PRODUCTION

&
OPERATIONS MANAGEMENT
SESSION 08-09
 CAPACITY PLANNING
• Capacity
• Extent of availability of the resources for use by various processes
• The upper limit or ceiling on the load that an operating unit can handle
• Capacity needs include
• Equipment
• Space
• Employee skills
• It also denotes the maximum output of products and services one can achieve using
these resources
• Capacity planning is a systematic approach to
• Estimate the amount of capacity required,
• Evaluation of alternative methods of augmenting capacity
• Devise methods to use capacity effectively
• Capacity planning is important
• It has a significant impact on the cost of operation of the system due to large fixed costs
associated with capacity
• Economies of scale is an concept in economics related to capacity
 ECONOMIES OF SCALE
• Economies of Scale
• If output rate is less than the optimal level, increasing the output rate results in
decreasing average per unit costs
• Reasons for economies of scale:
• Fixed costs are spread over a larger number of units
• Construction costs increase at a decreasing rate as facility size increases
• Processing costs decrease due to standardization
 DISECONOMIES OF SCALE
• Diseconomies of Scale
• If the output rate is more than the optimal level, increasing the output rate results in increasing average
per unit costs
• Reasons for diseconomies of scale
• Distribution costs increase due to traffic congestion and shipping from a centralized facility rather
than multiple smaller facilities
• Complexity increases costs
• Inflexibility can be an issue
• Additional levels of bureaucracy
 ECONOMIES OF SCALE

Average unit cost of output

2000 units
per month
10,000 units
5000 units
per month
per month

Units of output
 ECONOMIES OF SCALE

Minimum cost & optimal operating rate are

functions of size of production unit.
Average cost per unit

Small
plant Medium
plant
Large
plant

Output rate
 CAPACITY BUILDUP
Typical mode
Capacity

Units
Demand

Time
Reactive mode Proactive mode

Units
Units

Time Time
 INPUT MEASURES OF CAPACITY
• Firms operating in low volume, high variety situation find it relevant
• Refining capacity of BPCL refinery in Mumbai is 260,000 barrels of crude per day
• Television manufacturer often measures its capacity by millions of picture tubes that it
produces
• Tool room facility will measure its capacity in terms of machine hours
• A hospital will measure the capacity in terms of number of beds.
 OUTPUT MEASURES OF CAPACITY
• When the volume of production is high and the variety is relatively low output
measures are useful
• Toyota Kirloskar Auto Parts measures it capacity in terms of number of transmission gear
boxes it can produce
• Tata Bearings, a division of Tata Steel, has a capacity of 25 million pieces per annum
• MICO Bosch has an installed capacity of one lakh distributor pumps at its Jaipur plant
• An automated car wash facility’s capacity can be measured in terms of number of cars
serviced per day
 JAPANESE NOTION OF CAPACITY
• Capacity = Work + Waste
• Nine types of waste according to Canon production system:
• Waste in Operations
• Waste in Startup
• Waste in Equipment
• Waste in Defects
• Waste in Materials
• Waste in Indirect Labour
• Waste in Human Resources
• Waste in expense
 JAPANESE NOTION OF CAPACITY
• Nine Source of waste
Source of waste Amount (in INR million)
Waste due to human resources 1.96
Waste due to materials 21.53
Waste due to operations 1.47
Waste due to start up 5.24
Waste due to equipment 12.90
Under utilisation of machines 9.75
Unused machine capacity 2.50
Not maintaining specifications 0.65

Total of the above 43.10

Divisional turnover 135.92

Waste as a percent of turnover 31.70%

 CAPACITY PLANNING: TIME HORIZON
Criterion
Long term
Time frame 2 - 5 years
Augmenting capacity for
Planning premise projected growth
Capacity Augmentation; Capital
Budgeting Exercises
Key decisions made
Investment planning; Break-
even analysis, Discounted cash
flow techniques; Decision Trees
Tools & Techniques used
Time Horizon for planning
Medium term
Typically 1 year
Balancing demand - supply
Adjusting demand and supply
attributes to balance available
capacity to requirement
Aggregate Production Planning;
Make or Buy
Short-term
1 week to 3 months
Maximising availability; Efficent use of
resources
Resource deployment strategies,
Maintenance routines, Improvement
projects to be undertaken
Planning & Scheduling, Total Productive
Maintenance, Waste elimination by
continuous improvement; Simulation;
Heuristics; Waiting line models
 STRATEGIC CAPACITY PLANNING
• Goal
• To achieve a match between the long-term supply capabilities of an organization and the
predicted level of long-term demand
• Overcapacity→ operating costs that are too high
• Undercapacity→ strained resources and possible loss of customers
 DEFINING AND MEASURING CAPACITY
• Measure capacity in units that do not require updating
• Why is measuring capacity in dollars problematic?
• Two useful definitions of capacity
• Design capacity
• The maximum output rate or service capacity an operation, process, or facility is
designed for
• Effective capacity
• Design capacity minus allowances such as personal time and maintenance
 MEASURING SYSTEM EFFECTIVENESS

