Strategic Capacity
Planning for
Products and
Services
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 You should be able to:
1.
2.
3.
4.
5.
Summarize the importance of capacity planning
Discuss ways of defining and measuring capacity
Describe the determinants of effective capacity
Discuss the major considerations related to developing
capacity alternatives
Briefly describe approaches that are useful for
evaluating capacity alternatives
Instructor Slides
5-2
 Capacity
 The upper limit or ceiling on the load that an operating
unit can handle
 Capacity needs include
 Equipment
 Space
 Employee skills
Instructor Slides
5-3
 Goal
 To achieve a match between the long-term supply
capabilities of an organization and the predicted level of
long-term demand
 Overcapacity operating costs that are too high
 Undercapacity strained resources and possible loss of
customers
Instructor Slides
5-4
 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?
Instructor Slides
5-5
Labor
Capacity
Equipment
Capacity
Packaging
Capacity
Material
Receiving
Capacity
Production
Capacity
Equipment
Maintenance
Capacity
Facility
Capacity
Inventory
Storage
Capacity
Sales Force
Capacity

We measure the capacity of a plant, machine
department, worker, hospital, etc., either
•
•

in terms of output (number of units or number of
pounds manufactured) or
in terms of input (e.g. number of machine hours,
machines, labor hours, …).
A major function of capacity planning is to
match the capacity of the machine or facility
with the demand for the products of the firm.

Capacity planning can be classified into three
planning horizons:

Long range planning horizons of one year or longer to
provide sufficient time to build a new facility, to
expand the existing facility or to move to a new
facility due to expected changes in demand.

Medium range planning horizon ranges
approximately from one month and less than a year.
At this level of planning, decisions or activities
include acquisition of a major piece of machinery and
subcontracting.

Short range planning horizon covers capacity
planning activities on a daily or a weekly basis and are
generated as a result of disaggregation of the long or
medium range capacity plans. These activities include
machine loading and detailed production scheduling.
 Output rate is uncertain because:
 Employee absences
 Equipment breakdown
 Vacations
 Material delivery delays and shortages
 Quality problems and rework
 Capacity decisions
1.
impact the ability of the organization to meet future demands
2. affect operating costs
3. are a major determinant of initial cost
4. often involve long-term commitment of resources
5. can affect competitiveness
6. affect the ease of management
7. have become more important and complex due to globalization
8. need to be planned for in advance due to their consumption of
financial and other resources
Instructor Slides
5-10
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.
Instructor Slides
5-11
 Measure capacity in units that do not require
updating
 Why is measuring capacity in dollars problematic?
 Two useful definitions of capacity
 Design capacity
 The maximum output rate or service capacity an operation,
process, or facility is designed for
 Effective capacity
 Design capacity minus allowances such as personal time and
maintenance
Instructor Slides
5-12
 Actual output
 The rate of output actually achieved
 It cannot exceed effective capacity
 Efficiency
actual output
Efficiency 
effective capacity
 Utilization
actual output
Utilizatio n 
design capacity
Measured as percentages
Instructor Slides
5-13
 Design Capacity = 50 trucks per day
 Effective Capacity = 40 trucks per day
 Actual Output = 36 trucks per day
actual output
36
Efficiency 

