MAKE OR BUY

The make-or-buy decision is the act of making a strategic choice between producing an
item internally (in-house) or buying it externally (from an outside supplier). The buy side
of the decision also is referred to as outsourcing.

Factors Considered:
1.
2.
3.
4.
5.
6.

Available Capacity
Expertise
Quality Considerations
Nature of Demand
Cost
Risks

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DEVELOPING CAPACITY ALTERNATIVES

Aside from the general considerations about the development of alternatives, other
things that can enhance capacity management such as:
1. Design Flexibility into system
2. Take Stage of life cycle into account
- Capacity requirements are often closely linked to the stage of the life cycle
that a product or service is in.

3. Take a big picture approach to capacity changes

- consider how parts of the system interrelate
4. Prepare to deal with capacity chunks
- Capacity increases are often acquired in fairly large chunks rather than
smooth increments, making it difficult to achieve a match between desired
capacity and feasible capacity
5. Attempt to smooth out capacity requirements
- Unevenness in capacity requirements also can create certain problems.
6. Identify the optimal operating level
- Production units have an optimal rate of output for minimal cost.

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At the ideal level, cost per unit is the lowest level for that production unit.
Outside the ideal, it will result to either economies of scale or diseconomies of
scale.

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Economies of scale - If the output rate is less than the optimal level,
increasing the output rate will result in decreasing average unit cost, i.e., the
the cost per unit of output drops as volume of output increases
The reasons for economies of scale include the following:
a. Fixed costs are spread over more units, reducing the fixed cost per unit.
b. Construction costs increase at a decreasing rate with respect to the size of
the facility to be built.
c. Processing costs decrease as output rates increase because operations
become more standardized, which reduces unit costs.

However, if output is increased beyond the optimal level, average unit costs
would become increasingly larger. This is known as the diseconomies of scale. The
reasons for diseconomies of scale are as follows:
a. Distribution costs increase due to traffic congestion and shipping from one
large centralized facility instead of several smaller, decentralized facilities.
b. Complexity increases costs; control and communication become more
problematic.
c. Inflexibility can be an issue.
d. Additional levels of bureaucracy exist, slowing decision making and approvals
for changes.

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7. Choose a strategy if expansion is involved Consider whether incremental

expansion or single step is more appropriate. Factors include competitive
pressures, market opportunities, costs and availability of finds, disruption of
operations, and training requirements, Also, decide whether to lead or follow
competitors. Leading is more risky but it may have greater potential for rewards.

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CONSTRAINT MANAGEMENT
The Theory of Constraints was developed and popularized by Eliyahu Goldratt. TOC, as
it is commonly called, recognizes that organizations exist to achieve a goal.
A factor that limits a company's ability to achieve more of its goal is referred to as a
"constraint."
7 Principles of the Theory of Constraints:
1. The focus is on balancing flow, not on balancing capacity.
2. Maximizing output and efficiency of every resource will not maximize the
throughput of the entire system.
3. An hour lost at a bottleneck or constrained resource is an hour lost for the whole
system. An hour saved at a non-constrained resource does not necessarily make
the whole system more productive.
4. Inventory is needed only in front of the bottlenecks to prevent them from sitting
idle, and in front of assembly and shipping points to protect customer schedules.
Building inventories elsewhere should be avoided.
5. Work should be released into the system only as frequently as the bottlenecks
need it. Bottleneck flows should be equal to the market demand. Pacing
everything to the slowest resource minimizes inventory and operating expenses.
6. Activation of non-bottleneck resources cannot increase throughput, nor promote
better performance on financial measures.
7. Every capital investment must be viewed from the perspective of its global impact
on overall throughput (T), inventory (I), and operating expense (OE).
7 categories of constraints:
Market
Resource
Material

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Financial
Supplier
Knowledge or competency
Policy
However, in general, these types of constraints can just be either internal or external to
the system. An internal constraint is in evidence when the market demands more from
the system than it can deliver. If this is the case, then the focus of the organization
should be on discovering that constraint and following the five focusing steps to open it
up (and potentially remove it). An external constraint exists when the system can
produce more than the market will bear. If this is the case, then the organization should
focus on mechanisms to create more demand for its products or services.
Five-step process for recognizing and managing limitations
Step 1:

Identify the constraint

Step 2:

Develop a plan for overcoming the constraints

Step 3:

Focus resources on accomplishing Step 2

Step 4:
capability

Reduce the effects of constraints by offloading work or expanding

Step 5:

Once overcome, go back to Step 1 and find new constraints

EXAMPLE (Application of the 5-step process)

The demand for parts produced by a computer-controlled piece of equipment
known as the NCX10 exceeded the machine's capacity.
Since the factory could only assemble and sell as many products as they had
parts from the machine.
The capacity of the factory to make money was tied directly to the output of the
NCX10. The NCX10, therefore, was the constraint.

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STEP 1 IDENTIFY THE CONSTRAINT

In order to manage a constraint, it is first necessary to identify it.
In the above example, the NCX10 was identified as the constraint.
This knowledge helped the company determine where an increase in
"productivity" would lead to increased profits.
Concentrating on a non-constraint resource would not increase the throughput
because there would not be an increase in the number of products assembled.
To increase throughput, flow through the constraint must be increased.

STEP 2 DEVELOP PLAN FOR OVERCOMING CONSTRAINT

Once the constraint is identified, the next step is to focus on how to get more
production within the existing capacity limitations.
when the company and the labor union agreed to stagger lunches, breaks, and
shift changes so the machine could produce during times it previously sat idle.
This added significantly to the output of the NCX10, and therefore to the output of
the entire plant.
To manage the output of the plant, a schedule was created for the constraint. The
schedule showed the sequence in which orders would be processed and their
approximate starting time.

