Unit 2

Management of Conversion System

Chapter 5: Capacity Design

Lesson 16:- Capacity strategies

Learning Objectives

After reading this lesson you will be able to understand

Capacity cushion and its importance
Various capacity strategies

Today we will discuss various strategic issues related to capacity. These are:
Sizing capacity cushions,
Timing and sizing expansion,
Linking capacity and
Other operating decisions
So, let’s start with capacity cushions.

The capacity cushion is the amount of reserve capacity that a firm

maintains to handle sudden increases in demand or temporary losses of
production capacity. It measures the amount by which the average utilization
(in terms of effective capacity) falls below 100 percent. Specifically,
Capacity cushion = 100% - Utilization rate (%)
The appropriate size of the cushion varies by industry. In the capital-
intensive paper industry, where machines can cost hundreds of millions of
rupees each, cushions less than 10 percent are preferred. The less capital-
intensive hotel industry breaks even with a 60 to 70 percent utilization (40 to
30 percent cushion, and begins to suffer customer-service problems when
cushion drops to 20 percent.
The second issue of capacity is when to expand and by how much.
There are two extreme strategies,i.e.
the expansionist strategy
,( which involves large, infrequent jumps in capacity,) and
the wait-and-see strategy,
( which involves smaller, more frequent jumps.)
Figure 5.7 illustrates these strategies.

The timing and sizing of expansion are related. If demand is increasing and
the time between increments increases, the size of the increments must also
increase. The expansionist strategy, which stays ahead of demand,
minimizes the chance of sales lost to insufficient capacity. The wait-and –
see strategy lags behind demand, relying on short-term options such as:-
use of overtime,
temporary workers,
subcontractors,
stockouts, and
postponement of preventive maintenance to meet any shortfalls.
Friends, what could be the possible benefits of the expansionist strategy?
Anyone in the class?
Well, let me elaborate.
Advantages of the expansionist strategy
There are some advantages of the expansionist strategy.
Expansion may result in economies of scale and a faster rate of learning,
thus helping a firm reduce its costs and compete on price. This strategy
might increase the firm’s market share or act as a form of preemptive
marketing. The conservative wait-and-see strategy is to expand in smaller
increments, such as by renovating existing facilities rather than building new
ones. Because the wait-and-see strategy follows demand, it reduces the risks
of over expansion based on overly optimistic demand forecasts, obsolete
technology, or inaccurate assumptions regarding the competition.

Now we will discuss the important issue of linking capacity with other
decisions.
When managers make decisions about location, resource flexibility, and
inventory, they must consider the impact on capacity cushions. Capacity
cushions buffer the organization against uncertainty, as do resource
flexibility, inventory, and longer customer lead times. If a system is well
balanced and a change is made in some other decision area, the capacity
cushion may need change to compensate. Following are some examples of
linkage of strategies and capacity decisions.
Competitive priorities
Faster deliveries for a process requires a larger capacity cushion to
allow for quick response, if holding finished goods inventory is
infeasible or uneconomical
Quality management
Paying proper attention to appropriate qualitative issues
Capital intensity
 Smaller capacity cushion
Resource flexibility
Larger capacity cushion to compensate for the operation overloads
Inventory
Larger capacity cushion to meet increased demands
Scheduling
A change to a more stable environment allows a smaller cushion because
products or services can be scheduled with more assurance.

A Systematic approach to capacity Decisions consists primarily of the four

main steps. These are:
Step 1: Estimate capacity requirements
The long term capacity need is determined on the basis of forecasts of
demand, productivity, competition, and technological changes that extend
well into the future. The demand forecast has to be converted to a number
that can be compared directly with the capacity measure being used.
Suppose that capacity is expressed as the number of available machines at an
operation. When just one product is being processed, the number of
machines required, M, is

Number of machines required =

Pr oces sin g hours required for year's demand
Hours available from one machine per year, after deducting desired cushion

Dp
M=
N [1 − (c / 100)]

Where
D = number of units (customers) forecast per year
 p = processing time (in hours per unit or customers)
N = total number of hours per year during which the process operates
C = desired capacity cushion
If multiple products or services are involved, extra time is needed to
change over from one product or service to the next. Setup time is the time
required to change a machine from making one product or service to making
another. The total setup time is found by dividing the number of units
forecast per year, D, by the number of units made in each lot, which gives
the number of setups per year, and then multiplying by the time per setup.
For example, if the annual demand is 1200 units and the average lot size is
100, there are 1200/100 = 12 setups per year. Accounting for both
processing and setup time when there are multiple products (services), we
get

Number of machines required =

Pr oces sin gandsetuphoursrequiredforyear ' sdemand , summedoverallproducts
Hoursavailablefromonemachineperyear , afterdeductingdesiredcushion

[ Dp + ( D / Q) s ] product1 + [ Dp + ( D / Q) s ] product 2 + ..... + [ Dp + ( D / Q) s ] productn

M=
N [1 − (c / 100)]

where
Q = number of units in each lot
s = setup time (in hours) per lot
It is better to round up the fractional part unless it is cost efficient to use
short-term options such as overtime or stockouts to cover any shortfalls.
 Step 2: Identify Gaps
Can you tell me what is a capacity gap?
A capacity gap is any difference (positive or negative) between
projected demand and current capacity. Identifying gaps requires use of the
correct capacity measure. Complications arise when multiple operations and
several resource inputs are involved. (e.g. in 1970 when airline executive
states fly more seats to get more passengers many airlines responded by
buying more jumbo jets, but competitors flying smaller planes were more
successful. The correct measure of capacity was the number of departments
rather than the number of seats.)
I think, now is the time to consider an example. of this.

