MODULE IN CBME 1 (OPERATIONS MANAGEMENT AND TQM)

Credits: 3 units

Pre-Requisite: None

I. Lesson Title: Capacity Management and Managing Inventories in Supply Chain

II. Learning Outcomes:

LESSON OBJECTIVE:
At the end of the module, the learners will be able to:

1. Define capacity.
2. Discuss capacity utilization.
3. Define best operating level.
4. Identify reasons why capacity decisions are among the most fundamental of all the design
decisions that managers must make.

III. Lecture

CAPACITY MANAGEMENT IN OPERATIONS

The capacity management aspect once framed in a long-term strategic perspective revolves around
matching of accessible capacity to demand or making certain capacity available to meet the demand
variations. This is done on both the intermediate and short time horizons. Capacity management is very
vital for achieving the organizational objectives of efficiency, customer service and effectiveness in
general.

Capacity Defined

Capacity is the possibility output of a system that may be produced in a particular time, determined by
the size, scale and configuration of the system’s transformation inputs. At all stages of any process,
limitations are placed on capacity.

A machine has a maximum output per hour, a truck has a maximum load, a production line has a limit
to its speed of operation, an airplane has a certain number of seats for passengers, and a computer
processes a specified number of bytes per second, and so on.

Functionally, capacity can be described in three useful definitions:

1. Designed capacity is the maximum output of a process under ideal conditions

2. Effective capacity is the maximum output that can be realistically expected under normal conditions.
Usually, effective capacity is less than designed capacity, due to set-up times, breakdowns, stoppages,
maintenance, and so on. Whilst this is true in many cases, especially in materials processing operations,
there are instances in which effective capacity may be greater than designed capacity. For example,
under normal conditions it might be thought a hotel could it sell its rooms only once in a 24-hour period
but some hotels, those at airports for instance, routinely sell their rooms more than once per day.

3. Actual output is the rate of output actually achieved. It cannot exceed effective capacity and if often
less than effective capacity owing to breakdown, defective output, shortages of materials and other
similar factors. It will normally be lower than effective capacity. This will certainly be the case if
capacity is not managed well.

Excess capacity arises when actual production is less than what is feasible or optimal for a firm. This
often means that the demand in the market for the product is less than what the firm could potentially
supply to the market. Excess capacity is inefficient and will cause manufacturers to acquire additional
costs or drop market share.

CAPACITY PLANNING CONCEPTS

Capacity planning is the process of establishing the output rate that can be realized over a period of
time by a facility.

The role of capacity planning and scheduling management in making this aim feasible is to make sure
the products and services are accessible when needed by the consumer. This is achieved by managing
processes as efficiently as possible. The management of capacity focuses on two aspects of the
operation:

1. Transformation inputs and their organization into process. Transformation inputs are those resources
used to process the final outputs. Capacity planning is mainly focused on the effective and efficient
utilization of these transformation inputs.

2. Ensuring the transformation inputs are utilized efficiently based on the flow of inputs through the
system. This necessitates the adoption of a right strategy for inventory management.

Capacity planning involves long-term and short term considerations. Long-term considerations speak
about the overall level of capacity. Short-term considerations relate to variations in capacity
requirements appropriate to seasonal, random, and irregular fluctuations in demand.

When considering capacity planning within a company, three key inputs must be considered. The three
inputs are (1) the kind of capacity to be determined, (2) how much of the products will be needed, and
(3) when will the product be needed.

Capacity Utilization

Utilization is the ratio of actual output to designed capacity, while efficiency is the ratio of output to
effective capacity.

Capacity utilization is the percentage of how well available capacity is actually being utilized. Capacity
utilization can be computed as follows:
𝐴𝑐𝑡𝑢𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡 𝑟𝑎𝑡𝑒
Utilization = 𝑋 100
𝐶𝑎𝑝𝑎𝑐𝑖𝑡𝑦

These are two common measures of capacity which are:

1. Design Capacity- This is the maximum output rate that can be attained by a facility under ideal
conditions. Design capacity can be continued only for a relatively short period of time. A company
achieves this output rate by using many short-term measures like overtime, overstaffing, maximum use
of equipment and subcontracting. The formula for design capacity is:
𝐴𝑐𝑡𝑢𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡
Utilization design = 𝑋 100
𝐷𝑒𝑠𝑖𝑔𝑛 𝐶𝑎𝑝𝑎𝑐𝑖𝑡𝑦

2. Effective Capacity- This is the maximum output rate that can be maintained under normal conditions.
These conditions of realistic work schedules and breaks, regular staff levels, scheduled machine
maintenance and none of the temporary measures that are used to achieve design capacity. Effective
capacity is usually lesser than design capacity. The formula for effective capacity is:
𝐴𝑐𝑡𝑢𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡
Utilization effective = 𝑋 100
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝐶𝑎𝑝𝑎𝑐𝑖𝑡𝑦

Sample Problem:
Serrano’s Bakery has a design capacity of 30 cupcakes per day and effective capacity of 20 cupcakes
per day. Currently it is baking 27 cupcakes per day. Compute for the bakery’s capacity utilization both
for design and effective capacity.

Solution:
𝐴𝑐𝑡𝑢𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡
Utilization design = 𝑋 100
𝐷𝑒𝑠𝑖𝑔𝑛 𝐶𝑎𝑝𝑎𝑐𝑖𝑡𝑦

27
= 𝑋 100
20

= 90%
𝐴𝑐𝑡𝑢𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡
Utilization effective = 𝑋 100
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝐶𝑎𝑝𝑎𝑐𝑖𝑡𝑦

27
= 𝑋 100
20

= 135%

Best Operating Level

The best operating level for a facility is the percent of capacity utilization that minimizes average unit
cost. Rarely is the best operating level at 100 percent of capacity at higher levels of utilization,
productivity slows and things start to go wrong.

Average capacity utilization differs by industry. An industry with an 80% average utilization would
have 20% capacity cushion for unexpected surges in demand or temporary work stoppages. Capacity
cushion is the additional capacity added to regular capacity requirements to provide greater flexibility.

Large capacity cushions are common in industries where demand is highly variable, resource flexibility
is low, and customer service is important. Utilities, for example, maintain 20% capacity cushion.
Capital-intensive industries with less flexibility and higher costs maintain cushions under 10%. Airlines
maintain a negative cushion but overbooking is a common practice.

INVENTORY MANAGEMENT

Inventory management is the products or materials a company sells to its customers in order to make
profit. As part of the supply chain, inventory management includes several different aspects such as
controlling and overseeing purchases from suppliers and customers, maintaining the storage of stock,
controlling the amount of product for sale and order fulfillment. There are three core steps of inventory
management:

Purchasing inventory - raw materials or components are bought and delivered to the warehouse.

Storing inventory - inventory is stored until needed. Raw materials are moved to production facilities
to be made into finished goods and returned to stock areas until ready for shipment.

Profiting from inventory - the amount of product for sale is controlled. Finished goods are pulled to
fulfill orders. Products are shipped to customers.

Why is inventory management important?

In order to grow, it’s important to keep the promises you make and deliver orders efficiently. It’s vital
that companies with complex supply chains and manufacturing processes strike the right balance of
inventory size.
The management of inventory is necessary for any company so that excess stock is not stored at the
company while simultaneously ensuring demand for customers is met. The optimal balance, however,
is often achieved through properly planned and managed inventory.