CHAPTER 5: STRATEGIC CAPACITY PLANNING FOR PRODUCTS AND SERVICESSuman Niranjan

CAPACITY PLANNING

Capacity It is the upper limit on the load that an operating

unit can handle Capacity planning plays an strategic role in

designing of systems Example 1: How many machines do you need, are

they sufficient Example 2: How many servers do we need in a

restaurant The idea behind strategic capacity planning is

the long term supply capabilities with the long term demand Internal supply (manufacturing) External supply (purchase)

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CAPACITY PLANNING

Basic questions in capacity planning What kind of capacity is needed?

Depends on products and services that the management intends to produce or provide

How much capacity is needed? Forecasts are the key input

When is it needed? Factors that influence the choices of

capacity:- The stability of demand The rate of technological changes in equipment

and product design Competitiveness When a style of a product or service changes

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CAPACITY DECISIONS ARE STRATEGIC

Decisions involving capacity can be termed as the most critical for a organization: Impact on ability of an organization to

meet future demands of the products and services When Microsoft released Xbox in 2005 there were

insufficient supplies resulting lost sales and customers

Capacity decisions affect the operating costs Balancing the cost of over- and under capacity

Capacity is the major determinant of cost Greater the capacity, greater is the productivity,

greater the cost

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CAPACITY DECISIONS ARE STRATEGIC

Capacity decisions can affect the competiveness Having excess capacity or quickly add capacity

Capacity affects the ease of management Appropriate capacity – capacity mismatched

Globalization affects the capacity Supply chains and distant markets add to the

uncertainty of capacity need Capacity decisions are usually long-term

decisions Amount of investment and other resources involved Change in demand over the period of time

It takes years to construct a power plant, the estimated demand at the time the project starts - time when it is completed

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DEFINING AND MEASURING CAPACITY

Capacity refers to upper limit on the rate of output

Difficulty in measuring capacity Actually measuring Different interpretations of term “capacity” Identifying suitable measures for specific situation Single Vs. multiple product or service

Example of appliance manufacturer

Measure of capacity can be number of available inputs Service industry – hospitals Manufacturing industry- number of machine hours

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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, maintenance, and scrap

Actual output Rate of output actually achieved--cannot

exceed effective capacity.

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EFFICIENCY AND UTILIZATION

Actual outputEfficiency =

Effective capacity

Actual outputUtilization =

Design capacity

Both measures expressed as percentages 8

Actual output = 36 units/day

Efficiency = = 90%

Effective capacity 40 units/ day

Utilization = Actual output = 36 units/day =

72% Design capacity 50 units/day

EFFICIENCY/UTILIZATION EXAMPLE

Design capacity = 50 trucks/day

Effective capacity = 40 trucks/day

Actual output = 36 units/day

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DETERMINANTS OF EFFECTIVE CAPACITY

Many decisions about system design and operating decisions have an impact on capacity

Factors which influence these decisions are: Facilities

Size, location, expansion Product and service factors

Similar items Vs. different items Different rates of output

Process factors Influence on quality of output, rework, inspection etc.

Human factors Experience required, motivation, fatigue

Policy factors Overtime, second and third shifts

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DETERMINANTS OF EFFECTIVE CAPACITY

Factors which influence these decisions are: Operational factors

Equipment capabilities, differences in job requirements Importance of a every single component

Supply chain factors What will impact the suppliers, warehousing,

transportation, and distributers External factors

Maintaining minimum quality and standard Pollution standards on product or equipment Union contract limits

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STRATEGY FORMULATION

Capacity strategies are usually assumed on: Long-term demand pattern Growth rate and variability Facilities

Cost of building and operating Technological changes

Rate and direction of technology changes Behavior of competitors Availability of capital and other inputs

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KEY DECISIONS OF CAPACITY PLANNING Amount of capacity needed

