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 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

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 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) Utilization Efficiency = Actual output Effective capacity 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 = Actual output = 36 = 90% Effective capacity 40 Utilization = Actual output = 36 = 72% Design capacity 50

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 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

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 Calculating processing requirements requires: reasonably accurate demand forecasts, standard processing times available work time

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

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

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: 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?

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.

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 Operation 1 20/hr. Operation 2 10/hr. Operation 3 15/hr. 10/hr. Bottleneck Maximum output rate limited by bottleneck

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

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) 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)

Cost-volume relationships

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

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?

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 = $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. 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. 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. 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 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

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

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?

Solution Given these numbers, should the firm buy or make this item? Total cost = Fixed cost + Volume × Variable cost Make: $150,000 + 12,000 × $60 = $870,000 Buy: $0 + 12,000 × $80 = $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 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: 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

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) = 666.67 units

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.