STRATEGIC CAPACITY PLANNING

5
INTENDED LEARNING OUTCOMES
By the end of the learning experience, students must be able to:
1. Understand and discuss the concept of capacity;
2. Describe and list the types of capacity planning;
3. Discuss the importance of capacity to organizational operations;
4. Explain capacity planning and its purpose;
5. Identify and illustrate capacity planning for products and services;
6. Assess and measure the used of capacity estimations to organizations;
7. Demonstrate and evaluate the determinants of effective capacity employ by the
organizations;
8. Apply and illustrate the steps of capacity planning process for productive operations;
9. Assess and evaluate capacity alternative used by the organizations; and
10. Understand the concept of break-even analysis to organizational operations.

A. CAPACITY
Capacity is the rate of productive capability of a facility. Capacity is known as the
amount of output, that a system is capable over a specific period of time. Capacity is the upper
limit or ceiling on the load that an operating unit can handle.
Managers should recognize the broader effects capacity decisions have on the entire
organization. Common strategies include leading capacity, where capacity is increased to meet
expected demand, and following capacity, where companies wait for demand increases before
expanding capabilities. A third approach is tracking capacity, which adds incremental capacity
over time to meet demand.
Finally, the two most useful functions of capacity planning are design capacity and
effective capacity. Design capacity refers to the maximum designed capacity or output rate and
the effective capacity is the design capacity minus personal and other allowances. These two
functions of capacity can be used to find the efficiency and utilization.

Table 5.1. Examples of Capacity measures

Measures of Capacity
Type of Organization
Inputs Outputs
Manufacture Machine hours per shift Number of units of shifts
Hospital Number of berths/beds Number of patients treated
Airline Number of planes or seats Number of seat miles flown
Restaurant Number of seats Customer/time
Retailer Area of store Sales
Theatre Number of seats Customer/time

Importance of Capacity
Operations manager are concerned with the capacity of several reasons:
• They want sufficient capacity to meet customer demand in timely manner.

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 • Capacity affects the costs efficiency of operations, the ease or difficulty of scheduling
output, and the costs of maintaining the facility.
• Capacity requires an investment; since managers seek to a good return on investment
both the costs and revenues of a capacity planning decision must be carefully
evaluated.

B. CAPACITY PLANNING

Capacity Planning is the process of determining the production capacity needed by an

organization to meet changing demands for its products. It is the process used to determine how
much capacity is needed (and when) in order to manufacture greater product or begin production
of a new product. Capacity planning is central to the long term success of an organization.
Capacity planning is generally viewed in terms of three time horizons or durations.
Capacity planning that establishes some expectations about the capacity a company
acquires and develops over time. Long term capacity planning is an important part of strategic
planning of the firm. Companies which are in business for the long run must make continued
investment in people, technology, research and development and capital assets (such as buildings,
machinery and equipments etc).
External environment conditions such as economic, political, technological, and social and
market conditions and forecast of future levels of demand provide important inputs into long term
strategic planning and also into short term plans and decisions made by managers of the firm.
Managers must evaluate and consider trade-offs of a number of factors while establishing a long
term capacity plan for their firms. Some of these factors are:
• forecast growth in demand
• future upgrading of technology which may become necessary to gain competitive
edge over others
• anticipated moves by competing firms
• reliance on learning curves without additional investment
• forecast of availability of funds for the future investments
• the cost of new capacities and capacities which can provide economies of scale

Capacity Planning for Products and Services

Capacity refers to a system’s potential for producing goods or delivering services over a
specified time interval. Capacity planning involves long-term and short- term considerations.
Long-term considerations relate to the overall level of capacity; short-term considerations relate
to variations in capacity requirements due to seasonal, random, and irregular fluctuations in
demand.
Excess capacity arises when actual production is less than what is achievable or optimal
for a firm. This often means that the demand in the market for the product is below what the firm
could potentially supply to the market. Excess capacity is inefficient and will cause manufacturers
to incur extra costs. Capacity can be broken down in two categories: Design Capacity and Effective
Capacity. Three key inputs to capacity planning are:
• The kind of capacity that will be needed
• How much capacity will be needed?
• When will it be needed?