• Actual output
• The rate of output actually achieved
• It cannot exceed effective capacity
• Efficiency
actual output
Efficiency =
effective capacity

• Utilization
actual output
Utilization =
design capacity
Measured as percentages
 STRATEGY FORMULATION
• Strategies are typically based on assumptions and predictions about:
• Long-term demand patterns
• Technological change
• Competitor behavior
 CAPACITY STRATEGIES
• Leading
• Build capacity in anticipation of future demand increases
• Following
• Build capacity when demand exceeds current capacity
• Tracking
• Similar to the following strategy, but adds capacity in relatively small increments to keep
pace with increasing demand
 CAPACITY AUGMENTATION
• Waste Elimination
• Multi-skilling of workforce
• Sub-contracting/Outsourcing
• De-bottlenecking
• Addition of new capacity
 CAPACITY CUSHION
• Capacity Cushion
• Extra capacity used to offset demand uncertainty
• Capacity cushion = 100% - Utilization
• Capacity cushion strategy
• Organizations that have greater demand uncertainty typically have greater capacity cushion
• Organizations that have standard products and services generally have 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
• 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
 CALCULATING PROCESSING REQUIREMENTS
• Calculating processing requirements requires reasonably accurate demand
forecasts, standard processing times, and available work time

pD i i
NR = i =1
T
where
N R = number of required machines
pi = standard processing time for product i
Di = demand for product i during the planning horizon
T = processing time available during the planning horizon
 SERVICE CAPACITY PLANNING
• Service capacity planning can present a number of challenges related to:
• The need to be near customers
• Convenience
• The inability to store services
• Cannot store services for consumption later
• The degree of demand volatility
• Volume and timing of demand
• Time required to service individual customers
 DEMAND MANAGEMENT STRATEGIES
• Strategies used to offset capacity limitations and that are intended to achieve a
closer match between supply and demand
• Pricing
• Promotions
• Discounts
• Other tactics to shift demand from peak periods into slow periods
 IN-HOUSE OR OUTSOURCE?
• Once capacity requirements are determined, the organization must decide
whether to produce a good or service itself or outsource
• Factors to consider:
• Available capacity
• Expertise
• Quality considerations
• The nature of demand
• Cost
• Risks
 DEVELOPING CAPACITY ALTERNATIVES
• Things that can be done to enhance capacity management:
• Design flexibility into systems
• Take stage of life cycle into account
• Take a “big-picture” approach to capacity changes
• Prepare to deal with capacity “chunks”
• Attempt to smooth capacity requirements
• Identify the optimal operating level
• Choose a strategy if expansion is involved
 CONSTRAINT MANAGEMENT
• Constraint
• Something that limits the performance of a process or system in achieving its goals
• Categories
• Market
• Resource
• Material
• Financial
• Knowledge or competency
• Policy
 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 organization’s 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
• Capacity disposal strategies become important under these
conditions
 HIERARCHIES IN CAPACITY ESTIMATION
First Fabrication Paint Electrical & Assembly
operation Shop Shop Wiring & Testing

Shearing Pressing Welding

Unit Unit Unit

Hydraulic
Press
CNC Turret NC Press Denotes bottleneck
Press Brake in the process
63 Tonne
ECC Press
 COST-VOLUME ANALYSIS
• 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 (BEP)
• BEP
• The volume of output at which total cost and total revenue are equal
• Profit (P) = TR – TC = R x Q – (FC +v x Q)
= Q(R – v) – FC

