Capacity Constraints, Profit Margins and Stock Returns

This paper studies the effects of capacity utilization on accounting profit margins and stock returns. Since accounting profit margins represent the average profit per unit and not the economists' concept of unit contribution margin, the marginal/variable profit per unit, a firm with idle capacity can increase its profit margins by increasing sales (output). But, if the firm is operating at full capacity, an increase in output must be preceded by an increase in capacity (and fixed costs resulting in lower profit margins. Our empirical findings suggest that firms' profit margins increase in sales when there is idle capacity, but decreases in sales when the firm approaches full capacity. We show that firms experiencing high growth in sales operating in industries with high capacity utilization experience abnormally low stock returns in the following period.