Chapter 5

Strategic Capacity Planning for

Products and Services

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
 Capacity Planning

⮚ Capacity is the upper limit or ceiling on the load that an

operating unit can handle.
⮚ The load might be in terms of the number of physical units
produced or the number of services performed.
⮚ The operating unit might be plant, department, machine,
store or worker.
⮚ Capacity needs include equipment, space, and employee skills.

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 Strategic Capacity Planning
• Goal
– To achieve a match between the long-term supply
capabilities of an organization and the predicted level
of long-run demand.
• Organizations become involved in capacity planning due
to changes in demand, changes in technology, changes in
the environment, and perceived threats or opportunities.
• Overcapacity🡪 operating costs that are too high.
• Undercapacity🡪 strained resources and possible loss of
customers.

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 Capacity Planning Questions
• Key Questions:
– What kind of capacity is needed?
– How much capacity is needed to match demand?
– When is it needed?
• Related Questions:
– How much will it cost?
– What are the potential benefits and risks?
– Are there sustainability issues?
– Should capacity be changed all at once, or through
several smaller changes?
– Can the supply chain handle the necessary changes?

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Capacity Decisions Are Strategic
1. Capacity decisions have a real impact on the ability of the
organization to meet future demands for product and services;
capacity essentially limits the rate of output possible.
2. Capacity decisions affect operating costs. A decision must be
made to attempt to balance the cost of over and undercapacity.
3. Capacity is a major determinant of initial cost. The greater the
capacity of a productive unit, the greater its cost.
4. Capacity decisions often involve long-term commitment of
resources and once they are implemented, those decisions
may be difficult or impossible to modify without incurring
major costs.

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 Capacity Decisions Are Strategic
5. Capacity decisions can affect competitiveness. If a firm has
excess capacity, or can quickly add capacity, that fact may serve
as a barrier to entry by other firms. Also it affects delivery
speed, which can be a competitive advantage.
6. Capacity affects the ease of management; having appropriate
capacity makes management easier than when capacity is
mismatched.
7. Capacity decisions are more important and complex due to
globalization.
8. Capacity decisions need to be planned for in advance as they
involve substantial financial and other resources.

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 Defining and Measuring 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,
equipment maintenance, delays due to scheduling
problems, lunch breaks, coffee breaks and changing the
mix of products.
Actual output
– rate of output actually achieved, it cannot exceed effective
capacity and it is often less because of machine
breakdowns, absenteeism, shortages of materials and
quality problems, as well as factors that are outside the
control of the operations managers. 5-7
Measuring System Effectiveness
• Efficiency

• Utilization

Both measures are expressed as percentages

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Example– Efficiency and Utilization
• Design Capacity = 50 trucks per day
• Effective Capacity = 40 trucks per day
• Actual Output = 36 trucks per day

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 Measuring System Effectiveness
• Compared to the effective capacity of 40 units per day, 36
units per day look pretty good. However, compared to the
design capacity of 50 units per day, 36 units is much less.
• Because effective capacity acts as a lid on actual output, the
real key to improving utilization is to increase effective
capacity by correcting quality problems, maintaining
equipment, and fully training employees.
• Hence, increasing utilization depends on being able to
increase effective capacity and this requires knowledge of
what is constraining effective capacity.

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Determinants of Effective Capacity
• Facilities: design, location, and layout
• Product and service factors: design and product or service mix.
• Process factors: quantity and quality capabilities.
• Human factors: job content, job design, training, experience,
motivation, compensation, absenteeism and labor turnover.
• Policy factors: management policy by allowing or not allowing
capacity options such as overtime or second and third shifts.
• Operational factors: scheduling, materials management, quality
assurance, maintenance policies and equipment breakdowns.
• Supply chain factors: What impact will the changes have on
suppliers, warehousing, transportation, and distributors?
• External factors: safety regulations, pollution control standards

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 Strategy Formulation
• The three primary strategies are:
1.Leading capacity strategy builds capacity in anticipation of
future demand increases.
2.Following capacity strategy builds capacity when demand
exceeds current capacity
3.Tracking capacity strategy is similar to a following strategy,
but it adds capacity in relatively small increments to keep
pace with increasing demand.

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 Capacity Cushion
• It is the extra capacity used to offset demand uncertainty.
• It is an amount of capacity in excess of expected demand
when there is some uncertainty about the demand.
• Capacity cushion = capacity - expected demand.

• Organizations that have greater demand uncertainty

typically have greater capacity cushion.
• Organizations that have standard products and services
generally have smaller capacity cushion.

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 Steps in Capacity Planning
1. Estimate future capacity requirements
2. Evaluate existing capacity and facilities; identify gaps
3. Identify alternatives for meeting requirements
4. Conduct financial analyses
5. Assess key qualitative issues
6. Select the best alternative for the long term
7. Implement alternative chosen
8. Monitor results

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 Calculating Processing Requirements
• Calculating processing requirements requires reasonably
accurate demand forecasts for each product, standard
processing time per unit for each product, the number of work
days per year, and the number of shifts that will be used.

