• Action: Outsourced the component to a specialist supplier in a lower‑cost region.
• Result:
  • Capacity utilisation of core assembly lines rose from 68 % to 85 %.
  • Annual cost reduction of £2.4 million (including £0.3 million transaction costs).
  • Improved focus on product innovation, leading to a 12 % increase in market share.

---

13. Summary – Key Points to Remember

• Capacity utilisation = Actual Output ÷ Maximum Possible Output × 100. It directly influences unit cost and profitability.
• Most firms target a utilisation range of 70 %–90 % (capacity cushion 10‑30 %).
• Under‑capacity raises fixed‑cost per unit; over‑capacity raises variable costs, quality risk and maintenance expense.
• Improving utilisation can be achieved through shift work, equipment upgrades, process re‑engineering, product‑mix optimisation, or outsourcing of non‑core activities.
• Outsourcing can free internal capacity, reduce costs, and provide specialised expertise, but it also brings risks of loss of control, hidden costs and supplier dependency.
• A robust make‑or‑buy analysis combines the cost formula with strategic considerations and a thorough risk assessment.

---

14. Sample Exam Questions

1. Explain how outsourcing can improve a firm’s capacity utilisation. Use a real‑world example to support your answer.
2. Using the cost formulas provided, calculate whether a company should outsource a process that has the following data: \(F_{in}=£500,000\), \(V_{in}=£5\) per unit, \(F_{out}=£200,000\), \(V_{out}=£7\) per unit, \(C_{trans}=£50,000\), and expected output \(Q=100,000\) units. Show all steps.
3. Discuss three non‑financial risks associated with outsourcing and suggest ways to mitigate each risk.
4. Define capacity utilisation and calculate it for a plant with a maximum capacity of 250 000 units that produced 180 000 units in the last year.
5. Compare and contrast two methods (other than outsourcing) that a firm could use to improve capacity utilisation. Highlight the advantages and disadvantages of each.