FC
QBEP =
R−v
COST-VOLUME RELATIONSHIPS
.
 COST-VOLUME ANALYSIS
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?
1,200 pies/month
b. What would the profit (loss) be if 1,000 pies are made and sold in a month?
-$1,000
c. How many pies must be sold to realize a profit of $4,000?
2,000 pies
d. If 2,000 can be sold, and a profit target is $5,000, what price should be
charged per pie?
$7.50
 COST-VOLUME ANALYSIS
A manager has the option of purchasing one, two, or three machines. Fixed costs
and potential volumes are as follows:
Number of Total Annual 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.
a. Determine the break-even point for each range.
Machine 1: 320 units, Machine 2: 500 units, Machine 3: 666.67 units
b. If projected annual demand is between 580 and 660 units, how many
machines should the manager purchase?
 COST-VOLUME RELATIONSHIPS

• 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.
 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
 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
 NET PRESENT VALUE
• The difference between the market value of a project and its cost
• Discounted Cash Flow (DCF) Valuation:
• The first step is to estimate the expected future cash flows.
• The second step is to find the present value of the cash flows and subtract the initial
investment.
 COMPUTING NPV FOR THE PROJECT
• You are looking at a new project and you have estimated the following cash
flows:
• Year 0: CF = -165,000
• Year 1: CF = 63,120;
• Year 2: CF = 70,800;
• Year 3: CF = 91,080;
• Your required return for assets of this risk is 12%.
• NPV = 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 – 165,000 = 12,627.42
• Do we accept or reject the project?
 INTERNAL RATE OF RETURN
• Definition: IRR is the return that makes the NPV = 0
• Decision Rule: Accept the project if the IRR is greater than the required return
• This is the most important alternative to NPV
• Often used in practice
• Intuitively appealing
• Based entirely on the estimated cash flows and is independent of interest rates found
elsewhere
• Compute using trial and error process
 COMPUTING PAYBACK FOR THE PROJECT
• Assume we will accept the project if it pays back within two years.
• Year 1: 165,000 – 63,120 = 101,880 still to recover
• Year 2: 101,880 – 70,800 = 31,080 still to recover
• Year 3: 31,080 – 91,080 = -60,000 project pays back in year 3
• Do we accept or reject the project?
CAPACITY PLANNING FRAMEWORK

• Estimating the capacity requirements for the

planning Horizon
Step 1
• Computing the available capacity
• Estimating the quantum of capacity to be
Step 2 augmented

• Identifying the available alternatives

• Selecting the best one for capacity
Step 3 augmentation
 CAPACITY PLANNING: COMPUTATIONAL STEPS
• Step 1: Estimate the total requirement for the planning horizon
• Step 2: Estimate Labour and Machine requirements
• Step 3: Compute Capacity Availability
• Step 4: Compare availability with Requirement
• Step 5: Evaluate alternative methods for capacity augmentation
 CAPACITY PLANNING: COMPUTATIONAL STEPS
• Projected demand per unit time during the planning horizon = D
• Standard labour hours required per unit of product = SL
• Efficiency of labour = EL
D*SL
• Capacity requirements (Labour) = EL

D * SM
• Capacity requirements (Machine) = EM
 CAPACITY PLANNING: COMPUTATIONAL STEPS
• System availability
• Number of working days in the planning horizon: Nd
• Number of working hours per day: h
• System availability (Hours) = Nd * h

• Resource availability
• Number of machines available: Nm
• Machine: Time lost in breakdowns & maintenance = b %
• Number of workers available: NL
• Labour: Absenteeism of the workers = a %

• Capacity available in the system (Hours)