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 Calculating Processing Time

Annual capacity is 250*8 = 2000 hours

Number of machines required = 5,800 hours/2,000 hours = 2.90 machines.
Then we need three machines to handle the required volume.
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 Service Capacity Planning
Three very important factors in planning service capacity:
1.The need to be near customers: Convenience for
customers. Example hotels rooms must be where customers want to stay;
having a vacant room in another city won’t help.
2.The inability to store services: capacity must be matched
with the timing of the demand. Unlike goods, services can not be produced
in one period and stored for use in a later period. Thus an unsold seat on an
airplane, train or bus cannot be stored for use on a later trip. If a customer
wants a service and had to wait, this may result in a variety of negatives for
an organization
3.The degree of demand volatility: Volume and timing of
demand, time required to service individual customers. To cope with peak
demand periods, planners might consider hiring extra workers, hiring
temporary workers, outsourcing some or all of a service. Or using pricing
and promotion to shift some demand to slower periods.
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 In-House or Outsource?
• Once capacity requirements are determined, the organization
must decide whether to produce a good or service itself or
outsource from another organization.
• Factors to consider:
1. Available capacity
2. Expertise
3. Quality considerations
4. The nature of demand
5. Cost
6. Risks

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 Make or Buy
• A firm’s manager must decide whether to make or buy 12,000
units of 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
FC $150,000 -
• ShouldV the firm make or buy ?
60$/unit 80$/unit
• If the volume changed, at what volume would the manager be
indifferent between making and buying ?

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 Make or Buy
Total cost = Fixed cost + (Volume * Variable cost)
TC of make = $150000 + (12000*60) = $870000
TC of buy = 0 + (12000*80) = $960000

Total Cost (make) < Total Cost (buy)

So the solution is “Make”

• Total cost(make) = Total cost(buy)

$150000 + Q*60 = 0 + Q*80
Q = 7500 units

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 Developing Capacity Strategies
There are a number of ways to enhance development of capacity
strategies:
1.Design flexibility into systems.
2.Take stage of life cycle into account.
3.Take a “big picture” approach to capacity changes.
4.Prepare to deal with capacity “chunks”
5.Attempt to smooth out capacity requirements
6.Identify the optimal operating level.
7.Choose a strategy if expansion is involved.

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 Bottleneck Operations
• Bottleneck operation: An operation in a sequence of operations
whose capacity is lower than that of the other operations. As a
consequence, the capacity of the bottleneck limits the systems
capacity; the capacity of the system is reduced to the capacity of
the bottleneck operation.

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Bottleneck Operations

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Identify the Optimal Operating Level
The Best Operating Level is the output that results in the lowest
average unit cost.
•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.

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 Reasons for Economies of Scale
1. Fixed costs are spread over more units, reducing the FC per
unit.
2. Construction costs increase at a decreasing rate with respect to
the size of the facility to be built.
3. Processing costs decrease as output rates increase because
operations become more standardized, which reduces unit
costs.

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 Reasons for Diseconomies of Scale
1. Distribution costs increase due to traffic congestion and
shipping from one large centralized facility instead of several
smaller, decentralized facilities.
2. Complexity increases costs; control and communication become
more problematic.
3. Inflexibility can be an issue.
4. Additional levels of bureaucracy exist, slowing decision making
and approvals for changes.

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Identify the Optimal Operating Level
Production units have an optimal rate of output for minimal cost.

Average cost per unit

Minimu
m
cost
0
Rate of
output
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 Identify the Optimal Operating Level
• Minimum cost and optimal operating rate are functions of size
of a production unit
Average cost per unit

Smal
l Medium
plant plant Large
plant

0 Output rate
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 Evaluating Alternatives
• Alternatives should be evaluated from varying perspectives
– Economic
• Cost-volume analysis
• Financial analysis
• Decision theory
• Waiting-line analysis
• Simulation
– Non-economic
• Public opinion

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 Cost-Volume Analysis
• Focuses on the relationship between cost, revenue, and
volume of output.
• The purpose of CV analysis is to estimate the income of an
organization under different operating decisions.
– Fixed Costs (FC) tend to remain constant regardless of
output volume. Example: rental costs.
– Variable Costs (VC) vary directly with volume of output.
The major components of variable costs are generally materials and
labor costs
– TC = FC+VC
– VC = Quantity(Q) x variable cost per unit (v)
– TR = revenue per unit (R) x Q
– Profit = TR - TC
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 Cost-Volume Analysis
• Profit (P) = TR – TC = R x Q – (FC +v x Q)
= Q(R – v) – FC
• The required volume. Q, needed to generate a specified profit
is:

• Breakeven Point
❑The volume of output at which total cost and total revenue
are equal

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Cost-Volume Relationships

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 Cost – Volume Analysis Example
The owner of Old-Fashioned Berry Pies, S. Simon, is contemplating adding a new line of
pies, which will appear leasing new equipment for a monthly payment of $6000. variable
costs would be $2 per pie, and pies would retail for $7 each.
I.How many pies must be sold in order to break even ?
II.What would be profit (loss) be if 1000 pies are made and sold in a month?
III.How many pies must be sold to realize a profit of $4000 ?
IV.If 2000 can be sold, and a profit target is $5000, what price should be charged per pie ?

