Growing an existing business often involves expansion of capacity, in terms of plant, human resources, technological infrastructure, R&D facilities, etc. Any major capacity expansion is a strategic decision that involves significant resource commitments and is often difficult to reverse. So such a decision has to be made carefully.
Capacity expansion strategy is often narrowly applied to manufacturing. But in many businesses, there is no or little manufacturing. So, capacity needs to be understood in terms of the investments made in the most critical area of the value chain. Thus, in the pharmaceutical industry, capacity has to be defined in terms of scientific manpower and sales force. In a software development company, capacity has to be understood in terms of the number of programmers employed. In a Business School, capacity may be defined as the number of professors available to teach students.
According to Michael Porter, the decision to expand capacity has to take into account various factors. Some of them are:
- Future demand.
- Future input prices.
- Likelihood of technological obsolescence.
- Probable capacity expansion by competitors.
- Future industry capacity and individual market shares.
The main risk in capacity expansion strategy is the creation of excess capacity. When there is excess capacity, competition intensifies as players try to increase capacity utilization and profits come down. Excess capacity may result because of various reasons:
- Capacity often has to be added in lumps, not in incremental fashion.
- Economies of scale or significant learning curve can prompt indiscriminate capacity expansion.
- Long lead times in adding capacity may motivate firms to add capacity even when future demand is uncertain.
- Changes in production technology may attract new firms even as older plants continue to operate due to exit barriers.
- Equipment suppliers, through price cutting and attractive credit schemes, can lure manufacturers into buying their products.
- Large buyers, by promising more business in future can tempt the suppliers to add capacity.
- In some industries, such as airlines, the firm which has the largest capacity may be able to grab a disproportionately large chunk of the market.
- When there are several players in the market, they may all try to increase market share, by increasing capacity.
- Firms often build more capacity than is needed in the initial stages when future prospects look favorable.
- Excess capacity often results when firms overestimate the potential of their competitors and want to preempt them by adding more capacity.
- Many manufacturing firms do not like to be left behind by competition and embark on a regular process of capacity expansion.
- Tax incentives sometimes motivate manufacturers to invest in plant and equipment.
Capacity expansion strategy can be used as a pre emptive strategy to lock up a major share of the market and to discourage competitors from expanding and potential rivals from entering the industry. According to Porter, a preemptive strategy is risky. It tends to succeed only under the following conditions:
- The expansion of capacity is large relative to market size.
- There are substantial economies of scale and learning curve advantages.
- The firm’s strategy looks credible in terms of availability of resources, technological capabilities, past track record, etc.
- The firm announces its plans before competitors develop even a reasonable degree of commitment to the process.
A preemptive strategy is unlikely to succeed when competitors pursue non economic goals, consider the business to have strategic importance and are prepared to give up profits in the short run or have equal or better staying power.
Manufacturing firms may build excess capacity as an entry deterrent strategy. When a potential entrant realizes that the industry has excess capacity and its own entry will only add to the volume of unutilized industry capacity, it will be reluctant to enter. Capacity expansion is a credible deterrent strategy if capacity costs are very high. Otherwise, if the cost of adding capacity is low or capacity can be utilized for other purposes, it would be relatively easy for rivals to enter.
For example, DuPont used capacity expansion to increase its market share in the titanium dioxide market. In 1970, DuPont had been using ilmenite in the production of titanium dioxide. This proved advantageous since the price of rutile ore, the raw material used primarily by its competitors, sharply increased, giving DuPont a significant cost advantage over its competitors. In order to maximize this cost advantage, DuPont developed a growth strategy of rapidly expanding capacity to satisfy all of the future increases in demand and deter entry or expansion by existing competitors. At the time DuPont adopted this strategy, in 1972, its market share was 30%. By 1985, its market share was over 50% and five of its major rivals had exited the market.
Firms may instead choose to control capacity through a coordination strategy in which firms signal to one another their intentions concerning their future capacity. By indirectly informing one another of their plans, they seek to ensure jointly that capacity does not become so large that it promotes a price war. However, they must avoid over signaling, which is considered to be illegal tacit collusion under antitrust law.