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STRATEGIC
CAPACITY PLANNING
Chapter 5
MIS 373: Basic Operations Management
ANNOUNCEMENTS
• Week 1 problem solving assignment (PSA) has been graded
•
•
•
•
•
Q1 (a) 20 points
Q1 (b) 20 points
Q2 (a) 20 points
Q2 (c) 20 points
Q3 20 points
Tips for getting higher points in PSAs:
1. Read the problem description carefully
2. Answer all (sub-) questions
3. Show your work
4. If the problem description is not clear to you,
let me know ASAP
• Future PSAs will be released on Tuesdays
• So that you will have one more day to work on them
• You can now come to my Tuesday office hours for PSAs
• Encourage participation in the next contemporary issues
discussion (6/30)
• Team project proposal due date is postponed to 6/27
CONTEMPORARY ISSUES
• It appears to me that many of you were not particularly excited
when peers were sharing contemporary issues.
• For the next contemporary issues session:
• You can go solo or form a team of two for a contemporary issue
• In your discussion, give more visual materials, e.g.,
•
•
•
•
•
•
Slides
Video
Picture
Poster
Role play
… any things that can make the issue more vivid and memorable
LEARNING OBJECTIVES
• After this lecture, students will be able to
1.
2.
3.
4.
5.
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
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MOTIVATION
wsj.com 1/14/14 -- Auto Makers Dare to Boost
Capacity
• A large increase in production capacity poses a
serious risk for auto makers. They reap strong
profits if their factories are running near 100%
of capacity, but their losses mount rapidly if the
utilization rate falls below 80%. And when
manufacturers build more cars than they sell,
they often resort to price wars to boost sales.
• At the end of 2013, auto dealers had 3.45
million cars and trucks in stock… That is
enough to last 63 days at the current sales rate,
a level the industry considers optimal.
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
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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?
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• Capacity decisions:
• impact the ability of the organization to meet future demands
• When Microsoft introduced its new Xbox in late 2005, there were
insufficient supplies, resulting in lost sales and unhappy customers.
• affect operating costs
• Costs of over- and under-capacity
• affect competitiveness
• capacity can affect delivery speed
• affect the ease of management
• (often) involve long-term commitment of resources
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CAPACITY
• Design capacity
• Maximum output rate or service capacity an operation, process, or
facility is designed for
• Effective capacity
• Design capacity minus allowances such as personal time,
maintenance, and scrap
• Actual output
• Rate of output actually achieved--cannot
exceed effective capacity.
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CAPACITY: ILLUSTRATION
(Suppose) 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,
galley and 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 =
MIS 373: Basic Operations Management
Actual output
Design capacity
11
• Design Capacity = 50 trucks per day
• Effective Capacity = 40 trucks per day
• Actual Output = 36 trucks per day
Efficiency =
Actual output
Effective capacity
Utilization =
MIS 373: Basic Operations Management
Actual output
Design capacity
=
=
36
40
36
50
= 90%
= 72%
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• 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
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• 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
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• 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
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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
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BOTTLENECK OPERATION
• An operation in a sequence of operations whose capacity is
lower than that of the other operations
• Animation: http://brams.dk/technotes/flash-mx/performancebottlenect-simulation/
Bottleneck
Operation 1
20/hr.
Operation 2
10/hr.
Operation 3
15/hr.
?
10/hr.
Maximum output rate
limited by bottleneck
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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
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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.
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COMMON DEMAND PATTERNS
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EXERCISE
• Suppose that you are a capacity planner in General Motor.
• Discuss with a partner. What would you do to make sure you
have the right capacity in GM?
• Prediction? How?
• Planning? How?
• What other information do you need?
EXAMPLE:
ADVANCED FORECASTING METHODS
• Choi, H., and Varian, H. 2012. Predicting the Present with
Google Trends. Economic Record 88 2–9.
• Predicting sales of motor vehicles and parts
• “We have found that simple seasonal AR models that include relevant Google
Trends variables tend to outperform models that exclude these predictors by
5 per cent to 20 per cent.”
Auto-regressive (AR) models:
AR(k): Use the values from the past k
time periods to predict the current value:
Example:
AR(4): Use the values from the past 4
time periods to predict the current value:
Salest = constant +
α1 × Salest-1 + α2 × Salest-2 +
α3 × Salest-3 + α4 × Salest-4 +
β1 × Google_Trend_Cart-1 +
β2 × Google_Trend_Cart-2 +
β3 × Google_Trend_Cart-3 +
β4 × Google_Trend_Cart-4
EXAMPLE:
ADVANCED FORECASTING METHODS
• Google Flu Trend
CALCULATING PROCESSING
REQUIREMENTS
Product
Annual Demand
Standard processing
time per unit (hr.)
Processing time
needed (hr.)
