School of Accountancy, Business and Hospitality

Business Administration Department

Curriculum 2018-2019

COURSE LEARNING MODULE

OMGT 1013 (Operations Management and Total Quality Management)
AY 2022-2023

Lesson 8: Strategic Capacity Planning

Topic: Defining and Measuring Capacity

Forecasting Capacity requirement
Developing capacity strategies

Learning Outcomes: After reading this module, you are expected to:

1. Calculate capacity utilization;

2. Identify different ways to measure capacity and establish maximum capacity.

LEARNING CONTENT

Introduction:

After deciding what products or services should be offered and how they should be made, management
must plan the system’s capacity. Capacity is the maximum rate of output for a facility. The facility can be a
workstation or an entire organization. The Operations manager must provide the capacity to meet current and
future demand; otherwise, the organization will miss opportunities for growth and profits.

Capacity plans are made at two levels. Long-term capacity plans, which we describe in this chapter, deal with
investments in new facilities and equipment. These plans cover at least two years into the future, but
construction lead times alone can force much longer time horizons. Currently, US firms invest more than $600
billion annually in new plant and equipment. Service industries account for more than 68 percent of the total.
Such sizable investments require top-management participation and approval because they are not easily
reversed. Short-term capacity plans focus on work-force size, overtime budgets, inventories, and other types of
decisions that we explore later.

Lesson Proper:

STRATEGIC CAPACITY PLANNING

Capacity planning is central to the Iong-term success of an organization. Too much capacity can be as
agonizing as too little. When choosing a capacity strategy, managers have to consider questions such as the
following: How much of a cushion is needed to handle variable, uncertain demand? Should we expand
capacity before the demand is there or wait until demand is more certain? A systematic approach is needed to
answer these and similar questions and to deveIop a capacity strategy appropriate for each situation.

CAPACITY

OMGT 1013-Operations Management and TQM | 1

  Maximum rate of output for a facility; refers to an upper limit or ceiling on the load that an operation unit
can handle (operating unit might be a plant, department, machine store or worker). The load can be
specified in terms of either inputs or outputs
 According to the dictionary, the ability to hold, receive, store or accommodate
 In general business sense, it is the amount of output that a system is capable of achieving over a
specific period of time

TWO LEVELS OF CAPACITY PLANS

1. LONG TERM CAPACITY PLANS- deal with investments in new facilities and equipment.
Cover at least two years into the future but construction lead times alone can force much longer
time horizons

2. SHORT TERM CAPACITY PLANS- focus on work-force size, overtime budgets, inventories and other
types of decisions

Note: The capacity of an operation unit is an important piece of information for planning purposes. It enables
managers to quantify production in terms of inputs or outputs and thereby make other decisions or plans
related to those qualities.

The basic questions in capacity plans are:

1. What kind of capacity is needed?
2. How much is needed?
3. When is it needed?

*the question of what kind of capacity is needed relates to the products and services that management
intends to produce or provide.

MEASURES OF CAPACITY

OUTPUT MEASURES
 Usual choice for line flow processes
 As the amount of customization and the variety in the product mix becomes excessive, output-
based capacity measures become less useful
 Best utilized when the firm provides a relatively small number of standardized products and
services
 ex: produce one product

INPUT MEASURES
 Usual choice for flexible flow processes
 Demand (can complicate input measures), which invariably is expressed as an output rate, must
be converted to an input measure. Only after making the conversion can a manager compare
demand requirement and capacity on an equivalent basis
 ex: manager of a copy contest must convert its annual demand for copies from different clients
to the number of machines required.

1. UTILIZATION
-Degree to which equipment, space or labor is currently being used

Average output rate

Utilization= x 100 %
Maximum capacity

*average output rate and capacity must be measured in the same terms
OMGT 1013-Operations Management and TQM | 2
 *utilization rate indicates the need for adding extra capacity or eliminating unneeded capacity

2. PEAK CAPACITY
 Maximum output that a process or facility can achieve under ideal conditions
 When capacity is measured relative to equipment alone, the appropriate measure is rated
capacity: an engineering assessment of maximum annual output, assuming continuous
operation except for an allowance for normal maintenance and repair downtime.
 Can be sustained for only a short time (few hours in a day or few days in a month)

Average output rate

Utilization peak= x 100 %
Peak capacity

3. EFFECTIVE CAPACITY
 Maximum output that a process or firm can economically sustain under normal conditions
 CAPACITY- greatest level of output the firm can reasonably sustain by using realistic employee
work schedules and the equipment currently in place

Average output rate

Utilization effective = x 100 %
Effective capacity

Example:

If operated around the clock under ideal conditions, the fabrication department of an engine
manufacturer can make 100 engines per day. Management believes that a maximum output rate of
only 45 engines per day can be sustained economically over a long period of time. Currently the
department is producing an average of 50 engines per day.