• Machine: Nd * h * Nm * (1 – b/100)
• Labour: Nd * h * NL * (1 – a/100)
 EXAMPLE
A manufacturer of medium-voltage circuit breakers is planning for a capacity build-up
of 8 cubicles and 13 circuit breakers per day. A year consists of 305 working days. The
fabrication division is responsible for manufacturing metal sheet components that are
welded together to form the cubicle. Some metal sheet components are welded to
host the circuit breakers inside the cubicle. The components are painted after welding.
While the fabrication uses a CNC turret press, painting is manual job. The standard
time required at the CNC turret press for fabricating a cubicle is 150 minutes and the
time for the breaker housing is 36 minutes. A cubicle requires 43 m2 of area to be
painted and a breaker housing requires 2.60 m2 of paint. The standard time required to
paint 1 m2 of area is 18 minutes. The machines works at 80 percent efficiency and the
manual labour works at 90 percent efficiency. Using the given data, compute the
labour-hour and machine-hour requirements.
• Suppose the factory works on a two shift basis with six workers in the paint shop in
each shift. There is only one CNC turret press currently available. Suppose prior data
shows that the equipment at the shop has a downtime of 12 percent and the
absenteeism rate of employees is 5 percent. Assess the impact of the capacity
expansion initiative in the plant.
A product is manufactured in a shop using a five-stage process. The first step in the
process is to cut the sheet metal to required shapes and sizes using a shearing
process. After the shearing process, the components are subjected to pressing
operations to alter the shape of the flat sheet as per the design. In the third stage
of the process welding is done to join the components. The next step in the
process is a painting operation. After painting, the components are packed and
kept ready for dispatch. The time take for each of these operations are 20, 30, 15,
12 and 6 minutes respectively. Presently, each stage has only one machine for
operation.
• Map the process and analyze the capacity with respect to the following scenarios:
a) If the shop works for an 8-hour shift with an effective available time of 450 minutes, what is the production
capacity of the shop?
b) Where is the bottleneck in the system? If we want to add one machine, where should we make the
investment?
c) Identify the additional capacity required for a daily production target of 25 units. Compute the utilization of
the machines as per the revised capacity calculations.
d) What are the key inferences of this exercise?
 EXAMPLE
Shearing Pressing Welding Painting Packing
(20 minutes) (30 minutes) (15 minutes) (12 minutes) (6 minutes)

The production capacities are:

• Shearing: 450/20 = 22.50 Pressing: 450/30 = 15.00
• Welding: 450/15 = 30.00 Painting: 450/12 = 37.50
• Packing: 450/6 = 75.00
• The smallest number in the above calculation limits the production capacity for
the shop. Therefore, the current production capacity is 15 units per day.

Pressing
(30 minutes)
Shearing Welding Painting Packing
(20 minutes) (15 minutes) (12 minutes) (6 minutes)
Pressing
(30 minutes) Bottleneck
 EXAMPLE
• The production target is 25 per day now. Since a day has 450 minutes, the maximum time that the process can
take in each stage is 18 minutes.
• Packing, Painting and Welding sections have timings less than 18. Therefore, they do not need any more
investment in capacity.
• By adding one more machine at the pressing stage, the effective time will be less than 18 minutes.
• Similarly, by adding one more machine at the shearing stage, the effective time will be 10 minutes.
• Utilisation of Shearing = Daily production * process time
=
25 * 20
= 55 .56 %
number of machines * available time 2 * 450
25 * 30
• Utilisation of Pressing = = 83 .33 %
2 * 450
25 * 15
• Utilisation of Welding = = 83 .33 %
1 * 450

• Utilisation of Painting = 66.67% Utilisation of Packing = 33.33%

BOTTLENECK & CAPACITY ANALYSIS: THE WANDERING BOTTLENECK

Shearing Pressing Welding Painting Packing

(20 minutes) (30 minutes) (15 minutes) (12 minutes) (6 minutes)

Pressing
(30 minutes)
Shearing Welding Painting Packing
(20 minutes) (15 minutes) (12 minutes) (6 minutes)
Pressing
(30 minutes)
 CAPACITY PLANNING: DECISION TREE ANALYSIS
• A manufacturer of electronic accessories for use in computers currently has a capacity of 40,000 pieces per
month. The business strategy group for the company recently performed a forecasting exercise to assess the
emerging demand for the accessories in the next five years. The study revealed that there is 40 percent
probability that the growth in demand for the accessories will be strong during this planning horizon and a 60
percent probability that the growth in demand will be moderate. The study identified three options for the
manufacturer to augment capacity. Option 1 is to expand the capacity by adding new capacity to meet the
demand. Option 2 is to augment capacity in existing factory itself by some de-bottlenecking operation (in which
case there will be limits to capacity expansion). Option 3 is to go for subcontracting. The sub-contracting option
adds marginal capacity and could be used as a temporary arrangement. If there is a strong growth in demand,
then the new capacity could be added a year later. The study revealed the following additional information about
the emerging scenario and the costs and benefits of each of the alternatives:
1. The cost of adding new capacity is ₹ 750,000. this cost goes up by 5 percent if it is deferred by a year.
2. The cost of expanding the existing factory itself is ₹ 275,000.
3. The cost of subcontracting is negligible, as no major investments are envisaged either at supplier side or at the
manufacturer side.
4. The revenue accruing from new capacity is as follows: If it is strong growth, the revenue will be ₹ 850,000 and
in case of moderate growth the revenue will be ₹ 400,000. these figures do not change even if the new unit
comes into operation a year later.
5. The revenue accruing from the expansion of the existing capacity is: If it is strong growth, the revenue will be ₹
550,000 and in case of moderate growth, the revenue will be ₹ 300,000.
6. The revenue accruing from the existing factory with subcontracting is: If there is strong growth, the revenue
will be ₹ 350,000 and in case of moderate growth, the revenue will be ₹ 180,000
Arrive at an appropriate capacity planning strategy using a decision tree. All revenues are yearly figures.
CAPACITY PLANNING: DECISION TREE ANALYSIS
Demand Moderate Revenue: Rs. 400,000 per year