Types of Capacity Planning

• Long Range Capacity Planning: Which is usually having a time horizon of more than one
or two years. It is carried out for productive resources which take a long time to acquire or
dispose of such as buildings, equipment or facilities such as machinery, materials handling
equipments and transportation vehicles etc.

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 • Intermediate Range Capacity Planning: Which has a time horizon or duration for the
next 6-18 months. The intermediate range capacity may be varied by such alternatives
such as hiring or laying off labor, purchasing or making new tools and minor equipments
and outsourcing/subcontracting etc.
• Short Range Planning: Which has a time horizon or duration of less than one month. This
is concerned with day to day planning such as daily scheduling of activities and machine
loading or weekly scheduling process which involves making adjustments to eliminate the
variance between planned output and actual output. It is concerned with overtime,
transfer of personnel and changing the production routings.

Capacity Estimation
To estimate the capacities of existing facilities in a firm, it is necessary to know about the
various types of capacity and the measures of capacity.
• Production Capacity: It is the maximum rate of production (or output) of an
organization. Several factors underlying the concept of capacity make its
understanding and use somewhat complex. Variation in employee absenteeism,
equipment breakdowns, vacations, holidays, delays in material
procurement/delivery, work schedules, working hours, use of overtime, temporary
workers, outsourcing etc., must be taken into account when estimating the
production capacity.
• Design Capacity: Design capacity refers to the maximum output that can possibly be
attained. It is the maximum rate of output achieved under ideal conditions.
• Effective Capacity: Effective capacity is the maximum possible output given a
product mix, scheduling difficulties, machine maintenance, quality factors,
absenteeism etc.
• Maximum Capacity: It is also known as Peak capacity, it is the maximum output that
a facility can achieve under ideal conditions. Where capacity is measured relative to
equipment alone, it is known as related capacity.
• Measures of Capacity: Different measures of capacity are applicable in different
situations. For example, capacity of an automobile plant can be measured in terms of
the number of automobiles produced per unit of time whereas capacity of a hospital
is measured in terms of the number of patients that can be treated per day. Therefore,
capacity of a facility can be either measured in terms of inputs. An important measure
of system effectiveness is the capacity utilization rate which reveals how close a firm
is to its best operating point i.e. design capacity.

Formula: Capacity utilization rate = (Capacity used(i.e. Actual output)

(Best operating level (or design capacity)

Best operating level is the level of capacity for which the facility was designed and thus
is the volume of output at which average unit cost is minimum. Another measure of
system effectiveness is efficiency which is the ratio of actual output to the effective
capacity.

Formula: Efficiency = (Actual Output)

(Effective Capacity)

Determinants of effective capacity

Many decisions about design of the production system and operation of the production
system may have an impact on capacity. The main factors relate to the following:
• Facilities: The size and provision for expansion are key in the design of facilities. Other
facility factors include location factors, such as transportation costs, distance to

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 market, labor supply, and energy sources. The layout of the work area can determine
how smoothly work can be performed.
• Product and Service Factors: The more uniform the output, the more opportunities
there are for standardization of methods and materials. This leads to greater capacity.
• Process Factors: Quantity capability is an important determinant of capacity, but so
is output quality. If the quality does not meet standards, then output rate decreases
because of need of inspection and rework activities. Process improvements that
increase quality and productivity can result in increased capacity. Another process
factor to consider is the time it takes to change over equipment settings for different
products or services.
• Human Resource Considerations: The tasks that are needed in certain jobs, the array
of activities involved, and the training, skill, and experience required to perform a job
all affect the potential and actual output. Employee motivation, absenteeism, and
labor turnover all affect the output rate as well.
• Operational Factors: Scheduling problems may occur when an organization has
differences in equipment capabilities among different pieces of equipment or
differences in job requirements. Other areas of impact on effective capacity include
inventory stocking decisions, late deliveries, purchasing requirements, acceptability
of purchased materials and parts, and quality inspection and control procedures.
• External Factors: Minimum quality and performance standards can restrict
management’s options for increasing and using capacity.
• Policy Factors: Management policy can affect capacity by allowing or disallowing
capacity options such as overtime or second or third shifts
• Supply Chain Factors: Questions include: What impact will the changes have on
suppliers, warehousing, transportation, and distributors? If capacity will be increased,
will these elements of the supply chain be able to handle the increase? If capacity is to
be decreased, what impact will the loss of business have on these elements of the
supply chain?

