Strategic Capacity Planning
Chapter 5
Learning Objectives
• Name the three key questions in capacity
planning
• Explain the importance of capacity planning
• Describe ways of defining and measuring
capacity
• Name several determinants of effective
capacity
• Perform cost-volume analysis
Capacity Planning
• Capacity
– The upper limit or ceiling on the load that an operating unit can
handle
– Capacity needs include
• Equipment
• Space
• Employee skills
• Strategic Capacity Planning
– To achieve a match between the long-term supply capabilities of
an organization and the predicted level of long-term demand
• Over-capacity  operating costs that are too high
• Under-capacity  strained resources and possible loss of customers
Capacity Planning Questions
• Key Questions:
– What kind of capacity is needed?
– How much is needed to match demand?
– When is it needed?
• Related Questions:
–
–
–
–
How much will it cost?
What are the potential benefits and risks?
Are there sustainability issues?
Should capacity be changed all at once, or through several
smaller changes
– Can the supply chain handle the necessary changes?
Capacity Decisions Are Strategic
• Capacity decisions:
– impact the ability of the organization to meet future
demands
• http://www.microsoft.com/Investor/EarningsAndFinancials/
Earnings/SegmentResults/S2/FY14/Q1/Performance.aspx
–
–
–
–
–
affect operating costs
major determinant of initial cost
(often) involve long-term commitment of resources
affect competitiveness
affect the ease of management
Demand Management Strategies
• Strategies used to offset capacity limitations
and that are intended to achieve a closer
match between supply and demand
– Appointments
– Pricing
– Promotions
– Discounts
– Other tactics to shift demand from peak periods
into slow periods
Defining and Measuring Capacity
• Design capacity
–
Maximum output rate or service capacity an operation, process,
or facility is designed for.
• Effective capacity
–
Design capacity minus inefficiencies such as operational factors,
personal time, maintenance, scrap etc. - cannot exceed design
capacity.
• Actual output
–
Rate of output actually achieved—cannot exceed effective
capacity.
Capacity: Illustration
• These are design capacity
from Boeing.
• But you typically won’t get to
reach this design capacity
because some seats are taken
out for, say, extra room for
emergency exit. That’s why
you have effective capacity.
• Actual output would be equal
of less than the effective
capacity because you don’t
always have that many
passengers on the plane.
Measuring System Effectiveness
• Efficiency
(Measured as percentages)
Efficiency =
Actual output
Effective capacity
• Utilization
(Measured as percentages)
Utilization =
Actual output
Design capacity
Example: Efficiency and Utilization
• Design Capacity = 50 trucks per day
• Effective Capacity = 40 trucks per day
• Actual Output = 36 trucks per day
Efficiency =
Utilization =
Actual output
Effective capacity
Actual output
Design capacity
=
=
36
40
36
50
= 90%
= 72%
Determinants of Effective Capacity
• Facilities
– Size, expansions, layout, transportation costs, distance to
market, labor supply, energy sources
• Product and service factors
– (non) uniformity of output, product/service mix
• Process factors
– Productivity, quality, setup-time
• Human factors
– Tasks, variety of activities, training, skills, learning,
experience, motivation, labor turnover
Determinants of Effective Capacity
• Policy factors
– Overtime, second/third shifts
• Operational factors
– Scheduling, inventory, purchasing, materials, quality
assurance/control, breakdowns, maintenance
• Supply chain factors
– Suppliers, warehousing, transportation, distributors
• External factors
– Product standards, minimum quality, safety, environment,
regulations, unions
Capacity Strategies
• Leading
– Build capacity in anticipation of future demand increases
– E.g., let’s expand the restaurant because we expect to serve
more customers in the next year
• Following
– Build capacity when demand exceeds current capacity
– E.g., let’s expand the restaurant because we have been full up
all the time in the past year
• Tracking
– Similar to the following strategy, but adds capacity in relatively
small increments to keep pace with increasing demand
– E.g., let’s expand the restaurant because we have been full up
all the time in the past month
Capacity Cushion/Safety Capacity
• Capacity Cushion / Safety Capacity
– Extra capacity used to offset demand uncertainty
• Capacity cushion = Capacity – expected demand
• Capacity cushion strategy
– Organizations that have greater demand uncertainty
typically use greater capacity cushion
– Organizations that have standard products and
services generally use smaller capacity cushion
Forecasting Capacity Requirements
• Long-term considerations relate to overall level of capacity
requirements
– Require forecasting demand over a time horizon and converting
those needs into capacity requirements
– E.g., Our hotel expect to serve 10 thousand customers next year.
