1. Strategic Capacity Planning
Chapter 5

2. 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

3. Capacity Planning Capacity Strategic Capacity Planning
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

4. 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?

5. Capacity Decisions Are Strategic
impact the ability of the organization to meet future demands
affect operating costs
major determinant of initial cost
(often) involve long-term commitment of resources
affect competitiveness
affect the ease of management

6. 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

7. 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.

8. 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.

9. Measuring System Effectiveness
Efficiency
(Measured as percentages)
Utilization
Efficiency =
Actual output
Effective capacity
Utilization =
Actual output
Design capacity

10. Example: Efficiency and Utilization
Design Capacity = 50 trucks per day
Effective Capacity = 40 trucks per day
Actual Output = 36 trucks per day
Efficiency =
Actual output = 36
= 90%
Effective capacity 40
Utilization =
Actual output = 36
= 72%
Design capacity 50

11. 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

12. 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

13. Capacity Strategies Leading Following Tracking
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

14. 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

15. 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.

16. Common demand patterns

17. Calculating Processing Requirements
Calculating processing requirements requires:
reasonably accurate demand forecasts,
standard processing times
available work time

18. Example If annual capacity is 2,000 hours/machine, then
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
If annual capacity is 2,000 hours/machine, then
Units of capacity needed = 5,800 hours ÷ 2,000 hours = 2.90  3 machines

19. Service Capacity Planning
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

20. 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

21. Case Study How much would an all-American iPhone cost? NPR Marketplace
Audio (4:33)
Pay attention to:
Logistic efficiency
Cost structure
Components
International expertise
Consumer base
While listening, take notes on the above 5 items
Use the notes, discuss why/when a company decides to outsource?

22. Developing Capacity Strategies
There are a number of ways to enhance development of capacity strategies:
Design flexibility into systems.
Provision for future expansion
Take stage of life cycle into account.
Take a “big-picture” (i.e., systems) approach to capacity changes.
Prepare to deal with capacity “chunks.”
Capacity increments are not usually smooth
Attempt to smooth out capacity requirements.
Overtime; subcontract; inventory control
Identify the optimal operating level: economies of scale.

23. 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.

24. “Big-Picture ” Approach
Bottleneck Operation
An operation in a sequence of operations whose capacity is lower than that of the other operations
Operation 1 20/hr.
Operation 2 10/hr.
Operation 3 15/hr.
10/hr.
Bottleneck
Maximum output rate limited by bottleneck

25. Optimal Operating Level
Economies of Scale
If output rate is less than the optimal level, increasing the output rate results in decreasing average per unit costs
Minimum
cost
Average cost per unit 
Rate of output 
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 average cost per unit

26. 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

27. 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

28. 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

29. 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

30. 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

31. Break Even Point 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
0 = QBEP(R – v) – FC
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
VC = Q x variable cost per unit (v)

32. Cost-volume relationships

33. Cost-volume relationships
This line shows the difference between TR and TC.

34. 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.
How many pies must be sold in order to break even?
What would the profit (loss) be if 1,000 pies are made and sold in a month?
How many pies must be sold to realize a profit of $4,000?
If 2,000 can be sold, and a profit target is $5,000, what price should be charged per pie?

35. 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.
How many pies must be sold in order to break even?
FC = $ VC = $2 per pie R = $7 per pie
QBEP = FC / (R – VC) = 6000 / (7 – 2) = 1200 pies/month

36. 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.
What would the profit (loss) be if 1,000 pies are made and sold in a month?
FC = $ VC = $2 per pie R = $7 per pie
For Q = 1000, P = Q(R – v) – FC = 1000(7 – 2) – 6000 = –1000

37. 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.
How many pies must be sold to realize a profit of $4,000?
FC = $ VC = $2 per pie R = $7 per pie
Q = (P + FC) / (R – v) = ( ) / (7 – 2) = 2000 pies

38. 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.
If 2,000 can be sold, and a profit target is $5,000, what price should be charged per pie?
FC = $ 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 = ( × 2000) / 2000 = 7.5

39. Indifference Point (Profit) Two (multiple) Alternatives
The quantity at which a decision maker would be indifferent between two competing alternatives.
Alternative A (in-house)
R >> v
v low
FC high
BEP high
Alternative B (outsource)
R > v
v high
FC low
BEP low
Choose B
Choose A

40. Indifferent Point (Cost)
A manufacturer has 3 options:
Use process A with FC=$80,000 and v=$75/unit
Use process B with FC=$200,000 and v=$15/unit
Purchase for $200/units (in other words, FC=$0 and v=$200/unit)
80,000+75Q=200Q
QPA=640 units
80,000+75Q=200,000+15Q
QAB=2,000 units
Choose lowest cost:
0-640 units : Purchase
640-2,000 units: Process A
Above 2,000 units: Process B

41. 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:
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?

42. Solution Given these numbers, should the firm buy or make this item?
Total cost = Fixed cost + Volume × Variable cost
Make: $150, ,000 × $ = $870,000
Buy: $ ,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.

43. Solution
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

44. 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

45. 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.

46. Exercise
A manager has options to purchase one, two, or three machines. Fixed costs are as follows:
Variable cost is $10 per unit, revenue is $40 per unit
Determine the break-even point for each range.
If projected annual demand is between 580 and 660 units, how many machines should the manager purchase
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

47. Solution Determine the break-even point for each range.
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
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) = units

48. Exercise
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.