Chapter 4:

Capacity Planning

Instructor: Dao Minh Anh (PhD.)

 Chapter Outline

▪ Importance of capacity planning.

▪ Ways of defining and measuring capacity.
▪ Determinants of effective capacity.
▪ Major considerations related to developing
capacity alternatives.
▪ Approaches that are useful for evaluating
capacity alternatives
▪ BEP (Break Even Point) analysis
 Capacity Planning
▪ Capacity is the upper limit or ceiling on the
load that an operating unit can handle.

▪ Capacity also includes

▪ Equipment
▪ Space
▪ Employee skills
 Capacity Planning
▪ Capacity planning refers to the activities of
the firm in determining the capacity of a
plant or a facility in terms of equipment,
machines, space, workers, and processes
based on the resource constraints of the
facility.
▪ The basic questions in capacity handling
are:
▪ What kind of capacity is needed?
▪ How much is needed?
▪ When is it needed?
 Importance of Capacity Decisions
1. Impacts ability to meet future demands
- MS X-box shortage in 2005, flu-vaccine
2. Affects operating costs
3. Major determinant of initial costs
4. Involves long-term commitment
5. Affects competitiveness
- Extra capacity as a barrier to competitor and
increases speed
6. Affects ease of management
7. Globalization adds complexity
8. Impacts long range planning
 Capacity
▪ Design capacity
▪ maximum output rate or service capacity an
operation, process, or facility is designed for
▪ Effective capacity
▪ Design capacity minus allowances such as
personal time, maintenance, and scrap
▪ Actual output
▪ rate of output actually achieved--cannot
exceed effective capacity.
 Efficiency and Utilization
Actual output
Efficiency =
Effective capacity

Actual output
Utilization =
Design capacity

(Both measures expressed as percentages, %)

- It is important to increase the “effective capacity” to
increase maximum capacity utilization.
 Efficiency/Utilization Example
Design capacity = 50 trucks/day
Effective capacity = 40 trucks/day
Actual output = 36 trucks/day
(Max Unil.=40/50 = 80%)

Actual output 36 trucks/day

Efficiency = = = 90%
Effective capacity 40 trucks/ day

Utilization = Actual output 36 trucks/day

= = 72%
Design capacity 50 trucks/day
 Determinants of Effective Capacity
▪ Facilities: Size, location, layout, a/c etc.
▪ Product and service design:
e.g. standardization increases eff. Capacity, mix of goods
and services.
▪ Process factors: that can meet desired quality, e.g.
inspection time
▪ Human factors: skills and experience
▪ Policy factors: allowing overtime & shifts?
▪ Operational factors: scheduling & inv policies
▪ Supply chain factors: Can SC handle capacity
change?
▪ External factors: union (work hour limits), environ.
Regulations (pollution control)
 Strategy Formulation
▪ Capacity strategy for long-term demand
is based on following assumptions and
predictions:
▪ Growth rate and demand variability/patterns
▪ Costs of building and operating facilities of
various sizes
▪ Rate and direction of technology changes
▪ Behavior of competitors
▪ Availability of capital and other inputs
 Key Decisions of Capacity Planning
1. Amount of capacity needed
Capacity cushion/buffer = (100%) – (% Utilization)
2. Timing of changes
Availability of capital, lead time to make the changes
3. Need to maintain balance
Between the changes and the rest of the system
4. Extent of flexibility of facilities
In terms of variety of work requirements

Capacity cushion/buffer: extra capacity intended to offset

demand uncertainty
 Steps for Capacity Planning
1. Estimate future capacity requirements
2. Evaluate existing capacity & identify gaps
3. Identify alternatives/choices
4. Conduct financial analysis of each choice
5. Assess key qualitative issues for each
choice
6. Select the best alternative/choice
7. Implement the alternative chosen
8. Monitor results
 Forecasting Capacity Requirements

▪ Long-term vs. short-term capacity needs

▪ Long-term relates to overall level of capacity such as
facility size, trends, and cycles
▪ Short-term relates to variations from seasonal, random,
and irregular fluctuations in demand

Examples of seasonal demand patterns

Beer sales, toy sales, airline traffic, vacation, tourism, , power usage,
Year
gas consumption, sports and recreation, education
Month Welfare and social security checks, bank transactions
Retail sales, restaurant meals, automobile traffic, automotive rentals,
Week
hotel registrations

Telephone calls, power usage, automobile traffic, public transportation,

Day
classroom utilization, retail sales, restaurant meals
 Calculating Processing Requirements
Standard
Annual processing time Processing time
Product Demand per unit (hr.) needed (hr.)

#1 400 5.0 2,000

#2 300 8.0 2,400

#3 700 2.0 1,400

5,800

If annual capacity is 2000 hours with one machine, how

many machines do you need to handle the required
volume?
 Planning Service Capacity
▪ Need to be near customers
▪ Capacity and location are closely tied
▪ Inability to store services
▪ Capacity must be matched with timing of
demand
▪ Degree of volatility of demand
▪ Peak demand periods
 In-House or Outsourcing
Outsource: obtain a good or service
from an external provider
1. Available capacity
2. Expertise (e.g. Dell’s printers and monitors)
3. Quality considerations
4. Nature of demand
Steady or fluctuating/small orders
5. Cost: cheaper to outsource?
6. Risk: e.g. loss of operational control
Developing Capacity Alternatives
1. Design flexibility into systems
2. Take stage of “life cycle” into account
3. Take a “big picture” approach to capacity
changes: e.g. Think bottleneck.
4. Prepare to deal with capacity “chunks”
e.g. Output of 50 desired < 40 + 40/machine
5. Attempt to smooth out capacity requirements:
Averaging underutil. & overutil. E.g. using complementary
demand products e.g. snow & water ski
6. Identify the optimal operating level
Bottleneck Operation
Bottleneck operation: An operation
in a sequence of operations whose
capacity is lower than that of the
other operations
 Bottleneck Operation

Bottleneck

Operation 1 Operation 2 Operation 3

10/hr.
20/hr. 10/hr. 15/hr.

