Why Overcapacity Often Gets Worse

The global semiconductor industry is in severe overcapacity today. There are two causes for this current overcapacity: competitor expansion and a fall-off in demand. Competitors expanded rapidly over the last few years when demand was relatively high. New semiconductor capacity comes on stream in big chunks, produced in factories costing more than a billion dollars. Now, many of those factories are running at half their rated capacity as demand has fallen off in the last year. The situation is bad enough that, today, no company can make a profit on standard semiconductor memory chips.

So, why don’t semiconductor manufacturers reduce industry overcapacity by closing plants? The answer lies in the cost structure of these factories. Seventy percent of these factory costs are fixed. They neither rise nor fall with short term changes in demand. As a result, these factories continue operating as long as their operators can make a cash contribution to fixed costs.

These high fixed costs explain why semiconductor prices fall so low in overcapacity. Prices have to fall low enough to discourage someone from producing. That discouragement has to include pricing through the level of any fixed cost. In a commodity-like market, such as semiconductor memory chips, the industry price is equivalent to the cash costs of the next person into the market. As a market expands, the cash cost of the next addition to capacity sets the price. In a market that is shrinking, the cash cost of the last person to leave the market is a pretty good estimate for industry prices. The last person to leave the market is usually the high cost producer. So, a declining demand industry sees industry prices fall below the cash costs of the high cost producer until enough high cost production is taken off-line to balance demand.

Even once a plant reaches the stage where it can not make a cash contribution on sales in its present structure, there are still instances where that capacity does not close permanently. Instead, the capacity recycles in the industry as another competitor, often with a lower cost structure, acquires the productive facility and keeps it operating at a lower cash cost. (See the Symptom and Implication, “Industry profits are low but downsized capacity remains” on StrategyStreet.com.)

Once productive capacity exists, it goes away with difficulty, even in an industry downturn. High cost capacity may not go away permanently until it is unable to compete with the cost structure of newer, more technologically advanced plants, even in a rising price environment. (See the Symptom and Implication, “The industry is adding new more efficient capacity in the effort to reduce cost” on StrategyStreet.com.)