Full text of Economic Commentary (Federal Reserve Bank of Cleveland) : A User's Guide to Capacity-Utilization Measures, July 1, 1988

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July 1, 1988

or omission: either the definition of
capacity itself is unclear, or no definition is offered. The various reported
data series do not appear to use the
minimum of a plant's short-run avererage cost curve to measure capacity;
indeed, it is not clear what any of
these capacity-utilization estimates
actually measure.
In light of these difficulties, the
Federal Reserve's eclectic approach
may be the most reasonable way of
measuring engineering capacity and
capacity utilization, because it uses
all available information and some
informed judgments. Of course, as
discussed in the previous Economic
Commentary, engineering capacity
utilization may be a poor indicator of
price pressures and future investment.
Furthermore, when employing these
measures as signals of future pricing
and investment behavior for the economy as a whole, it should be recalled
that the reported indexes primarily
cover manufacturing, and that

together these sectors represent less
than a third of GNp'5 Even within
these sectors, changes in firm technology and behavior, or in government policies, can influence the relationships between capacity utilization,
investment, and price changes.
The Census Bureau and the Federal
Reserve try to make the best of this
imperfect situation. While their estimates are probably effective in tracking long-run shifts in engineering
capacity, the user is strongly advised
to remember how the indexes are
constructed and where these numbers come from "in the first instance."

Paul W Bauer is an economist at the
Federal Reserve Bank of Cleveland.
Mary E. Deily is a visiting economist at
the Bank and an assistant professor of
economics at Texas A&M University The
authors wish to thank Randall Eberts
and Mark Sniderrnan for helpful comments. Robin Ratliff provided editorial
assistance.
The views stated herein are those of
the authors and not necessarily those of
the Federal Reserve Bank of Cleveland
or of the Board of Governors of the
Federal Reserve System.

•

eCONOMIC
COMMeNTORY

Footnotes

l. Anonymous; quoted in Sir Josiah
Stamp, Some Economic Factors in
Modern Life, London: King and Son,
1929.

Federal Reserve Bank of Cleveland

2. For more detail on how the Census
Bureau constructs its capacity-utilization
series, see Elinor]. Champion and Charles
0. Thorpe.jr.,
"Census Bureau Survey of
Capacity Utilization," paper presented at
the Second Roundtable Conference on
Capacity Utilization, Washington, D.C.,
December 4,1987.

A User's Guide to
Capacity-Utilization Measures

3. For a more complete discussion of the
Federal Reserve's approach, see Richard
D. Raddock, "Federal Reserve Estimates
of Capacity and Utilization," paper presented at the Second Roundtable Conference on Capacity Utilization, Washington,
D.C., December 4, 1987.

by Paul W. Bauer and Mary E. Deily
The government are very keen on
amassing statistics. They collect
them, add them, raise them to the
nth power, take the cube root and
prepare wonderful diagrams. But
you must never forget that every
one Ofthesefigures comes in thefirs t
instance from the village watchman,
who just puts down what he damn
well pleases. I

4. Despite these differences, this survey's
results appear closely related to the Census Bureau's practical capacity-utilization
series, implying that firms are using an
engineering
definition of capacity.
5. The Federal Reserve also calculates
capacity and utilization indexes for mining and utilities.

the preceding Economic Commentary, we examined how capacity
utilization measures can be useful in
evaluating industry price pressures,
investment, and war mobilization
capabilities. An engineering definition
for capacity utilization is most appropriate for policymakers interested in
war mobilization, whereas the minimum of the short-run average cost
curve is the best choice if one is interested in price pressures or investment.

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Permit No. 385

Federal Reserve Bank of Cleveland
Research Department
p.o. Box 6387
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In this issue, we evaluate two of the
more widely disseminated indexes of
capacity utilization, those prepared
by the Census Bureau and by the
Federal Reserve. The two measures
tend to move together (see chart 1),
but are constructed quite differently,
as we wtll show.

