Chapter 5
Strategic Capacity
Planning
Slides prepared by
Laurel Donaldson
Douglas College
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
LO 1
Define capacity, explain the importance of long-term
capacity, know how to measure capacity and
understand two related performance measures,
and describe factors influencing effective capacity.
LO 2
Describe the strategic capacity planning process in
organizations, know how to forecast demand and
calculate capacity requirements, and discuss
major considerations for developing capacity
alternatives,
LO 3
Describe the break-even analysis approach for
evaluating capacity alternatives, and use it to
solve problems.
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Outline
 What is capacity?
 Measuring capacity
 Factors influencing capacity
 Developing capacity alternatives
 Evaluating alternatives
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3
What is capacity?
Capacity is the upper limit on the load
that an operating unit can handle.
The basic questions in capacity handling
are:
What kind of capacity is needed?
How much is needed?
When is it needed?
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4
Importance of Long-Term Capacity
Impacts ability to meet future demands
Affects operating costs
Major determinant of initial costs
Involves long-term commitment
Affects competitiveness
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Measuring capacity
Design capacity
maximum obtainable output under ideal
conditions
Effective capacity
Maximum capacity given delays, product mix,
scheduling difficulties, and other realities.
Actual output
rate of output actually achieved—cannot
exceed effective capacity.
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Common Measures of Capacity
Business
Inputs
Auto manufacturing
Steel mill
Oil refinery
Farming
Restaurant
Theatre
Retail sales
Barrels of crude oil
used per day
Number of acres
Number of tables,
number of seats
Number of seats
Square metres of floor
space, sales per sq. ft.
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Outputs
Number of cars per
shift
Tonnes of steel per
day
Barrels of gasoline per
day
Bushels of grain per
acres per year, litres of
milk per day
Number of meals / day
Number of tickets sold
per day
Revenue generated
per day
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Efficiency and Utilization
Actual Output
Efficiency 
Effective Capacity
Actual Output
Utilizatio n 
Design Capacity
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8
Efficiency/Utilization Example
Design capacity = 50 trucks/day
Effective capacity = 40 trucks/day
Actual output = 36 units/day
Actual Output
36 units day
Efficiency 

 90%
Effective Capacity 40units/day
Actual Output
36 units day
Utilizatio n 

 72%
Design Capacity 50units/day
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Example: Capacity
Actual production last week = 32,000 units
Effective capacity = 35,000 units
Design capacity = 250 units per hour
Factory operates 7 days/week, 3 - 8 hour shifts
Design capacity = (7 x 3 x 8) x (250) = 42,000 units
What is the design capacity for one week?
Calculate the efficiency and utilization rates.
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Example: Capacity
Actual production last week = 32,000 units
Effective capacity = 35,000 units
Design capacity = 250 units per hour
Factory operates 7 days/week, 3 - 8 hour shifts
Design capacity = (7 x 3 x 8) x (250) = 42,000 units
Utilization = 32,000/42,000 = 76.2%
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Example: Capacity
Actual production last week = 32,000 units
Effective capacity = 35,000 units
Design capacity = 250 units per hour
Factory operates 7 days/week, 3 - 8 hour shifts
Design capacity = (7 x 3 x 8) x (250) = 42,000 units
Utilization = 32,000/42,000 = 76.2%
Efficiency = 32,000/35,000 = 91.4%
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12
Factors Influencing Capacity
 Facilities
Floor space, layout
 Products or services
Limited menu in a restaurant
 Human
Training, skills and experience
 Planning and Operational
No of shifts per day, inventory, quality control
 External
Pollution standards, paper work
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Factors Influencing Capacity
Facilities
Products or
services
Planning
and
Operational
Human
External
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Capacity planning process
1. Forecast demand one to five years ahead
2. Determine capacity requirements
3. Measure the capacity now and
decide how to bridge the gap
a) Generate feasible
alternatives
b) Evaluate
alternatives
considering economic
and non economic
aspects
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c) Choose the best
alternative and
implement it
15
0
Growth
Volume
Volume
Some Possible Growth Patterns
Time
0
Decline
Time
Cyclical
Volume
Volume
0
Stable
Time
0
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Time
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Calculating Capacity Requirements
A department works one eight hour shift, 250 days a year, and has these
figures for products, their demand, and usage of a type of machine that
is currently being considered. How many machines would be needed to
handle the required volume?
Product
Annual
Demand
Standard Processing
time per unit (hr.)
Processing time
needed (hr.)
#1
400
5.0
2,000
#2
300
8.0
2,400
#3
700
2.0
1,400
8  250  2,000 machine hours per year
2,000  2,400  1,400
 2.9 machines
2,000
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17
Developing Capacity Alternatives
Design flexibility into systems
Differentiate between new and mature products
Take a “big picture” approach to capacity changes
Prepare to deal with capacity “chunks”
Attempt to smooth out capacity requirements
Use capacity cushion
Identify the optimal operating level
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Optimal operating level
Average cost
per unit
Minimum cost & optimal operating rate are
functions of size of production unit.
0
Small
plant
Medium
plant
Large
plant
Output rate
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19
Economies and Diseconomies of Scale
Average cost per unit
What makes the unit cost increase?
Large Facility
Small Facility
Medium Facility
Economies
of scale
Best
operating
level
Diseconomies
of scale
Best
operating
level
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Best
operating
level
Output
rate
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Economies and Diseconomies of Scale
Economies of scale
Fixed costs (facilities, equipment,
management) spread out over more units
Volume purchase discounts
Diseconomies of scale
Worker fatigue, equipment breakdown, less
room for error, difficulties in coordination
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Evaluating alternatives
 Economic considerations
 Cost, useful life, compatibility, revenue
 Non economic considerations
 Public opinion, reactions from employees,
community pressure
 Techniques used for evaluation:
a) Break Even Analysis
b) Payback Period
c) Net Present Value
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Break Even Analysis
TC  FC  VC
VC  Q  v
TR  Q  r
P  TR  TC  Q  r  FC  Q  v 
QBEP
FC

