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Tuesday, August 2, 2011

WHY capacity utilization can exceed 100%-and other costing fundae in investing

At times, companies proudly boast of surpassing 100% capacity utilization. Before you snort in disbelief/write a letter to the editor/suspect the sanity of the accountant, do understand that this can legitimately happen. In fact, this is quite common in the infrastructure sector-mining, power generation, pipelines, shipping etc. Lets understand how this is so.

As any chemical engineer would tell you, calculating capacity of a plant/process is not as simple as measuring the capacity of say a truck. Product mix, input quality, process hours, machine downtime, operating efficiency-all these can change the actual 'capacity' of a process. The rated capacity may be XYZ, the 'normal'/'expected' capacity may be ABC(<=XYZ) for that period based on the operating plan/budget. But when actual conditions differ, the output can be increased by say running extra shifts, handling operations better etc. For instance, take the NSCIT container terminal at JNPT port. While the rated capacity is 6,00,000 TEU, the terminal now handles 1.5million TEU with ease. This is not exactly a calculation mistake, but sometimes the capacity is kept low to incentivize the operator to achieve more(sounds stupid but it is more common than you think).

What other costing fundae can help you in investing? 
  1. As you would do for budget control purposes, calculate variances due to controllable reasons(aka organic growth) after removing exceptional items, financial fluctuations. Evaluate management as per that metric. For instance, if sales grow 10% v/s GDP growth of 20%, then all is not well, as the adjusted growth is in fact negative 10%.
  2. Value the equity reserves at their opportunity cost, and not at their explicit cost(measly dividend!)
  3. Calculate mix variance(if not provided) to estimate whether the company is playing a value game or a value game. This is not always apparent.
  4. Evaluate the company's disclosed transfer pricing policy. If transfer pricing is at arms length AND segment assets are mostly allocated to atleast 1 segment(less unallocated segments), then chances are company is well run, also that you can correctly use SOTP and other breakup value methods to value the company, relying on the segment data.
I guess I've gone a bit beyond the ambit of this post, but if its educative I suppose its fine. 

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