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
– 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
• Capacity decisions:
– 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
 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)
Actual output
Efficiency =
Effective capacity

• Utilization
(Measured as percentages)
Actual output
Utilization =
Design capacity
Example: Efficiency and Utilization
• Design Capacity = 50 trucks per day
• Effective Capacity = 40 trucks per day
• Actual Output = 36 trucks per day
Actual output 36
Efficiency = = = 90%
Effective capacity 40

Actual output 36
Utilization = = = 72%
Design capacity 50
 Exercise
• A computer repair service center has a Design
Capacity of 80 repairs per day. Its Effective
Capacity is 64 repairs per day but Actual
Output is only 62 repairs per day. Calculate
Efficiency and Utilization.
Actual output ?
Efficiency = = = ?%
Effective capacity ?

Actual output ?
Utilization = = = ?%
Design capacity ?
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
– 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
• 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.
 • Calculating processing requirements requires:
– reasonably accurate demand forecasts,
– standard processing times
– available work time
k

pD i i
NR = i =1

T
where
N R = number of required processors (servers)
pi = standard processing time for product i
Di = demand for product i during the planning horizon
T = processing time available per processor during the planning horizon
 Example
Product Annual Demand Standard processing time Processing time
per unit (hr.) 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
 Exercise
• Kristen expects higher demand and would like
to produce 26 dozen cookie (in one-dozen
order sizes) 4 hours a night.
• Capacity of an oven = 6 dozen/hour
• Capacity of a mixer = 10 dozen/hour
• How many ovens and mixers does Kristen
need?
• What are the utilization rates of the oven and
mixer?
 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
 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

26
Cost-volume relationships

This line shows

the difference
between TR and
TC.

27
 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.
a. How many pies must be sold in order to break even?
b. What would the profit (loss) be if 1,000 pies are
made and sold in a month?
c. How many pies must be sold to realize a profit of
$4,000?
d. 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.
a. 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.
b. 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.
c. 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.
d. 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

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
❑ Alternative B
(in-house)
(outsource)
• R >> v
• R>v
• v low
• v high
• FC high
• FC low
• BEP high
• BEP low
Choose A

Choose B
 Indifferent Point (Cost)
• A manufacturer has 3 options:
1. Use process A with FC=$80,000 and v=$75/unit
2. Use process B with FC=$200,000 and v=$15/unit
3. Purchase for $200/units (in other words, FC=$0 and
v=$200/unit)
80,000+75Q=200Q 500000

QPA=640 units
400000
80,000+75Q=200,000+15Q
300000
QAB=2,000 units
Cost

Process A
200000
Process B
Choose lowest cost: Buy
0-640 units : Purchase 100000

640-2,000 units: Process A

0
Above 2,000 units: Process B
# units
 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:

a) Given these numbers, 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

a) 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

b) 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:
Number of Total Annual Fixed Corresponding
Machines Cost 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, revenue is $40 per unit

a) Determine the break-even point for each range.
b) If projected annual demand is between 580 and 660 units,
how many machines should the manager purchase
 Solution
Number of Total Annual Fixed Corresponding
Machines Cost Range of output
1 $9,600 0 to 300
2 15,000 301 to 600
3 20,000 601 to 900

a) 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
b) 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.