Growing digital - Is capacity still relevant?

Every other year, the Paris Air show serves as the backdrop for the signing and announcement of the latest crop of megadeals between global airlines and aircraft manufacturers. Some new aircraft will replace ageing planes, but most will provide additional capacity for the airline industry.

In every market, analysts and industry players watch new capacity announcements with great interest as harbingers of the future.

What is Capacity? Why is it important to Business?

Capacity is a flow metric, meaning it has two dimensions: quantity and time. A manufacturer measures capacity as the highest number of units produced per unit time. Airlines, travel and hospitality measure the maximum number of passengers or customers that can be serviced in a unit of time.

The time dimension makes capacity perishable - meaning unused capacity is lost forever when that time period expires. Every empty airline seat, unbilled consultant hour, vacant hotel room or idle factory shift represents irrecoverable output or revenue.

To measure how efficiently its assets are being used, companies track capacity utilization - the ratio of actual output to maximum possible output. For obvious reasons, higher capacity utilisation usually results in higher profitability.

Capacity Decisions are Strategic
Capacity has some unique characteristics which make it a critical element of the strategic planning process.

 

• Capacity addition requires up-front capital investment: Adding new capacity is capital intensive. Whether it's building a new hotel, store, bank branch or software delivery centre, companies invest a significant amount of up-front capital in new capacity.
• Capacity decisions are a bet on the future: The creation of physical assets is a time consuming process, so most capacity decisions are based on medium-term demand forecasts.
• Capacity is lumpy: Adding capacity is usually a step function, while demand growth tends to be linear. Hence, organisations and industries are nearly always in a situation where capacity is either greater than demand (inefficient operations) or less than demand (lost revenue).

A robust capacity plan is a key component of any corporate strategy. Companies need to consider a diverse set of variables, including macroeconomic factors, demand drivers, customer preferences, product and pricing strategies, input costs and competitor strategies. They must also weigh options like "build," "buy" or "outsource" to ensure optimal allocation of capital resources. Sudden Capacity Increases Shake up Incumbents Consumers benefit from capacity increases in an industry because newer, more efficient, technologies deliver better quality, greater choice and, eventually, lower prices.

 

If the capacity augmentation is driven by an aggressive competitor with deep pockets or a new business model, it can have a negative impact on industry incumbents. The entry of low-cost airlines (like Southwest Airlines, Easyjet, Air Asia, etc.) shook up incumbents in almost every global market. A low-cost strategy combining short hauls, "no frills" service and a single aircraft type to reduce maintenance costs enabled these airlines to expand the passenger market, grab market share from their full-service counterparts and deliver cheaper airfares to consumers. The globalisation of manufacturing to China and IT to India disrupted the US and European incumbents. Customers experienced lower prices driven by lower labour costs, but local industry players had to adapt or risk being marginalised.

How Digital Economy Disrupts Conventional Capacity Equation

Imagine a situation where capacity addition does not follow the established algorithm:
1.    The capital cost of adding new capacity is nearly zero (or a fraction of existing capital cost)
2.    Capacity addition is immediate
3.    Capacity is linear and flexible (can be scaled up and down according to demand)

There are numerous examples of digital business models that enable companies to add capacity without capital investment, time and lumpiness inherent in the traditional business model. Amazon, the largest internet retailer in the US, has no physical stores. Uber owns no cars, and Airbnb offers accommodations in 190 countries without owning a single room. Moven, a digital-only bank has no branches, while Elance provides a platform for clients to access a million freelance technology professionals without adding to their payroll.

These digital companies are able to generate capacity in three ways:

1. Aggregate distributed capacity: Digital platforms seamlessly connect blocks of capacity scattered across the globe. Alibaba's members in rural China can access international markets without investing in a massive international supply chain, while Airbnb enables surplus real estate to be monetised worldwide.

2. Release latent capacity: Digital disruptors can harness and monetise idle resources by monitoring and releasing them to the market in real time. Uber taps into the spare time of private car owners to market a fleet of on-demand cabs. Elance enables students and part-time professionals to use their weekends and free time productively.

3.Create Virtual Capacity: Financial services are evolving to digital-only businesses, with Paypal and Moven completely eliminating the physical aspect of payments and banking. Their growth relies on attracting customers to digital platforms, rather than investing in bank branches and ATMs.

In the pre-digital world, a hotel chain would never view a spare bedroom as a threat, nor would a limo company view a college student with a car as competition. However, now it takes just a few hundred cars or empty bedrooms in an area to become a formidable competitive force. 3-D printing technology is emerging, but could potentially change the competitive scenario in manufacturing especially for small, non-complex parts. The combination of these factors changes the very nature of capacity, making it linear, scalable and infinitely flexible with lower capital intensity.

Consequently, the source of competitive advantage shifts from building and owning capacity to effectively accessing, aggregating and monetising distributed capacity.

Conclusion

One common fallacy is attributing lower consumer prices of digital economy players to the effect of low-cost capital from venture capital investors, and assuming that the strategy will be unsustainable in the long term.

But in many industries, digital platforms have changed the nature of capacity, resulting in a long-term and irreversible shift in the industry's economic model. The lesson in all this is: Look beyond traditional competitors and outdated capacity metrics to avoid being blindsided by digital disruptors who virtualise, aggregate or release latent capacity to fundamentally alter your industry's business model.

The author is Vice President & Head of Digital One, Syntel, Inc.