• Short-term considerations relate to probable variations in
capacity requirements
– Less concerned with cycles and trends than with seasonal
variations and other variations from average
– E.g., Our hotel expect to serve 10 thousand customers next year.
But the demand will be higher in the summer, lower in the
winter, and normal in the spring and fall.
Common demand patterns
• Calculating processing requirements requires:
– reasonably accurate demand forecasts,
– standard processing times
– available work time
k
NR 
pD
i
i 1
i
T
where
N R  number of required processors (servers)
pi  standard processing time for product i
Di  demand for product i during the planning horizon
T  processing time available per processor during the planning horizon
Example
Product
Annual Demand
Standard processing time Processing time
per unit (hr.)
needed (hr.)
#1
400
5
2000
#2
300
8
2400
#3
700
2
1400
Total=5800
• If annual capacity is 2,000 hours/machine,
then
• Units of capacity needed = 5,800 hours ÷
2,000 hours = 2.90  3 machines
In-House or Outsource
• Once capacity requirements have been determined, the
organization must decide whether to produce a good or
provide a service itself, or to outsource from another
organization.
• Factors to consider when deciding whether to operate
in-house or outsource
–
–
–
–
–
–
Available capacity
Expertise
Quality considerations
The nature of demand
Cost
Risks
Case Study
• How much would an all-American iPhone cost?
– NPR Marketplace
•
http://www.marketplace.org/topics/business/ive-always-wondered/how-much-would-all-american-iphone-cost
– Audio (4:33)
– Pay attention to:
1. Logistic efficiency
2. Cost structure
3. Components
4. International expertise
5. Consumer base
– While listening, take notes on the above 5 items
– Use the notes, discuss why/when a company decides to outsource?
Developing Capacity Strategies
• There are a number of ways to enhance development
of capacity strategies:
1. Design flexibility into systems.
• Provision for future expansion
2. Take stage of life cycle into account.
3. Take a “big-picture” (i.e., systems) approach to capacity
changes.
4. Prepare to deal with capacity “chunks.”
•
Capacity increments are not usually smooth
5. Attempt to smooth out capacity requirements.
•
Overtime; subcontract; inventory control
6. Identify the optimal operating level: economies of scale.
Product Life Cycle
• In the introduction phase, organizations should be
cautious in making large and/or inflexible capacity
investments.
• In the growth phase, organizations should consider
their market share, competitors’ moves, and
establishing competitive advantages.
• In the maturity phase, organizations may still be able to
increase profitability by reducing costs and making full
use of capacity.
• In the decline phase, organizations may eliminate the
excess capacity by selling it, or by introducing new
products or services.
“Big-Picture ” Approach
• Bottleneck Operation
– An operation in a sequence of operations whose capacity is lower than that of
the other operations
Bottleneck
Operation 1
20/hr.
Operation 2
10/hr.
Operation 3
15/hr.
Maximum output rate
limited by bottleneck
10/hr.
Economies of
Scale
If output rate is
less than the
optimal level,
increasing the
output rate
results in
decreasing
average per
unit costs
Average cost per unit 
Optimal Operating Level
0
Minimum average cost per unit
Diseconomies
of Scale
If the output rate is
more than the
optimal level,
increasing the
output rate
results in
increasing
average per unit
costs
Minimum
cost
Rate of output 
Economies of Scale
• Economies of Scale
– If output rate is less than the optimal level, increasing the output rate
results in decreasing average per unit costs
– Reasons for economies of scale:
• Fixed costs are spread over a larger number of units
• Processing costs decrease due to standardization
– There are two types of economies of scale:
• Internal. These are cost savings that accrue to a firm regardless of
the industry, market or environment in which it operates.
– It is easier for large firms to carry the overheads of sophisticated research
and development (R&D). E.g., pharmaceuticals industry
• External. These are economies that benefit a firm because of the
way in which its industry is organized.