Maximum output rate

limited by bottleneck
 Economies of Scale
▪ Economies of scale
▪ If the output rate is less than the optimal level,
increasing output rate results in decreasing
average unit costs
▪ Diseconomies of scale
▪ If the output rate is more than the optimal
level, increasing the output rate results in
increasing average unit costs
 Optimal Rate of Output
Production units have an optimal rate of output for minimal cost.

Minimum average cost per unit

Economies of Scale
Minimum cost & optimal operating rate are
functions of size of production unit.
 Reasons
▪ For economies of scale
▪ Fixed costs are spread over more units
▪ Construction costs increase at a decreasing rate w.r.t.
the size of facility
▪ Processing costs decrease as output rates increase b/c
of higher standardization
▪ For diseconomies of scale
▪ Distribution costs can increase due to from one large
centralized facility
▪ Complexity may increase costs: control and
communication become more problematic
▪ Possible additional levels of bureaucracy on decision
making and approvals
 Evaluating Alternatives
▪ Cost-volume analysis
▪ Break-even point
▪ Financial analysis
▪ Cash flow
▪ Present value
▪ Decision theory
▪ Waiting-line analysis
 Cost-Volume Relationships
▪ Legend:
▪ FC = Fixed Cost
▪ VC = total Variable Cost = v * Q
▪ v = Variable cost per unit
▪ TC = Total Cost
▪ TR = Total Revenue = R *Q
▪ R = Revenue per unit
▪ Q = Quantity or volume of output
▪ QBEP = Break-even quantity
▪ P = total Profit
 Cost-Volume Relationships
▪ FC = Fixed cost
▪ VC = Total variable cost TC = FC + VC
▪ v = Variable cost per unit
VC = v  Q
▪ TC = Total cost
▪ TR = Total revenue TR = R  Q
▪ R = Revenue per unit P = TR − TC = R  Q − ( FC + v  Q)
▪ Q = Quantity or volume of
output = Q( R − v) − FC
▪ QBEP = Break-even P + FC
quantity Q=
R−v
▪ P = total Profit
FC
QBEP =
R-v = Contribution R−v
Margin
Cost-Volume Relationships
 Examples of Cost-Volume
Ex. #1 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 $2.00 per pie, and pie would retail
for $7.00 each.

a. How many pies must be sold in order to break even?

b. What would be the profit (loss) 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?
Break-Even Problem with
Step Fixed Costs
 Examples of Cost-Volume
Ex. #2 A manager has the option of purchasing
one, two, or three machines. Fixed costs and
potential volumes are as follows:
Nr. Mach. Total Annual F.C Corres. Outputs
1 $9,600 0 – 300
2 $15,000 301-600
3 $20,000 601-900
Variable cost is $10 per unit, and revenue is $40 per unit.

a. Determine break-even point for each range.

b. If projected annual demand is between 580 and 660
units, how many machines should the manager
purchase?
 Assumptions of Cost-Volume
Analysis
1.One product is involved
2.Everything produced can be sold
3.Variable cost per unit is the same
regardless of volume
4.Fixed costs do not change with volume
5.Revenue per unit constant with volume
6.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 flows of an
investment proposal.
 Decision Theory
▪ Helpful tool for financial comparison of
alternatives under conditions of risk or
uncertainty
▪ Suited to capacity decisions
 Waiting-Line Analysis
(Queuing Analysis)
▪ Useful for designing or modifying service
systems
▪ Waiting-lines occur across a wide variety of
service systems
▪ Waiting-lines are caused by bottlenecks in
the process
▪ Helps managers plan capacity level that will
be cost-effective by balancing the cost of
having customers wait in line with the cost of
additional capacity
 Exercise 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
VC / 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 or buying?
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 Exercise 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 in a single
location. Currently, operations are in three widely
scattered location. 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.
a. What is the break-even point?
b. Determine profit when volume equals 22,000 units
5-36
 Exercise 3
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 $11,000 each. The equipment can be
operated eight hours a day, 250 days a year.
Either machine can be used to perform two types of
chemical analysis, C1 and C2. Annual service requirements
and processing times are shown below. Which type of
equipment should be purchased, and how many of that type
will be needed? The goal is to minimize total purchase cost.
PROCESSING TIME PER
ANALYSIS (hrs)
Analysis Type Annual volume A B
C1 1,200 1 2
C2 900 3 2
5-37
 Exercise 4
▪ A manager must decide which type of
machine to buy, A, B or C. Machine costs
are: Machine Cost ($)
A 40,000
B 30,000
C 80,000

▪ Product forecasts and processing times on

the machines are as follows:
▪ Machines operate 10 hours a day, 250 days a
year
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 Exercise 4
Product Annual Processing time per unit
Demand (minutes)
A B C
1 16,000 3 4 2
2 12,000 4 4 3
3 6,000 5 6 4
4 30,000 2 2 1

▪ Assume that only purchasing costs are being

considered. Which machine would have the
lowest total cost, and how many of that
machine would be needed? 5-39
 Practice
▪ Exercise 1, 2 (p192); 6, 7 (p193)

5-40