Solution:
Calculating Utilization
Average output rate
Utilizationpeak = x 100%
Maximum capacity
50
= x 100%
100
= 50%

Average output rate

Utilizationeffective = x 100%
Maximum capacity
50
= x 100%
45
= 111%

BOTTLENECK- An operation that has the lowest effective capacity of any operation in the facility and thus
limits the system’s output

ECONOMIES OF SCALE
 The average unit cost of a good or service can be reduced by increasing its output rate

• Deciding on the best level of capacity involves consideration for the efficiency of the operations. A
concept known as economies of scale states that the average unit cost of a service or good can be
reduced by increasing its output rate.

4 PRINCIPAL REASONS why it can drive costs down when output increases:
OMGT 1013-Operations Management and TQM | 3
 1. Spreading fixed costs
 When the output rate - and therefore the facility’s utilization rate – increases, the average unit
cost drops because fixed costs are spread over more units
2. Reducing construction costs
 Doubling the size of the facility usually doesn’t double construction cost
3. Cutting costs of purchased materials
 Higher volumes can reduce the costs of purchased materials and services. They give the
purchaser a better bargaining position and the opportunity to take advantage of quantity
discounts
4. Finding process advantages
 Firms may be able to justify the expense of more efficient technology or more specialized
equipment

DISECONOMIES OF SCALE
 The average cost per unit increases as the facility’s size increases
 Reason is that excessive size can bring complexity, loss focus and inefficiencies that raise the
average unit cost of a product or service

CAPACITY STRATEGIES

1. Sizing Capacity Cushion

 Average utilization rates should not get too close to 100 percent. That usually is a signal to
increase capacity or decrease order acceptance so as to avoid declining productivity
 Capacity cushion- amount of reserve capacity that a firm maintains to handle sudden
increases in demand or temporary losses of production capacity; it measures the amount by
which the average utilization (in terms of effective capacity) falls below 100%

Capacity cus h ion=100 %−utilizationrate (%)

 business find large cushions when demand varies and when future demand is uncertain,
particularly if resource flexibility is low

2. Timing and Sizing Expansion

 When to expand and by how much
 If demand is increasing and the time between increments increases, the size of the increments
must also increase

a. Expansionist strategy
 involves large, infrequent jumps in capacity
 stays ahead of demand, minimizes the chance of sales lost to insufficient capacity

b. Wait-and-see strategy
 involves smaller, more frequent jumps
 lags behind demand, relying on short-term options (overtime, temporary workers,
subcontractors, stock outs) and postponement of preventive maintenance to meet any
shortfalls

c. Follow-the-leader
 intermediate strategy, expanding when others do
 if others are right, so are you, and nobody gains a competitive advantage
 if they make a mistake and over expand, so have you, but everyone shares in the agony
of over capacity

3. Linking capacity and other decisions

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  When managers make decisions about location, resource flexibility, and inventory, they must
consider the impact on capacity cushions
 capacity cushions- buffer the organization against uncertainty
 Examples of links with capacity:
a) Competitive priorities- a change in competitive priorities that emphasizes faster
deliveries requires a larger capacity cushion to allow for quick response and uneven
demand, if holding finished goods inventory is infeasible or uneconomical
b) Quality management- a drive that has obtained higher levels of quality allows for a
smaller capacity cushion because there will be less uncertainty caused by yield losses
c) Capital intensity- an investment in expensive new technologies makes a process more
capital intensive and increases pressure to have a smaller capacity cushion to get an
acceptable return on investment
d) Resource flexibility- a change to less worker flexibility requires a larger capacity
cushion to compensate for the operation overloads that are more likely to occur with a
less flexible workforce
e) Inventory- a change to less reliance on inventory in order to smooth the output rate
requires a larger capacity cushion to meet increased demands during peak periods
f) Scheduling- a change to more stable environment allows a smaller cushion because
products or services can be scheduled with more assurance

