BBN

Chapter V Capacity Planning for Products and Services

Capacity: Capacity refers to an upper limit on the load that an operating unit can handle. The operating unit can be a plant, department, machine, store, or worker. Importance of Capacity Planning: The goal of strategic capacity planning is to achieve a match between the long-term supply capabilities of an organization and the predicted level of long-term demand. Organizations plans capacity for various reasons. Among the major reasons are changes in demand, changes in technology, changes in environment, and recognized threats or opportunities. A gap between current and desired capacity will result in capacity that is out of balance. Overcapacity causes operating costs that are too high, while undercapacity causes damaged resources and possible loss of customer. For a number of reasons capacity decisions are among the most fundamental of all the design decisions. They are as follows: (i) Capacity decisions have a real impact on the ability of the organization to meet future demands for products and services. Capacity essentially limits the rate of output possible. (ii) Capacity decisions affect operating costs. If the capacity and demand matches, the operating cost decreases. (iii) Capacity is a major determinant of initial cost. The greater the capacity the greater its initial cost. (iv) Capacity decisions involve long-term commitment of resources. Once these decisions are implemented, it may be difficult or impossible to modify them without incurring major cost. (v) Capacity decisions can affect competitiveness. Defining and measuring capacity: In selecting a measure of capacity, it is important to choose one that does not require updating. For example, dollar amounts are often a poor measure of capacity because price changes necessitate updating of that measure. The measure of capacity must be tailored to the situation. Keeping this in mind, we define the capacity by two ways: (i) Design capacity: It is the maximum rate of output achieved under ideal conditions. (ii) Effective capacity: Design capacity minus allowances (such as personal time, maintenance). It is usually less than design capacity owing to realities of changing product mix, the need for periodic maintenance of equipment, lunch break, coffee breaks, etc. Measures of system effectiveness: Above different measures of capacity are useful in defining two measures of system effectiveness: (a) Efficiency: Efficiency is the ratio of actual output to effective capacity. actual output Efficiency = 100% effective capacity

BBN (b) Utilization: Capacity utilization is the ratio of actual output to design capacity. actual output utilization = 100% design capacity Example: Given the information bellow, compute the efficiency and the utilization of the vehicle repair department. Design capacity = 50 trucks per day Effective capacity = 40 trucks per day Actual output = 36 tracks per day Solution: Efficiency = actual output 36 = 100% = 90% effective capacity 40

actual output 36 = 100% = 72% design capacity 50 Compared to the effective capacity of 40 units per day, 36 unit per day looks pretty good. However, compared to the design capacity of 50 units per day, 36 unit per day is much less impressive although probably more meaningful. Increasing utilization depends on being able to increase effective capacity and this requires a knowledge of what is constraining effective capacity. utilization = Example 2: Determine efficiency and utilization for a loan processing operation that processes an average of 7 loans per day. The operation has a design capacity of 10 loans per day and an effective capacity of 8 loans per day. Example 3: In a job shop, effective capacity is only 50% of the design capacity, and actual output is 80% of effective output. What design capacity would be needed to achieve an actual output of eight jobs per week? Determinants of effective capacity: Many decisions about system design have an impact on capacity. The main factors relate to 1. Facilities 4. Operational factors 2. Product or service process 5. Supply chain 3. Human considerations 6. External

1. Facilities: Among the design of facilities location factors such as transportation costs, distance to market, labor supply, and energy sources are important. Also, layout of the work area often determines how smoothly work can be performed. Environmental factors such as heating, lighting, and ventilation also play an important role in determining whether personnel can perform effectively. 2. Product and service factors: Product and service design have a tremendous influence on capacity. For example, when items are similar, the ability of the system to produce those items is generally much greater than when successive items differ. 3. Human factors: The tasks that make up a job, the variety of activities involved, and the training, skill and experience required to perform a job all have an impact on the 2

BBN potential and actual output. Also motivation of employee has an important impact on capacity. 4. Operational factors: Scheduling, inventory stocking decisions, purchasing requirements, quality inspection and control have impact on effective capacity. 5. Supply chain factors: It should be taken into account in capacity planning if substantial capacity changes are involved. Ex. If the capacity increases, will the elements of supply chain be able to handle the increase? 6. External factors: Product standards, safety regulations, pollution control have impact on capacity planning. Facilities: (i) design location (ii) layout (iii) environment 4. Operational (i) Scheduling (ii) Quality assurance (iii) Purchasing 2. Product/ service (i) Design (ii) Product /service mix 5. External (i) Product standard (ii) Safety regulations (iii) Pollution control 3. Human factors (i) Job content (ii) Training (iii) Motivation