FC = $6000 c = $2 p = $7
Qbep = FC / ( p - c ) = 6000 / ( 7 – 2 ) = 1200 pies / month

For Q = 1000 TP = TR – TC = p*Q - FC - c*Q

TP = Q(p – c ) - FC = 1000*(7 – 2 ) - 6000 = - 1000 $ loss
For TP = 4000 Q = (TP + TC ) / (p – c) = (4000 + 6000) / ( 7 - 2 ) = 2000 pies

For Q = 2000 and TP = 5000 TP = Q(p – c ) - FC

5000 = 2000 ( p - 2 ) - 6000
p = 7.5 $

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 Breakeven Analysis
A manager has the option of purchasing one, two, or three
machines. Fixed costs and potential volumes are as follows:
Corresponding range of
Number of machines $ Total annual fixed cost
output
1 9600 To 300 000
2 15000 To 600 301
3 20000 To 900 601

Variable cost is $ 10 per unit, and revenue is $ 40 per unit

I. Determine the break even point for each range.

II. If projected annual demand is between 580 and 660 units, how many machines
should the manager purchase?

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 Breakeven Analysis
For one machine
Q1bep = FC / ( p - c ) = 9,600 / ( 40 – 10 ) = 320 units
For two machines
Q2bep = FC / ( p - c ) = 15,000 / ( 40 – 10 ) = 500 units
For three machines
Q3bep = FC / ( p - c ) = 20,000 / ( 40 – 10 ) = 667 units

b. Comparing the projected range of demand to the two stages

for which a break-even point occurs, you can see that the BEP
is 500, which is in the range 301-600. While at the top end of
projected demand, the volume would still be less than the BEP
for that range, so there would be no profit. Hence the manager
should choose 2 machines.
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 Breakeven Analysis
300 600 900

6
66

500
3

1
0
32

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 Breakeven Analysis
T C
C= $ BEP
+V
FC 3
TC T
C= BEP
+V 2
FC
3 C
machines T
C
C =T C 3
+V 2 T
FC
machines C 2
1
T 1
machine
Quantit R Quantity
y
Step fixed costs and variable Multiple break-even points
costs.

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 Breakeven Analysis
Thomas Manufacturing intends to increase capacity by
overcoming a bottleneck operation through the addition of
new equipment. Two vendors have presented proposals as
follows:

Proposal Fixed Costs Variable Costs

A $ 50,000 $12
B $ 70,000 $10

The revenue for each product is $20

What is the breakeven quantity for each proposal?

BEQ = FC / (p-v)
BEQ (A) = 50,000 / (20-12) = 6250 units.
BEQ (B) = 70,000 / (20-10) = 7000 units.
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 Financial Analysis
• Need to rank investment proposals via financial analysis due
to problem of allocating scarce funds.
• Two important terms in financial analysis are:
• Cash Flow is the difference between cash received (from sales
and from other sources like sales of old equipment) and
cash outflow for labor, materials, etc.
• Present Value is expresses in current value the sum of all future
cash flows of an investment proposal

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 Financial Analysis
3 most commonly used methods
1.Payback focuses on the length of time it will take for an
investment to return its original cost.
2.Present Value method summarizes the initial cost of an
investment, its estimated annual cash flows, and any expected
salvage value, taking into account the time value of money.
3.Internal Rate of Return summarizes the initial cost,
expected annual cash flows, and estimated future salvage value of
an investment proposal in an equivalent interest rate. In other
words, this method identifies the rate of return that equates the
estimated future returns and the initial cost.

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 Payback Time – Example
• 

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 Waiting Line Analysis
• Analysis of lines is often useful for designing or modifying
service systems.
• Waiting lines have a tendency to form in a wide variety of
service systems (e.g., airport ticket counters, telephone calls,
hospital emergency rooms).
• The lines are symptoms of bottleneck operations.
• Analysis is useful in helping managers choose a capacity level
that will be cost-effective through balancing the cost of having
customers wait with the cost of providing additional capacity.
• It can aid in the determination of expected costs for various
levels of service capacity.

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Waiting Line Analysis

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 Simulation
• Simulation can be a useful tool in evaluating what-if scenarios.

• Simulation allows the manager to both quantify and observe

the system's behavior. Whether the system is a production line,
a distribution network or a communications system, simulation
can be used to study and compare alternative designs or
troubleshoot existing operations.

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