Steps in the Capacity Planning Process

1. Estimate future capacity requirements
2. Evaluate existing capacity and facilities and identify gaps
3. Identify alternatives for meeting requirements
4. Conduct financial analyses of each alternative
5. Assess key qualitative issues for each alternative
6. Select the alternative to pursue that will be best in the long term
7. Implement the selected alternative
8. Monitor results

Evaluating Capacity Alternatives

There are two major ways to evaluate the capacity alternatives to select the best one:
economic and non-economic.
1. Economic Considerations: Take into account the cost, useful life, compatibility and
revenue for each alternative. Techniques used for evaluation are:
• Break Even Analysis (this is the only one discussed in this chapter)
• Payback Period
• Net Present Value
2. Non-Economic Considerations: Include public opinion, reactions from employees and
community pressure.

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 Break-even Analysis
A break-even analysis is a financial tool which helps a company to determine the stage at
which the company, or a new service or a product, will be profitable. In other words, it is a financial
calculation for determining the number of products or services a company should sell or provide
to cover its costs (particularly fixed costs). Break-even is a situation where an organization is
neither making money nor losing money, but all the costs have been covered.
Break-even analysis is useful in studying the relation between the variable cost, fixed cost and
revenue. Generally, a company with low fixed costs will have a low break-even point of sale. For
example, say Happy Ltd has fixed costs of Php 10,000 vs Sad Ltd has fixed costs of Php 1,00,000
selling similar products, Happy Ltd will be able to break even with the sale of lesser products as
compared to Sad Ltd.

Components of Break Even Analysis

Fixed costs
Fixed costs are also called overhead costs. These overhead costs occur after the decision to start
an economic activity is taken and these costs are directly related to the level of production, but
not the quantity of production. Fixed costs include (but are not limited to) interest, taxes, salaries,
rent, depreciation costs, labour costs, energy costs etc. These costs are fixed respective of the
production. In case of no production also the costs must be incurred.

Variable costs
Variable costs are costs that will increase or decrease in direct relation to the production volume.
These costs include cost of raw material, packaging cost, fuel and other costs that are directly
related to the production.

Calculation of Break-Even Analysis

The basic formula for break-even analysis is derived by dividing the total fixed costs of production
by the contribution per unit (price per unit less the variable costs).

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For an example:

Variable costs per unit: Php400.00

Sale price per unit: Php 600.00
Desired profits: Php 4,00,000.00
Total fixed costs: Php 10,00,000.00

First, calculate the break-even point per unit, so you will divide the Php.10,00,000 of fixed costs
by the Php 200.00 which is the contribution per unit (Php 600.00 – Php 400.00).

Break Even Point = Php10,00,000.00/ Php 200.00 = 5000 units

Next, this number of units can be shown in pesos by multiplying the 5,000 units with the selling
price of Php 600.00 per unit.

Break Even Sales at 5000 units x Php 600 = Php 30,00,000 (Break-even point in pesos)

Contribution Margin
Break-even analysis also deals with the contribution margin of a product. The excess between the
selling price and total variable costs is known as contribution margin. For example, if the price of
a product is Php100.00, total variable costs are Php 60.00 per product and fixed cost is Php 25.00
per product, the contribution margin of the product is Php 40.00 (Php 100.00 – Php 60.oo). This
Php40.00 represents the revenue collected to cover the fixed costs. In the calculation of the
contribution margin, fixed costs are not considered.

When is Break even analysis used?

Starting a new business: To start a new business, a break-even analysis is a must. Not only it helps
in deciding whether the idea of starting a new business is viable, but it will force the start-up to be
realistic about the costs, as well as provide a basis for the pricing strategy.