– E.g., The creation of a better transportation network
Diseconomies of Scale
• Diseconomies of Scale
– If the output rate is more than the optimal level, increasing
the output rate results in increasing average per unit costs
– Reasons for diseconomies of scale
• Congestion (transportation)
• Complexity (customerization)
• Inflexibility
• Additional levels of management
Evaluating Alternatives
• Cost-volume analysis
– Break-even point
– Indifference point
• Financial analysis
– Cash flow
– Present value
• Decision theory
– Comparison of alternatives under risk and uncertainty.
• Waiting-line analysis
– Balance waiting cost and increased capacity cost
• Simulation
– Evaluate “what-if” scenarios
Cost-Volume Analysis Assumptions
• Cost-volume analysis is a viable tool for comparing
capacity alternatives if certain assumptions are
satisfied:
–
–
–
–
One product is involved
Everything produced can be sold
The variable cost per unit is the same regardless of volume
Fixed costs do not change with volume changes (or they
are step changes)
– The revenue per unit is the same regardless of volume
– Revenue per unit exceeds variable cost per unit
Cost-Volume Analysis
• Focuses on the relationship between cost,
revenue, and volume of output
– Fixed Costs (FC)
• tend to remain constant regardless of output volume
– Variable Costs (VC)
• vary directly with volume of output
• VC = Quantity (Q) x variable cost per unit (v)
– Total Cost
• TC = FC + VC
– Total Revenue (TR)
• TR = revenue per unit (R) x Q
Break Even Point
• Break-Even-Point (BEP)
– The volume of output at which total cost and total
revenue are equal (profit = 0)
• P: Profit
– Profit (P) = 0 = TR – TC
= (R × Q) – (FC + v × Q)
= Q(R – v) – FC
• Q: Quantity
• TR: Total Revenue
•
TR = revenue per unit (R) x Q
• TC: Total Cost
•
TC = FC + VC
• FC: Fixed Costs
• VC: Variable Costs
0 = QBEP(R – v) – FC
•
VC = Q x variable cost per unit (v)
Cost-volume relationships
32
Cost-volume relationships
This line shows
the difference
between TR and
TC.
33
Exercise
• The owner of Old-Fashioned Berry Pies, S. Simon,
is contemplating adding a new line of pies, which
will require leasing new equipment for a monthly
payment of $6,000. Variable costs would be $2
per pie, and pies would retail for $7 each.
a. How many pies must be sold in order to break even?
b. What would the profit (loss) be if 1,000 pies are
made and sold in a month?
c. How many pies must be sold to realize a profit of
$4,000?
d. If 2,000 can be sold, and a profit target is $5,000,
what price should be charged per pie?
Solution
• The owner of Old-Fashioned Berry Pies, S. Simon,
is contemplating adding a new line of pies, which
will require leasing new equipment for a monthly
payment of $6,000. Variable costs would be $2
per pie, and pies would retail for $7 each.
a. How many pies must be sold in order to break even?
FC = $6000
VC = $2 per pie
R = $7 per pie
QBEP = FC / (R – VC) = 6000 / (7 – 2) = 1200 pies/month
Solution
• The owner of Old-Fashioned Berry Pies, S. Simon,
is contemplating adding a new line of pies, which
will require leasing new equipment for a monthly
payment of $6,000. Variable costs would be $2
per pie, and pies would retail for $7 each.
b. What would the profit (loss) be if 1,000 pies are
made and sold in a month?
FC = $6000
VC = $2 per pie
R = $7 per pie
For Q = 1000, P = Q(R – v) – FC = 1000(7 – 2) – 6000 = –1000
Solution
• The owner of Old-Fashioned Berry Pies, S. Simon,
is contemplating adding a new line of pies, which
will require leasing new equipment for a monthly
payment of $6,000. Variable costs would be $2
per pie, and pies would retail for $7 each.
c. How many pies must be sold to realize a profit of
$4,000?
FC = $6000
VC = $2 per pie
R = $7 per pie
Q = (P + FC) / (R – v) = (4000 + 6000) / (7 – 2) = 2000 pies
Solution
• The owner of Old-Fashioned Berry Pies, S. Simon,
is contemplating adding a new line of pies, which
will require leasing new equipment for a monthly
payment of $6,000. Variable costs would be $2
per pie, and pies would retail for $7 each.
d. If 2,000 can be sold, and a profit target is $5,000,
what price should be charged per pie?