Factors that determine effective capacity. Steps in Capacity planning process: 1. Estimate future capacity requirements. 2. Evaluate existing capacity and facilities and identify gaps. 3. Identify alternatives for meeting requirements. 4. Conduct financial analysis of each alternative. 5. Asses key qualitative issues for each alternative. 6. Select one alternative to pursue. 7. Implement the selected alternative. 8. Monitor results. Developing capacity alternatives: To improve capacity management the followings can be done: 1. Design flexibility in the systems: Provision for future expansion in the original design of structure frequently can be obtained at a small price compared to what it would cost to remodel an existing structure. Example: If water lines, power hookups, and waste disposal lines are put in place initially, the modification to this structure can be minimized. 2. Take stages of life cycles into account: Capacity requirements are often closely linked to the stage of the life cycle (introduction phase, growth phase, maturity phase, ) that a product or service is in.

BBN At introduction phase, it is difficult to determine both market size and the organizations share of that market. So the organization should be cautious in making inflexible capacity investment. In growth phase, the overall market may experience rapid growth. In the maturity phase, the size of the market levels off and the organizations tend to have stable market share. 3. Take a big picture approach to capacity changes: When developing capacity alternatives, it is important to consider how parts of the system interrelate? 4. Prepare to deal with capacity chunks: Capacity increases are often acquired in large chunks rather than smooth increments, making it difficult to achieve a match between desired capacity and feasible capacity. Ex. if the desired capacity of an operation is 55 units/ hr but the machine is able to produce 40 units/hr. So one machine causes 15 unit/hr short but two machine cause 25 units/hr excess. 5. Attempt to smooth out requirements: Unevenness in capacity requirements create certain problems. Ex. during bad weather public transportation ridership tends to increase compare to that of good weather. 6. Identify the optimal operating level: At the optimal level cost per unit is the lowest for that production unit. If the output rate is less than the output level, increasing the output rate will result in decreasing average unit costs. This is called economics of scale. But if the output is increased beyond the optimal level, average unit costs will be larger. This is called diseconomies of scales. Evaluating alternatives: An organization needs to examine alternatives for future capacity from different perspectives. Most obvious are economic considerations. Less obvious is possible negative public opinion. Techniques used evaluating capacity alternatives are: (i) Cost-Volume analysis (ii) financial analysis and (iii) decision theory

Cost-Volume analysis: It is a relation between cost, revenue, and volume of output. It estimates the income of an organization under different operating conditions. It is useful as a tool for comparing capacity alternatives. Formulation: Step 1: Identify all costs related to the production of a product. Step 2: Designate them as fixed (remain constant) cost (Ex. equipment cost, property taxes) or variable costs (vary with volume of output, Ex. material cost and labor cost). Total cost = Fixed cost + total variable cost. If we define, total cost, fixed cost, and total variable cost by TC, FC, VC, then TC = FC + VC . VC = Q v , where v variable cost per unit and Q is the quantity or volume of output. But

BBN

TC=VC+FC

TR

Amount ($) () FC

VC

Amount ($) ()

0
Q (Volume in units)

0
Q (Volume in units)

Similarly, if revenue per unit is R and total revenue is TR then, TR = R Q Then profit, P = TR TC = R Q ( FC + v Q ) = Q( R v ) FC . Therefore, the required volume P + FC Q needed to generate a specified profit is, Q = Rv QBEP , the volume of output at which total cost = total revenue. The break-event (BEP) FC QBEP = R v
Profit TR
TC

Amount ($) ()

Loss

BEP Units Q (Volume in units)

Break-even point (BEP): The volume at which total cost = total revenue. When volume is less than the break-even point, there is a loss and when volume is greater than the break-even point, there is a profit. Example: The owner of a old-fashioned berry pies, is considering 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 revenue is $7 per pie. (a) How many pies must be sold in order to break even? (b) What would the profit or loss be if 1,000 pies made and sold in a month? (c) How many pies must be sold to realize a profit of $4,000? (d) If 2,000 pies can be sold, and a profit target is $5,000, what price should be charged per pie? Solution: 5

BBN Given, FC = $6,000, (a) QBEP = VC = $2 per pie, R = $7 per pie.