Creating a new product: In the case of an existing business, the company should still perform a
break-even analysis before launching a new product—particularly if such a product is going to add
a significant expenditure.

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Changing the business model: If the company is about to the change the business model, like,
switching from wholesale business to retail business, then a break-even analysis must be
performed. The costs could change considerably and break-even analysis will help in setting the
selling price.

Break-even analysis is useful for the following reasons:

• It helps to determine remaining/unused capacity of the company once the breakeven is

reached. This will help to show the maximum profit on a particular product/service that
can be generated.
• It helps to determine the impact on profit on changing to automation from manual (a fixed
cost replaces a variable cost).
• It helps to determine the change in profits if the price of a product is altered.
• It helps to determine the amount of losses that could be sustained if there is a sales
downturn.

Additionally, break-even analysis is very useful for knowing the overall ability of a business to
generate a profit. In the case of a company whose break-even point is near to the maximum sales
level, this signifies that it is nearly impractical for the business to earn a profit even under the best
of circumstances.
Therefore, it’s the management responsibility to monitor the break-even point constantly. This
monitoring certainly reduces the break-even point whenever possible.

Ways to monitor Break even point

• Pricing analysis: Minimize or eliminate the use of coupons or other price reductions
offers, since such promotional strategies increase the break-even point.
• Technology analysis: Implementing any technology that can enhance the business
efficiency, thus increasing capacity with no extra cost.
• Cost analysis: Reviewing all fixed costs constantly to verify if any can be eliminated can
surely help. Also, review the total variable costs to see if they can be eliminated. This
analysis will increase the margin and reduce the break-even point.
• Margin analysis: Push sales of the highest-margin (high contribution earning) items and
pay close attention to product margins, thus reducing the break-even point.
• Outsourcing: If an activity consists of a fixed cost, try to outsource such activity
(whenever possible), which reduces the break-even point.

Benefits of Break-even analysis

· Catch missing expenses: When you’re thinking about a new business, it’s very much possible
that you may forget about a few expenses. Therefore, a break-even analysis can help you to review
all financial commitments to figure out your break-even point. This analysis certainly restricts the
number of surprises down the road or at least prepares a company for them.

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· Set revenue targets: Once the break-even analysis is complete, you will get to know how much
you need to sell to be profitable. This will help you and your sales team to set more concrete sales
goals.

· Make smarter decisions: Entrepreneurs often take decisions in relation to their business based
on emotion. Emotion is important i.e. how you feel, though it’s not enough. In order to be a
successful entrepreneur, decisions should be based on facts.

· Fund your business: This analysis is a key component in any business plan. It’s generally a
requirement if you want outsiders to fund your business. In order to fund your business, you have
to prove that your plan is viable. Furthermore, if the analysis looks good, you will be comfortable
enough to take the burden of various ways of financing.

· Better Pricing: Finding the break-even point will help in pricing the products better. This tool is
highly used for providing the best price of a product that can fetch maximum profit without
increasing the existing price.

· Cover fixed costs: Doing a break-even analysis helps in covering all fixed cost.

References

Anil Kumar, S and N. Suresh. (2009). Operations Management. New Age International (P) Ltd.,
Publishers. New Delhi. Retrieved from
http://182.160.97.198:8080/xmlui/bitstream/handle/123456789/436/Operations_Management%2
0-%20Kumar%20A%20A%20and%20Suresh%20N.pdf?sequence=1

Slack, N., Brandon-Jones, A. and Johnston, R. (2013). Operations Management. 7th Edition.
Pearson Education Limited. Retrieved at
https://colbournecollege.weebly.com/uploads/2/3/7/9/23793496/operations_management_by_sl
ack_nigel_7th.pdf

Stevenson, W. J. (2012). Operations Management. 11th Edition. McGraw-Hill/Irwin. New York.

Retrieved from https://baixardoc.com/documents/operation-management-by-william-j-
stevenson-11th-edition-shuvo--5cf6d512051d3

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