 90%
effective capacity 40
actual output
36
Utilizatio n 

 72%
design capacity 50
Instructor Slides
5-14
 Facilities
 Product and service factors
 Process factors
 Human factors
 Policy factors
 Operational factors
 Supply chain factors
 External factors
Instructor Slides
5-15
 Leading
 Build capacity in anticipation of future demand increases
 Following
 Build capacity when demand exceeds current capacity
 Tracking
 Similar to the following strategy, but adds capacity in relatively
small increments to keep pace with increasing demand
 Strategies are typically based on assumptions and
predictions about:
 Long-term demand patterns
 Technological change
 Competitor behavior
Instructor Slides
5-17
 Capacity Cushion
 Extra capacity used to offset demand uncertainty
 Capacity cushion = 100% - Utilization
 Capacity cushion strategy
 Organizations that have greater demand uncertainty
typically have greater capacity cushion
 Organizations that have standard products and services
generally have greater capacity cushion
Instructor Slides
5-18
1.
Estimate future capacity requirements
2.
Evaluate existing capacity and facilities; identify gaps
3.
Identify alternatives for meeting requirements
4.
Conduct financial analyses
5.
Assess key qualitative issues
6.
Select the best alternative for the long term
7.
Implement alternative chosen
8.
Monitor results
Instructor Slides
5-19
 Long-term considerations relate to overall level of
capacity requirements
 Require forecasting demand over a time horizon and
converting those needs into capacity requirements
 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
Instructor Slides
5-20
 Calculating processing requirements requires
reasonably accurate demand forecasts, standard
processing times, and available work time
k
NR 
pD
i
i 1
i
T
where
N R  number of required machines
pi  standard processing time for product i
Di  demand for product i during the planning horizon
T  processing time available during the planning horizon
Instructor Slides
5-21
Standard
processing time
per unit (hr.)
Product
Annual
Demand
Processing time
needed (hr.)
#1
400
5.0
2,000
#2
300
8.0
2,400
#3
700
2.0
1,400
5,800
If annual capacity is 2000 hours, then we need three machines to handle the
required volume: 5,800 hours/2,000 hours = 2.90 machines
5-22
 If a department works one eight hour shift, 250
days per year how many machines are needed?
 (5,800)/(8 X 250) = 2.9 or 3 machines
 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
Instructor Slides
5-24
 Strategies used to offset capacity limitations and that
are intended to achieve a closer match between
supply and demand
 Pricing
 Promotions
 Discounts
 Other tactics to shift demand from peak periods into
slow periods
Instructor Slides
5-25
 Once capacity requirements are determined, the organization
must decide whether to produce a good or service itself or
outsource
 Factors to consider:
 Available capacity
 Expertise
 Quality considerations
 The nature of demand
 Cost
 Risks
Instructor Slides
5-26
 Things that can be done to enhance capacity
management:
 Design flexibility into systems
 Take stage of life cycle into account
 Take a “big-picture” approach to capacity changes
 Prepare to deal with capacity “chunks”
 Attempt to smooth capacity requirements
 Identify the optimal operating level
 Choose a strategy if expansion is involved
Instructor Slides
5-27
 Leading
 Build capacity in anticipation of future demand increases
 Following
 Build capacity when demand exceeds current capacity
 Tracking
 Similar to the following strategy, but adds capacity in relatively
small increments to keep pace with increasing demand
Instructor Slides
5-28
 An operation in a
sequence of operations
whose capacity is lower
than that of the other
operations
Instructor Slides
5-29
Figure 5.2
Machine #1
Machine #2
Bottleneck operation: An operation
in a sequence of operations whose
capacity is lower than that of the
other operations
10/hr
10/hr
Machine #3
Bottleneck
Operation
10/hr
Machine #4
10/hr
30/hr
Bottleneck
Operation 1
20/hr.
Operation 2
10/hr.
Operation 3
15/hr.
Maximum output rate
limited by bottleneck
10/hr.
Average cost per unit
Minimum
cost
Optimal
Output
Rate
Instructor Slides
Rate of output
5-32
 Economies of Scale
 If output rate is less than the optimal level, increasing
the output rate results in decreasing average per unit
costs
 Diseconomies of Scale
 If the output rate is more than the optimal level,
increasing the output rate results in increasing average
per unit costs
Instructor Slides
5-33
 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
 Construction costs increase at a decreasing rate as facility
size increases
 Processing costs decrease due to standardization
Instructor Slides
5-34
 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
 Distribution costs increase due to traffic congestion and
shipping from a centralized facility rather than multiple
smaller facilities
 Complexity increases costs
 Inflexibility can be an issue
 Additional levels of bureaucracy
Instructor Slides
5-35
Average cost per unit
Minimum cost & optimal operating rate are
functions of size of production unit.
Small
plant
Medium
plant
Large
plant
Output rate
Instructor Slides
5-36
 Constraint
 Something that limits the performance of a process or system in
achieving its goals
 Categories
 Market
 Resource
 Material
 Financial
 Knowledge or competency
 Policy
Instructor Slides
5-37
1.
2.
3.
4.
5.
Identify the most pressing constraint
Change the operation to achieve maximum benefit, given
the constraint
Make sure other portions of the process are supportive of
the constraint
Explore and evaluate ways to overcome the constraint
Repeat the process until the constraint levels are at
acceptable levels
Instructor Slides
5-38
 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?
 What will its useful life be?
 Will it be compatible with present personnel and present
operations?
 Non-economic
 Public opinion
Instructor Slides
5-39
 Techniques for Evaluating Alternatives
 Cost-volume analysis
 Financial analysis
 Decision theory
 Waiting-line analysis
 Simulation
Instructor Slides
5-40
 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
Instructor Slides
5-41
 BEP
 The volume of output at which total cost and total
revenue are equal
 Profit (P) = TR – TC = R x Q – (FC +v x Q)
= Q(R – v) – FC
QBEP
Instructor Slides
FC