Material may be reprinted provided that
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ISSN 0428·1276

• Census Bureau Approach
The Census Bureau bases its estimates
of capacity utilization on a subsample
of the An nual Survey of Manufactures,
which covers about 450 manufacturing industries at the four-digit Standard Industrial Classification code level.
The survey collects information for
the fourth quarter of the year from
about 9,000 manufacturing establishments.
The survey is sent to each plant in the
sample; thus, firms with more than
one plant may fill out more than one
survey form. Respondents are asked
to report the actual market value of
production, the market value of "preferred" bperations (defined as the production level the firm would prefer to
maintain, at which profits are maximized and where unit price equals
marginal cost), and the market value
of "practical" operations (defined as
the production level that could reasonably be attained using existing
work schedules and machinery and
equipment in place). The survey further instructs respondents that the
preferred output level may not exceed
the practical output level.
Two separate capacity-utilization
measures are calculated from this data.
The preferred rate is the market value
of actual output divided by the value

The U.S. Census Bureau and the Federal Reserve prepare the two most
widely disseminated indexes of
capacity utilization. This article, the
second of a two-part series on capacity utilization, explains how the
indexes are constructed and analyzes
the advantages and shortcomings of
both approaches.

of preferred output, and the practical
rate is the value of actual output divided
by the value of practical output. These
plant-level utilization measures are
then aggregated, using value-added
weights, to obtain preferred and practical capacity-utilization indexes for
each industry and for all of manufacturing.
• Advantages and Shortcomings of
the Census Bureau Approach
The Census Bureau bases its estimates
of capacity utilization on the most
extensive and statistically sound

sample of any reported capacity or
capacity-utilization measures. Two
obvious limitations are that the Census Bureau's estimates represent only
manufacturing (which is only 20 to 22
percent of GNP), and that the estimates cover only the fourth quarter
of the year. But there are other, less
obvious, problems with the reported
measures as well.
The quality of the data may be suspect, since it is unclear who responds
to the survey and how they interpret
its questions. The respondent may
be a plant manager, a governmentreports unit, an accountant, a personnel officer, or a plant owner, among
others. While someone actually based
at the plant may be best informed
about its operations, such individuals
are unlikely to spend their days filling
out government reports. Those who
do fill out these reports may not have
the best information, nor the incentive to obtain it.
In addition, the definitions of the
survey's two measures of capacity suffer from a variety of problems. Preferred capacity is intended to be
closest to an economic concept of
capacity but it is not measured as
output at the minimum of the shortrun average cost function-the
measure we advocate. If plants are maximizing their profits, then they are
always producing where unit price
equals marginal cost. But preferred
output is then always equal to actual
output, and the measure of capacity
contains no information. Also, because
this definition makes capacity dependent on unit prices, it causes capacity
to vary procyclically, even if there is
no underlying change in the plant's or
industry's capital stock or other fixed
factors.
Since the preferred capacity-utilization rate is usually reported to be in
the range of 70 to 80 percent for most
manufacturing industries, it appears

unlikely that the survey respondents
are reporting exactly what the Census
Bureau defines as preferred operations. In many cases, the reported
figures are likely to represent output
levels at which costs start to rise
sharply This interpretation is supported by the similarity of reported
preferred and practical output levels:
about half of the respondents state
their preferred level of capacity as
equal to their practical capacity, and
three-fourths report values for the two
measures that are within 10 percent of
each other- Given this apparent duplication, perhaps the Census Bureau
might try to elicit information about
the level of output at which short-run
unit costs are minimized, instead of
plants' preferred rate of output.
The practical capacity measure is closest to the engineering definition of
capacity, and is probably closer to the
layman's idea of capacity than the
preferred measure. While the practical measure is more readily understandable, it is still somewhat vague. It
is also inherently difficult to measure,
since plants rarely operate at practical
capacity In addition, this capacityutilization measure is more useful for
assessing the nation's industrial base
for war mobilization than for providing information to policymakers about
future investments or price changes.
Finally, because the Census Bureau
data are collected at the plant level,
potential bottlenecks at the firm, industry, or economy level may not be
taken into account. For example, if
two plants, both operating at less than
full capacity rely on inputs from a
third plant that is operating at full
capacity, then the Census Bureau's
aggregate measure of capacity utilization would indicate some unused
capacity, whereas in fact, the three
firms taken together are operating at
full capacity. This effect tends to bias