FC 6000 = = 1,200 pies per month. R VC 7 2

(b) For Q = 1000 , P = Q( R v ) FC = 1000( 7 2 ) 6000 = $1000. (c) For P = $4000 , Q = P + FC $4000 + $6000 = = 2,000 pies Rv $7 $2

(d) P = Q( R v ) FC 5000 = 2000( R 2 ) 6000 R = $7.50 Example 2: A manager has the option of purchasing 1, 2, or 3 machines. Fixed cost and potential volumes are as follows No. of Total Corresponding Machines fixed costs range of output 1 $9,600 0 to 300 2 $15,000 301 to 600 3 $20,000 601 to 900 Variable cost is $10 per unit, and revenue is $40 per unit. Determine the break-even point for each range. (b) If projected annual demand is between 580 to 660 unit, how many machines should the manager purchase? Solution: (a) QBEP1 = QBEP 2 = QBEP 3 = FC 9600 = = 320 units. (Out side the range 0 300, so, no break-even point). R VC 40 10

(a)

FC 15000 = = 500 units. (Inside the range 301 600, so, a break-even point). R VC 40 10

FC 20000 = = 666.67 units. (Inside the range 601 900, so, a break-even point). R VC 40 10 b) From the break-even points we see that in the second range, the break-even point is 500 which is in 301 - 600. This means that even if the demand is at the low end of the range (580 - 660), it would be above the break-even point and thus yield a profit. But in the 3rd range, the break-even point is 666.67 which is in 601 - 900. This means that even if the demand is at the upper end of the range (580 - 660), the volume would still be less than the break-even point and thus yield no profit. Hence the manager should choose to purchase two machines.

BBN

3
2 1 300 600 900

Financial analysis: A problem that is universally encountered by managers is how to allocate limited funds. A common approach is to apply financial analysis to rank investment proposals. Cash flow and present value are two important terms used in financial analysis. Cash flow is the difference between the cash received from sales and the cash outflow for labor, materials, and taxes. Present value expresses in current value the sum of all future cash flows of an investment proposal. Three common methods in financial analysis are: (i) Payback (ii) present value (iii) internal rate of return Payback: It focuses on the length of time it will take for an investment to return its original cost. Example: An investment with an original cost of $6,000 and a monthly net cash flow of $1,000 has a payback period of six months. Payback ignores the time value of money. Present value: The present value method summaries the initial cost of an investment, its estimated annual cash flows, and any expected salvage value (save money or recover money) in a single value called equivalent current value taking into account the time value (e.g. interest rates) of money. Internal rate of return: It summaries the initial cost, expected annual cash flows and estimated salvage value of an investment proposal in an equivalent interest rate. Decision theory: Decision theory is used for financial comparison of alternatives under conditions of risk or uncertainty. Example: A firms manager must decide whether to make or buy a certain item used in the production of vending machines. Making would involve annual lease costs of $150,000. Cost and volume estimates are as follows. Make Buy Annual fixed cost $150,000 None Variable cost per unit $60 $80 Annual volume (units) 12,000 12,000 (a) 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? Solution: 7

BBN (a) Annual cost to make the item= 150,000 + 12,000 60 = $870,000 Annual cost to buy the item = 0 + 12,000 80 = $960,000 So, the manager would choose to make the item. (b) TC make = TC buy 150,000 + Q 60 = 0 + Q 80 Q = 7,500 Example: A small firm produces and sells automotive items in a five state area. The firm expects to combine assembly of its battery chargers line at a single location. Currently, operations are in three widely scattered locations. The leading candidate for location will have a monthly fixed cost of $42,000 and variable costs of $3 per charger. Chargers sell for $7 each. Prepare a table that shows total profits, fixed costs, variable costs, and revenues for monthly volumes of 10,000, 12,000, and 15,000 units. What is the break-even point? Also determine profit when volume equals 22,000 units. Example: A produces of pottery is considering the addition of a new plant to absorb the backlog of demand that now exists. The primary location being considered, will have fixed costs of $9,200 per month and variable costs of $0.7 per unit produced. Each item is sold at a price that averages $0.9. (i) What volume per month is required in order to break-even? (ii) What profit would be realized on a monthly volume of 61,000 per month? (iii) What volume is needed to obtain a profit of $16,000 per month? (iv) What volume is needed to provide a revenue of $23,000 per month?