Rv
5-42
Instructor Slides
5-43
 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.
Instructor Slides
5-44
Figure 5.7a
3 machines
2 machines
1 machine
Quantity
Step fixed costs and variable costs.
 FC = Fixed cost
 VC = Total Variable Cost
 v = Variable cost per unit
 TC = Total cost
 TR = Total revenue
 R = Revenue per unit
 Q = Quantity
 QBEP = Breakeven Quantity
 P = Profit
 TC = FC + VC
 VC = v x Q
 TR = R x Q
 P = TR – TC
 P = R x Q – (FC + v x Q)
 P = Q(R – v) – FC
 Q = (P + FC) / (R - v)
 QBEP = FC / (R – v)
Given FC = $6,000; VC = $2 / unit;
Revenue = $7 / unit
Q1 : Breakeven point?
QBEP = FC / (R – v) = 6000 / (7-2) = 1,200 units
Q2 : What is the profit if 1,000 units are sold?
P = Q(R – v) – FC = 1,000(7-2)-6,000 = -1,000
Q3: How many units must be sold to realize a
profit of $4,000?
Q = (P + FC) / (R - v) = (4,000+6,000)/(7-2)
Q = 2,000 units
 Given the following costs for a make or buy
decision:
Annual fixed cost
Variable cost/unit
Make
$150,000
$60
Buy
None
Q1: For an annual volume of 12,000, should we
make or buy?
TCmake = 150,000 + 60 x 12,000 = $870,000
TCbuy = 80 x 12,000 = $960,000
Decision: make
$80
Q2: Determine the volume at which the two
choices would be equivalent.
TCmake = 150,000 + 60 x Q
TCbuy = 80 x Q
TCmake = TCbuy
150,000 + 60Q = 80Q
Q = 7,500 units
Q3: Over what range of volume the “buy” decision
is preferred?
Make
Decion:
Buy if Q < 7,500
Cost $
Q = 7,500
Buy
Units Q
Make if Q > 7,500
 Alternatives: Buy 1, 2 or 3 machines:
# of
Fixed
Output
Machines
Costs
Range
1
$
9,600
0-300
2
$ 15,000 301-600
3
$ 20,000 601-900
Variable cost is $10; revenue is $40 per unit
Q1: Determine QBEP for each output range.
1: QBEP = 9600/(40-10) = 320 > 300 not BEP
2: QBEP = 15000/(40-10) = 500 units
3: QBEP = 20000/(40-10) = 666.67
 If projected annual demand is between 580 and
660 units, how many machines should the
manager purchase?
 Answer: 2 machines (why?)
Figure 5.7b
$
BEP
3
TC
BEP2
TC
3
TC
2
1
Quantity
Multiple break-even points
 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
Instructor Slides
5-55
 Cash flow
 The difference between cash received from sales and
other sources, and cash outflow for labor, material,
overhead, and taxes
 Present value
 The sum, in current value, of all future cash flow of an
investment proposal
Instructor Slides
5-56
 Helpful tool for financial comparison of
alternatives under conditions of risk or
uncertainty
 Suited to capacity decisions
 See Chapter 5 Supplement
 Useful for designing or modifying service systems
 Waiting-lines occur across a wide variety of
service systems
 Waiting-lines are caused by bottlenecks in the
process
 Helps managers plan capacity level that will be
cost-effective by balancing the cost of having
customers wait in line with the cost of additional
capacity
Volume
0
0
Time
Cyclical
Time
Volume
Growth
Decline
0
Time
Volume
Volume
Figure 5-1
0
Stable
Time
A
B
C
D
E
F
Effective
Capacity
Demand
 Capacity planning impacts all areas of the organization
 It determines the conditions under which operations will have to function
 Flexibility allows an organization to be agile
 It reduces the organization’s dependence on forecast accuracy and reliability
 Many organizations utilize capacity cushions to achieve flexibility
 Bottleneck management is one way by which organizations can enhance
their effective capacities
 Capacity expansion strategies are important organizational considerations
 Expand-early strategy
 Wait-and-see strategy
 Capacity contraction is sometimes necessary
 Capacity disposal strategies become important under these
conditions
Instructor Slides
5-61