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Case Study Summary:
The Opportunity Cost of
Using Excess Capacity
Authors: Robyn McLaughlin & Robert A. Taggart, Jr.
Published in: Financial Management, Vol. 21, No. 2 (Summer, 1992), pp.
12–23
Stable URL: https://www.jstor.org/stable/3665660
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Initial Study (Information)
Understanding Case Concept
📘 Meaning of "The Opportunity Cost of Using Excess Capacity"
Opportunity Cost refers to the value of the next best alternative
foregone when a choice is made.
So, when we talk about:
"The Opportunity Cost of Using Excess Capacity" —
It means:
💡 The value the firm gives up by using currently unused or idle
assets (like machinery, plant space, or manpower) for a new
project, instead of keeping them available for future or
alternative (possibly better) uses.
🔍 Breaking it Down:
Excess Capacity: These are resources a company owns but is not
currently using—e.g., an idle factory, equipment, or floor space.
Using It: If the firm decides to deploy this idle capacity for a new
product or service, it might seem like a good idea since there’s no
new cost.
But the Trade-Off?
o Once used, that capacity is no longer available for other
potentially more profitable uses.
o It may also lead to earlier wear-and-tear or require
replacement sooner.
🧠 Real Example (Simplified):
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A factory has idle space (excess capacity). The management considers
using it to manufacture a low-margin product.
On paper, the project shows a positive Net Present Value (NPV).
But: If in the future, a higher-margin product needs that space
and can't use it anymore, the firm loses that opportunity.
Thus, the opportunity cost = the value of the best future use forgone
by using the excess capacity now.
📊 Financial Relevance
In capital budgeting, this becomes important:
You must account for the opportunity cost of using idle capacity.
Not doing so overstates project returns and leads to suboptimal
investment decisions.
🇮🇳 Application in Indian Context
In India:
Public Sector Units (PSUs) often have underutilized assets.
Private companies in infrastructure, textiles, or heavy industries
may have idle capacity due to demand cycles.
Ignoring the opportunity cost of using these idle resources can result in:
Wrong product mix
Missed high-margin opportunities
Unnecessary capital expenditures (capex) later
✅ In Summary:
The opportunity cost of using excess capacity is the value of what
you lose by not saving or reallocating that capacity to a
potentially better future use.
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This concept urges finance professionals to look beyond current
profitability and evaluate the strategic value of keeping flexibility
for future, possibly superior, opportunities.
Decrypting Case
🔑 Summary and Financial Relevance in
Indian Markets
🎯 Objective
This paper redefines how opportunity cost should be viewed in capital
budgeting decisions, especially when a firm uses idle or excess
capacity (e.g., an unused plant) for new projects. The authors argue that
traditional approaches—like using Equivalent Annual Cost (EAC)—
ignore the value of real options embedded in existing capacity.
1. Reframing Opportunity Cost via Real Options
Traditional View: Opportunity cost = Replacement cost or EAC of
capacity lost.
Proposed View: Opportunity cost = Value of forgone production
and investment options (McLaughlin & Taggart, 1992).
📌 Indian Market Relevance: Firms in capital-heavy sectors like
power, steel, PSUs, or railways often have excess capacity.
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Recognizing its option value helps improve decisions about asset
redeployment or privatization under policies like National Monetisation
Pipeline (NMP) or Atmanirbhar Bharat.
Reference: McLaughlin & Taggart (1992), p. 12–13
2. Real Options Explained
Idle capacity gives the firm a portfolio of options:
European production options (one per year during the asset’s
life)
American replacement options, allowing flexible investment
timing
By reallocating capacity (e.g., from Product A to Product B), the firm:
Loses: Flexibility to use or delay A’s production/investment
Gains: Option to invest in A-capacity now, but at a cost
Reference: Pindyck (1988); McDonald & Siegel (1986); McLaughlin &
Taggart (1992), pp. 13–15
3. Why the Traditional EAC Method Falls Short
Assumes predictable, fixed investment timing
Ignores uncertainty and flexibility
Fails in volatile environments where decisions are contingent on
future information
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📌 Application: In Indian startups, SMEs, or government budgeting,
decisions like delaying expansion, outsourcing production, or
refurbishing PSU assets cannot be effectively modeled using EAC
alone.
Reference: Brealey & Myers (1991); McLaughlin & Taggart (1992), p. 15
4. Empirical Simulations and Key Findings
Using numerical models and binomial option valuation (Cox-Ross-
Rubinstein method), the authors show that:
Impact on Opportunity Cost (Real
Variable
Options)
Investment cost Increases, but at a decreasing rate
Price volatility Raises value of flexibility
Time to Longer time → higher cost (more options
replacement lost)
When high, few options exercised → low
Production cost
cost
Interest rate Slight decrease in real options value
Economic Longer horizon → greater cost initially,
horizon then plateaus
Reference: Cox, Ross, & Rubinstein (1979); Trigeorgis & Mason (1987);
McLaughlin & Taggart (1992), pp. 16–21
📌 Indian Finance Insight: This is crucial for modeling long-term
infrastructure or real estate projects where project execution spans
decades (e.g., Gati Shakti, Smart Cities)
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5. Strategic Implications for Finance Professionals
Use real options analysis in decisions involving capacity
reallocation, investment timing, and production flexibility.
Avoid over-reliance on static models (e.g., NPV or EAC) in dynamic
industries like energy, pharma, or telecom.
Estimate upper bounds of opportunity cost using:
1. Replacement cost of capacity
2. Value of forgone production options
Reference: Trigeorgis (1991); Myers & Majd (1990)
FINAL TAKEAWAYS
Excess capacity is not free—its strategic value depends on future
optionality.
EAC underestimates costs in volatile markets; real options add
precision.
Indian firms must model:
Regulatory/policy shifts (e.g., PLI, import duties).
Commodity cycles (steel, oil, agriculture).
Tech disruption (EVs, AI, green hydrogen).
Action Step: Integrate real options into capital budgeting for projects
>₹500 Cr where uncertainty is high.
📚 References
1. McLaughlin, R., & Taggart, R. A. (1992). The Opportunity Cost of
Using Excess Capacity. Financial Management, 21(2), 12–23.
https://www.jstor.org/stable/3665660
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2. Brealey, R. A., & Myers, S. C. (1991). Principles of Corporate Finance
(4th ed.). McGraw-Hill.
3. McDonald, R., & Siegel, D. (1986). The Value of Waiting to Invest.
Quarterly Journal of Economics, 101(4), 707–727.
4. Pindyck, R. S. (1988). Irreversible Investment, Capacity Choice and
the Value of the Firm. American Economic Review, 78(5), 969–985.
5. Cox, J. C., Ross, S. A., & Rubinstein, M. (1979). Option Pricing: A
Simplified Approach. Journal of Financial Economics, 7(3), 229–263.
6. Trigeorgis, L., & Mason, S. P. (1987). Valuing Managerial Flexibility.
Midland Corporate Finance Journal, 5(1), 14–21.
7. Myers, S. C., & Majd, S. (1990). Abandonment Value and Project Life.
Advances in Futures and Options Research, 4, 1–21.