FC = $6000
VC = $2 per pie
R = $7 per pie
Profit = Q(R – v) – FC
5000 = 2000(R – 2) – 6000  R = $7.5
Alternative approach:
R = (P + FC – v × Q) / Q = (5000 + 6000 + 2 × 2000) / 2000 = 7.5
Indifference Point (Profit)
Two (multiple) Alternatives
• The quantity at which a decision maker would be
indifferent between two competing alternatives.
 Alternative B
(outsource)
• R>v
• v high
• FC low
• BEP low
 Alternative A
(in-house)
• R >> v
• v low
• FC high
• BEP high
Choose A
Choose B
Indifferent Point (Cost)
• A manufacturer has 3 options:
1. Use process A with FC=$80,000 and v=$75/unit
2. Use process B with FC=$200,000 and v=$15/unit
3. Purchase for $200/units (in other words, FC=$0 and
v=$200/unit)
80,000+75Q=200Q
QPA=640 units
400000
300000
Cost
80,000+75Q=200,000+15Q
QAB=2,000 units
500000
Process A
200000
Choose lowest cost:
0-640 units :
Purchase
640-2,000 units:
Process A
Above 2,000 units: Process B
Process B
Buy
100000
0
# units
Exercise
• A firm's manager must decide whether to make or buy a
certain item used in the production of vending machines.
Cost and volume estimates are as follows:
a)
b)
Given these numbers, should the firm buy or make this item?
There is a possibility that volume could change in the future.
At what volume would the manager be indifferent between
making and buying?
Solution
a) Given these numbers, should the firm buy or make
this item?
Total cost = Fixed cost + Volume × Variable cost
Make:
Buy:
$150,000 + 12,000 ×
$0
+ 12,000 ×
$60
$80
= $870,000
= $960,000
Because the annual cost of making the item is less than the annual cost of buying it,
the manager would reasonably choose to make the item.
Solution
b)
There is a possibility that volume could change in the future. At
what volume would the manager be indifferent between making
and buying?
To determine the volume at which the two choices would
be equivalent, set the two total costs equal to each other
and solve for volume:
TC make = TC buy
Thus,
$150,000 + Q($60) = 0 + Q($80).
Solving, Q = 7,500 units.
For lower volumes, the choice would be to buy, and for
higher volumes, the choice would be to make
Cost-Volume Analysis Assumptions
• Cost-volume analysis is a viable tool for comparing
capacity alternatives if certain assumptions are
satisfied:
–
–
–
–
One product is involved
Everything produced can be sold
The variable cost per unit is the same regardless of volume
Fixed costs do not change with volume changes (or they
are step changes)
– The revenue per unit is the same regardless of volume
– Revenue per unit exceeds variable cost per unit
Step Costs
• Capacity alternatives may involve step costs,
which are costs that increase stepwise as
potential volume increases.
– The implication of such a situation is the possible
occurrence of multiple break-even quantities.
Exercise
• A manager has options to purchase one, two, or three
machines. Fixed costs are as follows:
Number of
Machines
Total Annual Fixed
Cost
Corresponding
Range of output
1
$9,600
0 to 300
2
15,000
301 to 600
3
20,000
601 to 900
Variable cost is $10 per unit, revenue is $40 per unit
a) Determine the break-even point for each range.
b) If projected annual demand is between 580 and 660 units,
how many machines should the manager purchase
Solution
Number of
Machines
Total Annual Fixed
Cost
Corresponding
Range of output
1
$9,600
0 to 300
2
15,000
301 to 600
3
20,000
601 to 900
a) Determine the break-even point for each range.
1 machine: QBEP = $9,600/($40/unit-$10/unit) = 320 units
2 machine: QBEP = $15,000/($40/unit-$10/unit) = 500 units
3 machine: QBEP = $20,000/($40/unit-$10/unit) = 666.67
units
Exercise
b)
If projected annual demand is between
580 and 660 units, how many machines
should the manager purchase
Comparing the projected range of demand to the two
ranges for which a BEP occurs, you can see that the
BEP is 500, which is in the range 301 to 600. This
means that even if demand is at the low end of the
range, it would be above the BEP and thus yield a
profit. That is not true of range 601 to 900. At the top
end of projected demand, the volume would still be
less than the BEP for that range, so there would be no
profit. Hence, the manager should choose two
machines.