What is a Capacity Cost?

Capacity cost is a type of fixed cost that is associated with the ongoing operation of a business. Costs of this type usually experience little to no variance from one month to the next, which makes the management of those resources much easier in terms of adjusting costs without actually impacting production. Addressing capacity cost is one of the ways to decrease overhead and allow a business to earn more of a net return on the operation without actually making any chances to production levels.

One example of a capacity cost is the rent on an office or a production facility. This type of expense tends to be constant from one month to the next, and can possibly be lowered by re-negotiating the monthly rental with a landlord or by moving the operation to a new location where the rental fee is lower. If steps are taken to lower this particular cost, and it can be accomplished without interfering with the efficiency of the production process, then the business will increase profits simply by lowering one of its major expenses.

There are situations where the capacity cost can be lowered by outsourcing certain functions. For example, a small business may choose to cut costs by contracting with an outside firm to take care of its Information Technology needs, rather than keep a full-time IT professional on salary. This reduces the fixed cost of a salary to a fixed cost for a monthly fee to the outsource partner, which is typically much lower than the cost of providing benefits to an employee. The same approach may be taken with accounting functions such as payroll or invoicing functions, allowing the business to still manage those tasks efficiently but at a reduced cost.

One characteristic of a capacity cost is that while it may be possible to reduce that cost and thus increase the profitability of a business, it cannot be eliminated without creating some sort of negative impact on the entire operation. This means that while it is possible to save a great deal of money by outsourcing IT functions, eliminating IT support in any form would remove one capacity cost, but would probably result in other problems that would ultimately have a negative impact that could shut down the business.

There is some difference of opinion as to whether utilities should be classified as a capacity cost. One school of thought holds that utilities should be classified in this manner, since they are constant and are necessary to the operation. Others note that utilities are often variable costs rather than fixed costs, and should be excluded for that reason. Both approaches are workable in terms of considering capacity cost, as long as utilities are consistently viewed in the same manner from one economic period to the next.