r v
TC  Total Cost
FC  Total Fixed Cost
VC  Total Variable Cost
TR  Total Revenue
v  variable cost per unit
r  revenue per unit
Q  volume of output
QBEP  break even volum e
P  profit
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Break-Even Analysis
Total revenue
Total cost
Amount ($)
Break-even point
Total revenue = Total cost
Variable cost
Fixed cost
Q (quantity in units)
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Example: Break-Even
Fixed costs = $40,000
Labour costs = $3/unit
FC
QBEP = R - VC =
Material = $1.50/unit
Selling price = $10.00 per unit
$40,000
10.00 - (3 +1.50)
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= 7273
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Example: Break-even Analysis
The school cafeteria can make pizza for
about $.30 per slice.
Cost for kitchen and labour is $200 per day
The nearby Pizza Den delivers for $9.00 per
pizza (8 slices)
Cost for labour reduced to $75 per day
Make or Buy?
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Break-Even Problem with Step Fixed Costs
$
3 machines
2 machines
1 machine
Quantity
Step fixed costs and variable costs.
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Multiple Break-Even Points
BEP3
$
BEP2
TC
TC
3
TC
2
1
Quantity
Multiple break-even points
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Assumptions of Break Even Analysis
One product is involved
Everything produced can be sold
Variable cost per unit is the same regardless of
volume
Fixed costs do not change with volume
Revenue per unit constant with volume
Revenue per unit exceeds variable cost per unit
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29
Further Financial Analysis
Cash Flow
(cash received from sales and other sources)
-- (cash outflow for labour, material, overhead, taxes)
Present Value
the sum, in current value, of all future cash flows of an
investment proposal.
most used methods of financial analysis:
Payback period
Net present value (NPV)
Internal rate of return (IRR)
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What is Capacity?
Capacity usually refers to the upper limit of:
A) inventories
B) demand
C) supplies
D) rate of output
E) finances
Ans: D
Page: 141
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What is capacity?
Capacity decisions are mostly long term decisions.
Ans: False
Page: 141
Stating capacity in dollar amounts generally results in a
consistent measure of capacity.
Ans: False
Page: 142
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Capacity performance
The maximum possible output given a product mix,
scheduling difficulties, quality factors, and so on,
is:
A) utilization
B) design capacity
C) efficiency
D) effective capacity
E) available capacity
Ans: D
Page: 142
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33
Capacity Performance
Efficiency is defined as the ratio of:
A) actual output to effective capacity
B) actual output to design capacity
C) design capacity to effective capacity
D) effective capacity to actual output
E) design capacity to actual output
Ans: A
Page: 143
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Capacity Performance
Utilization is defined as the ratio of:
A) actual output to effective capacity
B) actual output to design capacity
C) design capacity to effective capacity
D) effective capacity to actual output
E) design capacity to actual output
Ans: B
Page: 143
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
35
Learning Checklist
 Define capacity and identify some common ways
it is measured.
 Distinguish between efficiency and utilization and
be able to calculate them.
 Describe factors that influence effective capacity.
 Describe the steps of the strategic capacity
planning process.
 Discuss major considerations for developing
capacity alternatives.
 Use break-even analysis to solve problems.
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
36