both measures of capacity utilization
downward. In fact, the Census Bureau's
estimates are consistently lower than
those based on survey data obtained
from the entire firm (such as McGrawHili's).
• Federal Reserve Approach
The Federal Reserve collects no primary data of its own, relying instead
on capacity-utilization surveys compiled by McGraw-Hill and by the Census Bureau, and on various industry
sources. In combining these disparate
data, the Federal Reserve seeks to provide consistent estimates, so that a
given capacity-utilization rate reflects
the same degree of "tightness" over
time.
The Federal Reserve follows six basic
steps in constructing each of its capacity-utilization series.> First, it calculates
a preliminary implied, end-of-year
index of industrial capacity for a sector by dividing the sector's index of
industrial production by the corresponding utilization rate from a survey
for that end-of-year period. Although
the Federal Reserve has traditionally
relied primarily on McGraw-HilI's survey, it is increasingly using the Census
Bureau's survey because of its larger
sample and finer classification of manufacturing industries. These preliminary capacity estimates are checked
against production indexes (which
provide lower bounds and suggest
upper bounds for the capacity index,
particularly at major cyclical peaks)
and against any available estimates of
capacity utilization published by
industry associations.
In the second step, the annual movements of the preliminary capacity
index are adjusted because these initial indexes tend to fluctuate more
than movements in the capital stock
would suggest, rising in expansions
and dropping in recessions. The
Federal Reserve smooths the indexes
using data from estimates of industry

CHART 1

CAPACITY UTiLIZAfION
Percent

90
80
"'"

"'" - - Preferred Rate

/
/ / ••• ••• -

.
- P racttca IR ate

60
1973

1975

1977

1979

1981

1983

1985

1987

NOTE: Solid lines indicate Federal Reserve measures; dotted lines indicate Census Bureau measures.
SOURCES: U.S. Census Bureau; and Board of Governors of the Federal Reserve System.

capacity based on physical units, from
estimates of an industry's capital stock,
and from businesses' direct estimates
of the annual percentage change in
their capacity If none of this information is available, a time trend is estimated from the preliminary capacity
indexes.
Third, the Federal Reserve uses straightline interpolation to obtain monthly
estimates of capacity from its adjusted
estimates of year-end capacity Adjustments to the capacity figures may be
made during an ongoing year if new
information becomes available.
The fourth step is to adjust the capacity measures for certain sectors (materials, mining, utilities, and certain
manufacturing areas) to remove shortterm peak capacity, so that capacity
figures will reflect the maximum sustainable capacity
The fifth step uses value-added
weights to sum the individual series
to obtain sector estimates; these are

the same weights used in constructing
the Federal Reserve's industrial production indexes.

biases. Problems with the Census
Bureau figures have already been discussed. An advantage of the McGrawHill survey is that it is based on firmlevel data, and thus picks up bottlenecks that do not show up at the plant
level. The main drawbacks of this
survey are its relatively small sample
and the lack of a definition for capacity utilization (respondents can
interpret it as they wish)."
The Federal Reserve insulates itself
from some of these problems by relying on more than one source of information and by further refining the
data in calculating its capacity and
capacity-utilization series. Ultimately,
however, the measure appears closer
to an engineering definition of capacity than to a cost-based measure because of biases in the McGraw-Hill
and Census surveys and because the
Federal Reserve adjusts the series
using output and capital-stock
measures.

• Advantages and Shortcomings of
the Federal Reserve Approach
A major advantage of this measure is its
eclectic nature. The Federal Reserve
tries to include all relevant data when

Finally, even though the Federal
Reserve strives to construct capacityutilization series that are consistent
over time, such consistency is difficult
to achieve. Major institutional and
technological changes have occurred
in the past and are certain to continue
in the future, possibly affecting the
degree of tightness a given capacityutilization rate represents. For example, a plant using a just-in-time

constructing its capacity indexes.
Smoothing excess volatility from the
capacity series is particularly appropri-

inventory process will be much more
dependent on its outside suppliers
than a plant using a more traditional

ate, because this volatility cannot be
explained by movements in capital
stocks or investment. Using observed
production levels to adjust capacity
figures is also reasonable, since actual
output contains some information,
albeit imperfect, about capacity

inventory process. Capacity restrictions
at these suppliers would not necessarily show up in either the Census
Bureau or McGraw-Hill surveys, and
could cause a shift in tightness represented by the Federal Reserve's
capacity-utilization series.

Of course, because the Census Bureau
and McGraw-Hili surveys are the two
main sources of data, the Federal
Reserve series incorporates their

• Conclusions
Month-to-month
year movements

In the sixth and final step, the Fed calculates monthly capacity-utilization
rates by dividing its monthly production index by the capacity index it has
constructed.

and even year-toin capacity utiliza-

tion should be used with caution.
Each series is flawed by commission