STEP 3 FOCUS RESOURCES ON ACCOMPLISHING STEP 2 or SUBORDINATE

Exploiting the constraint does not ensure that the materials needed next by the
constraint will always show up on time.
The most important component of subordination is to control the way material is
fed to the non-constraint resources.
TOC says that non-constraint resources should only be allowed to process
enough materials to match the output of the constraint.

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 The release of materials is closely controlled and synchronized to the constraint

schedule
STEP 4 REDUCE THE EFFECTS OF CONSTRAINTS BY OFFLOADING WORK OR
EXPANDING CAPABILITY
The next step is to determine if the output of the constraint is enough to supply
market demand. If not, it is necessary to find more capacity by "elevating" the
constraint.
In the above example, schedulers were able to remove some of the load from
the constraint by rerouting it across two other machines.
They also outsourced some work and brought in an older machine that could
process some of the parts made by the NCX10.
These were all ways of adding capacity, or elevating the constraint.

STEP 5 - GO BACK TO STEP 1

Once the output of the constraint is no longer the factor that limits the rate of
fulfilling orders, it is no longer a constraint.
Step 5 is to go back to Step 1 and identify a new constraint -because there
always is one.

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EVALUATING ALTERNATIVES
Alternatives should be evaluated from varying perspectives
1. ECONOMIC
Cost-volume analysis
Break-even point
Financial analysis
Cash flow
Present value
Decision theory
Waiting-line analysis
Simulation
2. NON-ECONOMIC
Public opinion
Cost-Volume Analysis
-

focuses on the relationship between cost, revenue and volume of out-put.

purpose of cost-volume analysis is to estimate the income of an organisation
under different operating conditions.
It is particularly useful as a tool for comparing capacity alternatives.

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Assumptions of Cost-Volume Analysis

One product is involved.

Everything produced can be sold.

The variable cost per unit is the same regardless of the 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.

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Financial Analysis
Important terms in financial analysis:

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

3 most commonly used methods of financial analysis:

a. Payback - a crude but widely used method that focuses on the length of time
it will take for an investment to return its original costs. Payback ignores the
time value of money. Its use is easier to rationalize for short-term than for
long-term projects.
b. Present Value summarizes the initial costs of an investment, its estimated
annual cash flows, and any expected salvage value in a single value called
equivalent current value, taking into account the time value of money (interest
rates)
c. Internal Rate of Return (IRR) summarizes the initial cost, expected annual
cash flows, and estimated future salvage value of an investment proposal in
an equivalent interest rate. In other words, this method identifies the rate of
return that equates the estimate future returns and the initial costs.
These techniques are appropriate when there is a high degree of certainty
associated with estimates of future cash flows. In many instances, however,
operations managers and other managers must deal with situations better
described as risky or uncertain.
Decision Theory
a helpful tool for financial comparison of alternatives under conditions of risk or
uncertainty. It is suited to capacity decisions and to a wide range of other decisions
managers must make such as product and service design, equipment selection and
location planning.

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Causes of Poor Decision:

1. Mistakes in Decision Process
2. Bounded Rationality
3. Suboptimization

Mistakes in Decision Process

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 It happens because of mistakes on the following decisions steps:

1
2
3
4
5
6
7
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ecausofthlimLndB,grwyxpkbv.TR

Suboptimization

Usually occurs because organizations typically departmentalize decisions. The

result of different departments each attempting to reach a solution that is
optimum for that department. Unfortunately, what is optimal for one department
may not be optimal for the organization as a whole.

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Decision-making under Certainty

When it is known for certain which of the possible future conditions will actually happen,
the decision is usually relatively straightforward simply choose the alternative that has
the best payoff under that state of nature.

Decision-making under Uncertainty

At the opposite extreme is complete uncertainty. No information on how likely the
various states of nature are. Under those conditions, 4 possible decision criteria are:

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M
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Decision-making under Risk
Between the two extremes of certainty and uncertainty lies the case of risk: the
probability of occurrence for each state is known. Decisions made under the condition
that the probability of occurrence for each state of nature can be estimated. A widely
applied criterion is expected monetary value (EMV).
In EMV, the manager determines the expected payoff of each alternative, and then
chooses the alternative that has the best expected payoff. This approach is most
appropriate when the decision maker is neither risk averse nor risk seeking

Decision Tree
-

A schematic representation of the alternatives available to a decision maker

and their possible consequences. The term gets its name from the tree-like
appearance of the diagram. The decision tree is particularly useful for
analyzing situations that involve sequential decisions. A decision tree is
composed of a number of nodes that have branches emanating from them.

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Other methods under Decision Theory are:

Expected Value of Perfect Information (EPVI) - The difference between the expected
payoff with perfect information and the expected payoff under risk
Sensitivity Analysis provides a range of probability for which an alternative has the
best expected payoff.

WAITING-LINE ANALYSIS Analysis of lines is often useful for designing or modifying

service systems. Waiting lines have a tendency to form in a wide variety of service
systems. The lines are symptoms of bottleneck operations. Analysis is useful in helping
managers choose a capacity level that will be cost-effective through balancing the cost
of having customers wait with the cost of providing additional capacity.

SIMULATION This is useful in evaluating what if scenarios. What if analysis is a

powerful tool for improvement that evaluates how strategic, tactical or operational
changes may impact the business. Through different scenarios you will be able to
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perform a true-to-life analysis of your processes without putting your business operation
at risk.
One will be able to answer questions like:

How would the processing time of a case decrease if the number of available
resources is doubled?
What would be the cost/benefit rate of reducing the process time in a specified activity?
What would be the effect of altering the working shift configuration in the operational
cost and service level?

OPERATIONS STRATEGY
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 organizations 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

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 Capacity disposal strategies become important under these

conditions

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