STEPS IN CAPACITY PLANNING

1. ESTIMATE CAPACITY REQUIREMENTS
a. When one product/service is being processed
'
Processing hours required for yea r s demand
No . of mac hines required= after deducting desired cus h ion ¿ ¿
Hours available one mac hine per year ,¿
¿

Dp
M=
N [1− ( 100C )]
Where:D= number of units (customers) forecast per year
p= processing time
N= total number of hours per year during which the process operates
C= desired capacity cushion

b. When multiple products/services are involved, extra time needed to change over from one
product or service to the next
*Set up time- time required to change a machine from making one product or service to making
another

No . of units forecast per year ( D )

total set up time ( s )= x time per set up
number of units made∈eac h lot

Processing∧set up hours required for

summed
yea r ' s demand , products
all
No . of mac hines required= after deducting desired cus hion ¿ ¿
Hours available one mac hine per year , ¿
¿

OMGT 1013-Operations Management and TQM | 5

 M=
[ ( )][ ( )]
Dp+
D
Q
s + Dp+
D
Q
s +… …+ Dp+
D
Q
s
[ ( )]
N [1− ( 100C )]
Where:Q= number of units in each lot
s= set up time (in hours) per lot

*ALWAYS round up the fractional part unless it is cost efficient to use short-term options such as
overtime or stockouts to cover any shortfalls

Example:
A copy center in an office building prepares bound reports for two clients. The center makes multiple
copies (the lot size) of each report. The processing time to run, collate, and bind each copy depends
on, among other factors, the number of pages. The center operates 250 days per year, with one eight-
hour shift. Management believes that a capacity cushion of 15% is best. Based on the following table of
information, determine how many machines are needed at the copy center.

Item Client X Client Y

Annual demand forecast (copies) 2000 6000
Standard processing time (hour/copy) 0.50 0.70
Average lot size (copies per report) 20 30
Standard set up time (hours) 0.25 0.40

Solution:

M=
[ ( )][ ( )]
Dp+
D
Q
s + Dp+
D
Q
s +… …+ Dp+
D
Q
s
[ ( )]
N [1− ( 100C )]

=
[ 2000(0.50)+ ( 2000
20 ) ] [
0.25 + 6000 (0.70)+(
30 )
6000
0.40
]
¿ 2000 hours / year [1−(
100 )
15
]

= 5305
1700
= 3.12 (Rounding up to the next integer gives a requirement of 4 machines)

*Note: N = (250 days/year)(1 shift/day)(8 hours/shift) = 2000 hours/year

2. IDENTIFY GAPS
*CAPACITY GAPS- any difference (positive or negative) between projected demand and current
capacity
Capacity gap=demand−capacity
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 Example: Say that the copy center currently has 3 machines, so

Capacity gap=demand−capacity
=4–3
= 1 machine
This means that the copy center will need 1 more machine to be able to fully serve its 2 clients. The
copy center may either opt to buy a new one or rent from another.

NOTE: Capacity gap may either be positive or negative

3. DEVELOP ALTERNATIVES
*BASE CASE- to do nothing and simply lose orders from any demand

4. EVALUATE THE ALTERNATIVES

*QUALITATIVE CONCERNS- manager has to look at how each alternative fits the overall capacity
strategy and other aspects of the business not covered by the financial analysis
*QUANTITATIVE CONCERNS- manager estimates the change in cash flows for each alternative
*Cash flows- difference between the flow of funds into and out of an organization over a period
of time

TOOLS FOR CAPACITY PLANNING

1. WAITING LINE MODELS- use probability distributions to provide estimates of average customer
time, average length of waiting lines, and utilization of the work
center
2. DECISION TREES- can be particularly valuable for evaluating different capacity expansion
alternatives when demand is uncertain and sequential decisions are
involved

*** END of LESSON***

REFERENCES

Textbooks

Chase, Richard,et.al. Production and Operations management: Manufacturing and Services 8th ed.
Irwin/McGrwa-Hill. Boston

Stevenson, William J. (2018). Operations management thirteenth edition. McGraw Hill Education, 2 Penn
Plaza, New York, NY 10121.

Learning Materials

Worksheets (teacher-made)

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