A
Demand High Revenue: Rs. 850,000 per year

Demand Moderate Revenue: Rs. 200,000 per year

1 B
Demand High Revenue: Rs. 450,000 per year

Demand Moderate Revenue: Rs. 180,000 per year

C
Demand High
Revenue: Rs. 850,000 per year
2
Denotes the best option
at each decision point
Revenue: Rs. 350,000 per year
 CAPACITY PLANNING: DECISION TREE ANALYSIS
Decision point 2
• Revenue from adding new capacity = Rs. 850,000 x 4 = Rs. 34,00,000.00
• Cost of adding new capacity = Rs. 7,87,500.00
• Net revenue from this option = Rs. 26,12,500.00
• Revenue from sub-contracting option= Rs. 350,000 x 4 = Rs. 14,00,000.00

Therefore the best option at this stage is to go for adding new capacity

Node A
• Revenue in the case of high demand = Rs. 850,000 x 5 = Rs. 42,50,000.00
• Revenue (moderate demand) = Rs. 400,000 x 5 = Rs. 20,00,000.00
• Expected revenue at node A
E[A] = (42,50,000 * 0.40 + 20,00,000 * 0.60) = Rs. 29,00,000.00
• Cost of adding new capacity = Rs. 7,50,000.00

Net revenue from this option = Rs. 21,50,000.00

 CAPACITY PLANNING: DECISION TREE ANALYSIS
Node B
• Revenue in the case of high demand = Rs. 550,000 x 5 = Rs. 27,50,000.00
• Revenue (moderate demand) = Rs. 300,000 x 5 = Rs. 15,00,000.00
• Expected revenue at node B
E[B] = (27,50,000 * 0.40 + 15,00,000 * 0.60) = Rs. 20,00,000.00
• Cost of expanding the capacity = Rs. 2,75,000.00

Net revenue from this option = Rs. 17,25,000.00

Node C
• In the case of high demand, it is better to add new capacity after I year than continuing with the sub-
contracting option. This will fetch a net revenue of Rs. 26,12,500.00 during the last four years. Moreover, in the
first year, it would have fetched a revenue of Rs. 3,50,000.00. Therefore,
• Revenue in the case of high demand = Rs. 29,62,500.00
• Revenue (moderate demand) = Rs. 180,000 x 5 = Rs. 9,00,000.00
• Expected revenue at node C
E[C] = (29,62,500 * 0.40 + 9,00,000 * 0.60) = Rs. 17,05,000.00
• Cost of sub-contracting is none.
• Net revenue from this option = Rs. 17,05,000.00
1. A firm’s manager must decide whether to make or buy a certain item used in
the production of vending machines. Making the item 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/unit $60 $80
Annual volume (units) 12,000 12,000

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?
2. A small firm produces and sells automotive items in a five-state area. The firm
expects to consolidate 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?

3. Determine profit when volume equals 22,000 units.

4. A manager must decide which type of equipment to buy, Type A or Type B.
Type A equipment costs $15,000 each, and Type B costs $11,000 each. The
equipment can be operated eight hours a day, 250 days a year.
Either machine can be used to perform two types of chemical analysis, C1 and
C2. Annual service requirements and processing times are shown in the
following table. Which type of equipment should be purchased, and how many
of that type will be needed? The goal is to minimize total purchase cost.