Example 5.4
A restaurant is experiencing a boom in business. The owner expects to serve
a total of 80,000 meals this year. Although the kitchen is operating at 100
percent capacity, the dining room can handle a total of 1,05,000 dinners per
year. Forecasted demand for the next five years is as follows:
Year 1: 90,000 meals
Year 2: 1,00,000 meals
Year 3: 1,10,000 meals
Year 4: 1,20,000 meals
Year 5: 1,30,000 meals
What are the capacity gaps in the restaurant’s kitchen and dining room
through year 5?
Dear students, make an honest effort and solve it.
Now, tally your answer with the solution given below.
Solution. The kitchen is currently the bottleneck at a capacity of 80,000
meals per year. Based on the forecasted demand the capacity gap for the
kitchen is
Year 1: 90,000 – 80,000 = 10,000
Year 2: 1,00,000 – 80,000 = 20,000
Year 3: 1,10,000 – 80,000 = 30,000
Year 4: 1,20,000 – 80,000 = 40,000
Year 5: 1,30,000 – 80,000 = 30,000

In year 3 and subsequently, there are capacity gaps for the dining room
Year 3: 1,10,000 – 1,05,000 = 5,000
Year 4: 1,20,000 – 1,05,000 = 15,000
Year 5: 1,30,000 – 1,05,000 = 25,000

Step 3: Develop alternatives

The next step is to develop alternative plans to cope with projected gaps.
One alternative is base case, which is do nothing and simply lose orders
from any demand that exceeds current capacity. Other alternatives are
various timing and sizing options for adding new capacity, including the
expansionist and wait-and-see strategies.

Step 4: Evaluate the alternatives

In this final step, the manager evaluates each alternative both
quantitatively and qualitatively.
What are Qualitative concerns?
Qualitative concerns are uncertainties about demand, competitive reaction,
technological change, and cost estimates. “What if” analysis allows the
manager to get an idea of each alternative’s implication before making a
final choice.
And what about the Quantitative concerns?

Quantitative concerns are estimates of the change in cash flows for each
alternative over the forecast time horizon compared to the base case. Cash
flow is the difference between the flows of funds into and out of an
organization over a period of time, including revenues, costs, and changes in
assets and liabilities.
Let’s focus now on the Tools for capacity planning

Tools for capacity planning

Long-term capacity planning requires demand forecasts for an extended
period of time. Forecast accuracy declines as the forecasting horizon
lengthen. Tools that deal more formally with demand uncertainty and
variability are: waiting-line models, simulation, and decision trees.

Waiting-line models
Waiting-line models often are useful in capacity planning. Waiting lines
generally develop in front of a ticket counter, a machine center, or a central
computer. The reason is that the arrival time between jobs or customers
varies and the processing time may vary from one customer to the next.
Waiting-line models use probability distributions to provide estimates of
average customer delay time, average length of waiting lines, and utilization
of the work center. Managers can use this information to choose the most
cost-effective capacity, balancing customer service and the cost of adding
capacity.

Simulation
More complex waiting-line problems can be analysed by simulation. It can
identify the process’s bottlenecks and appropriate capacity cushions, even
for complex processes with random demand patterns with predictable surges
in demand during a typical day.

Decision trees
A decision tree can be particularly valuable for evaluating different capacity
expansion alternatives when demand is uncertain and sequential decisions
are involved. For example, the owner of a restaurant may expand the
restaurant now, only to discover in year 4 that demand growth is much
higher than forecasted. In that case, he needs to decide whether to expand
further. In terms of construction costs and down time, expanding twice is
likely to be much more expansive than building a large facility from the
outset. However, making a large expansion now when demand growth is low
means poor facility utilization.

In the last part, we are now focusing our attention to the issue of Linking
capacity and other decisions. Let’s see how it develops.

Linking capacity and other decisions

 Capacity decisions should be closely linked to strategies and
processes throughout the organization. When managers make
decisions about location, resource flexibility, and inventory, they must
consider the impact on capacity cushions.

Another crucial linkage is between capacity and location decisions. If

capacity is expanding suitable location for new facilities to identified. If
capacity is downsizing, it is needed to identify which locations to eliminate.

A systematic approach to capacity decisions

There are four main approaches given below:
1. Estimate future capacity requirements
2. Identify gaps by comparing requirements with available capacity
3. Develop alternative plans for filling the gaps
4. Evaluate each alternative, both qualitatively and quantitatively, and
make the final choice.
With that, we have come to the end of today’s discussions.

Points to ponder