#1
400
5
2000
#2
300
8
2400
#3
700
2
1400
Total=5800
Units of capacity needed =
Processing time needed
Processing time capacity per unit
If annual capacity is 2,000 hours/machine, then
Units of capacity needed = 5,800 hours ÷ 2,000 hours = 2.90  3 machines
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• Service capacity planning can present a number of
challenges related to:
• The need to be near customers
• Convenience
• The inability to store services
• Cannot store services for consumption later
• The degree of demand volatility
• Volume and timing of demand
• Time required to service individual customers
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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
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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
• E.g., SSD and USB Flash Drive
2.
3.
4.
5.
Take a “big-picture” (i.e., systems) approach to capacity changes
Attempt to smooth out capacity requirements
Take stage of life cycle into account
Identify the optimal operating level: economies of scale
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Sales
PRODUCT LIFE CYCLE
Introduction
Growth
Maturity
Decline
• 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.
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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
MIS 373: Basic Operations Management
Diseconomies
of Scale
Minimum average cost per unit
Minimum
cost
If the output rate is
more than the
optimal level,
increasing the
output rate
results in
increasing
average per unit
costs
Rate of output 
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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
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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
Inflexibility
Additional levels of management
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DISCUSSIONS
• Discuss with a partner:
• What are the examples that a company/product failed because it did
not achieve economies of scale (i.e., too small to compete)?
• If possible, also discuss why they failed to achieve economies of scale.
Was it because of the problems in marketing, finance, or operations?
• What are the examples that a company/product failed because of it
encountered diseconomies of scale (i.e., too big to compete)?
EVALUATING ALTERNATIVES
 Alternatives should be evaluated from varying perspectives
 Economic





Is it economically feasible?
How much will it cost?
How soon can we have it?
What will operating and maintenance costs be?
Will it be compatible with present personnel and present
operations?
 Non-economic
 Public opinion
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EVALUATING ALTERNATIVES
• Techniques for 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
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COST-VOLUME ANALYSIS
• 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
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BREAK-EVEN POINT (BEP)
• Break-Even-Point (BEP)
• The volume of output at which total cost and total
revenue are equal (profit = 0)
• Profit (P) = 0 = TR – TC
= (R × Q) – (FC + v × Q)
= Q(R – v) – FC
Recall:
• P: Profit
• Q: Quantity
• TR: Total Revenue
•
TR = revenue per unit (R) x Q
• TC: Total Cost
•
0 = QBEP(R – v) – FC
• FC: Fixed Costs
• VC: Variable Costs
•
MIS 373: Basic Operations Management
TC = FC + VC
VC = Q x variable cost per unit (v)
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REFORMULATION OF THE
EQUATION
• The equation can be easily reformulated to obtain
other components of interest:
• P = TR – TC
= (R × Q) – (FC + v × Q)
= Q(R – v) – FC
• Q = (P + FC) / (R – v)
• R = (P + FC + v × Q) / Q
Recall:
• P: Profit
• Q: Quantity
• TR: Total Revenue
•
TR = revenue per unit (R) x Q
• TC: Total Cost
•
TC = FC + VC
• FC: Fixed Costs
• VC: Variable Costs
•
MIS 373: Basic Operations Management
VC = Q x variable cost per unit (v)
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COST-VOLUME RELATIONSHIPS
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COST-VOLUME RELATIONSHIPS
This line shows
the difference
between TR and
TC.
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EXERCISE PROBLEMS
• (Textbook page 203) 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?
EXERCISE SOLUTIONS
• (Textbook page 203) 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
EXERCISE SOLUTIONS
• (Textbook page 203) 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
EXERCISE SOLUTIONS
• (Textbook page 203) 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
EXERCISE SOLUTIONS
• (Textbook page 203) 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
Another way to solve it:
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
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EXAMPLE:
INDIFFERENCE POINT
• 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
Choose lowest cost:
0-640 units :
Purchase
640-2,000 units:
Process A
Above 2,000 units: Process B
MIS 373: Basic Operations Management
400000
300000
Cost
80,000+75Q=200,000+15Q
QAB=2,000 units
500000
Process A
200000
Process B
Buy
100000
0
# units
47
EXAMPLE:
INDIFFERENCE POINT
• 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
Choose lowest cost:
0-640 units :
Purchase
640-2,000 units:
Process A
Above 2,000 units: Process B
MIS 373: Basic Operations Management
400000
300000
Cost
80,000+75Q=200,000+15Q
QAB=2,000 units
500000
Process A
200000
Process B
Buy
100000
0
# units
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EXERCISE PROBLEMS
• 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. Given these numbers, should the firm buy or make this item?
b. There is a possibility that volume could change in the future. At what
volume would the manager be indifferent between making and buying?
EXERCISE SOLUTIONS
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.
EXERCISE SOLUTIONS
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:
Thus,
TC make = TC buy
$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
KEY POINTS
• Capacity decisions can be critical to the success of a
business organization because capacity is the supply side of
the supply-demand equation, and too little or too much
capacity is costly.
• The key issues in capacity planning relate to determining
what kind of capacity is needed, how much is needed, and
when it is needed.
• Volatile demand and long lead times to achieve capacity
changes can be challenging.
• Cost-volume analysis (break-even point and indifference
point) can give useful information for capacity planning.
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