Having excess capacity in an industry can trigger acquisitions.

Be fearful when others are greedy and greedy when others are fearful. – Warren Buffett

Let’s look at how smart business owners use acquisitions to eliminate excess capacity within their industries. For the sake of example, let’s consider as a scenario a small town with three bakeries. To keep things simple and easy to follow, I will use nice round numbers. Let’s pretend that each of the three bakeries sells $1 million worth of baked goods per year.

Bakery                    Annual Revenue

A                                        $1 million

B                                        $1 million

C                                        $1 million

Total Market Size              $3 million

Bakery closed.

That’s the supply side. On the demand side the residents of the town also just happen to want about $3 million of baked goods per year. So in effect we have what economists call a state of equilibrium. The bakeries are making a profit and the customers are reasonably happy with the quality and pricing. This is about as good as it gets in a free market.

Now let’s suppose that some event takes place which reduces the demand side by one-third down to just $2 million worth of goods. Perhaps the town’s biggest employer, a shoe factory, shuts down and lays off hundreds? The laid-off workers off then move to other towns in order to find work. Now you suddenly have three bakeries with excess capacity trying to survive in a market that only has enough demand for two of them at past sales levels.

The new sales situation is:

Bakery                    Annual Revenue

A                                     $0.666 million

B                                     $0.666 million

C                                     $0.666 million

An obvious solution is for one, two, or all three bakeries to reduce their capacity until equilibrium is reached again at the new $2 million market size. This could mean laying off employees, reducing inventory, and downsizing in terms of space. Sometimes this is the option that makes the most sense. At other times it’s not. For example, Bakery A could be a division of a publicly-listed company which will be loathe to admit that it’s down-sizing due to a dip in sales. News of this nature would drive the share price down. Or perhaps Bakery A is heavily burdened with debt and cannot afford to operate at anything below $1 million in sales because it will then have difficulty covering its loan payments.

However, in most cases when small businesses are involved the participants will simply choose to downsize their operations until the storm blows over. That’s the easy lazy way to deal with the problem.

The best defense is a good offense.

In crises lies opportunity.

However, there are exceptions to this rule. Some business owners will see the opportunity that lies hidden in a state of excess capacity. They will then explore the option of acquiring a troubled competitor at a fire sale price. If in our example, Bakery A is able to acquire Bakery B, it can then shutter it entirely or add the latter’s profit centers to its own while eliminating the cost centers. Picture it this way, if B had the best muffins in town, A can choose to take the recipe and bake them in its own plant while shutting down B and selling off its assets

Then the sales situation looks like this:

Bakery                    Annual Revenue

A                                    $1.333 million

B                                    $0

C                                    $0.666 million

It’s this type of initiative and audacity that separates those who build something substantial from those who don’t.

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