Capacity cushion (100% - Utilization) Timing of changes

Availability of capital, lead time, and expected demand

Need to maintain balance Proportional changes in capacity to all related

areas Extent of flexibility of facilities

Uncertainty in demand

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STEPS IN CAPACITY PLANNING

1. Estimate future capacity requirements2. Evaluate existing capacity3. Identify alternatives4. Conduct financial analysis5. Assess key qualitative issues6. Select one alternative7. Implement alternative chosen8. Monitor results

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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

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CALCULATING PROCESSING REQUIREMENTS

P r o d u c tA n n u a l

D e m a n d

S t a n d a r dp r o c e s s i n g t i m e

p e r u n i t ( h r . )P r o c e s s i n g t i m e

n e e d e d ( h r . )

# 1

# 2

# 3

4 0 0

3 0 0

7 0 0

5 . 0

8 . 0

2 . 0

2 , 0 0 0

2 , 4 0 0

1 , 4 0 0 5 , 8 0 0

If annual capacity is 2000 hours, then we need three machines to handle the required volume: 5,800 hours/2,000 hours = 2.90 machines

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BOTTLENECK OPERATION

Machine #2Machine #2BottleneckOperation

BottleneckOperation

Machine #1Machine #1

Machine #3Machine #3

Machine #4Machine #4

10/hr

10/hr

10/hr

10/hr

30/hr

Bottleneck operation: An operationin a sequence of operations whosecapacity is lower than that of theother operations

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BOTTLENECK OPERATION

Operation 120/hr.

Operation 210/hr.

Operation 315/hr.

10/hr.

Bottleneck

Maximum output ratelimited by bottleneck

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COST-VOLUME ANALYSIS

Fixed Cost (FC) tend to remain constant regardless of volume of output

Variable Cost (VC) vary directly with the volume of output

Examples of fixed cost Rental costs, property taxes, equipment costs

etc. Examples of variable cost

Material and labor cost

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COST-VOLUME ANALYSIS

* ,

where variablecost per unit

Q = Quantity or volume of output

* ,

whereTR = total revenue

R = Revenue per unit

* *

where P = Profit

TC FC VC

VC Q v

v

TR R Q

P TR TC R Q FC v Q

Q R v FC

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COST-VOLUME ANALYSIS

, also known as contribution margin

The required volume, Q,needed togeneratea specified profit is:

Minimum volumeof needed for total revenue to equal total cost

is also known as break-even point, comput

R v

P FCQ

R v

ed using:-

BEP

FCQ

R v

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EXAMPLE 3

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 pies would retail for $7.00 each.a) How many pies must be sold in order to break even?b) What would the profit (loss) be 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?

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EXAMPLE 4

A manager has the option of purchasing one, two, or three machines. Fixed costs and potential volumes are as follows:

Variable cost is $10 per unit, and revenue is $40 per unit.a) Determine the break-even point for each range.b) If projected annual demand is between 580 and

660 units, how many machines should the manager purchase? 23

COST-VOLUME RELATIONSHIPS

Am

ou

nt

($)

0Q (volume in units)

Total c

ost = VC +

FC

Total v

ariable co

st (V

C)

Fixed cost (FC)

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COST-VOLUME RELATIONSHIPS

Am

ou

nt

($)

Q (volume in units)0 BEP units

Profit

Tota

l rev

enue

Total cost

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Loss

BREAK-EVEN PROBLEM WITH STEP FIXED COSTS

Quantity

FC + VC = TCFC + VC = TC

FC + VC =

TC

Step fixed costs and variable costs.

1 machine

2 machines

3 machines

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BREAK-EVEN PROBLEM WITH STEP FIXED COSTS

$

TC

TC

TCBEP2

BEP3

TR

Quantity1

2

3

Multiple break-even points 27

ASSUMPTIONS OF COST-VOLUME ANALYSIS

1. One product is involved2. Everything produced can be sold3. Variable cost per unit is the same regardless

of volume4. Fixed costs do not change with volume5. Revenue per unit constant with volume6. Revenue per unit exceeds variable cost per

unit

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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

PLANNING SERVICE CAPACITY

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IN-HOUSE OR OUTSOURCING

Available capacity Expertise Quality considerations Nature of demand Cost Risk

Outsource: obtain a good or service from an external provider

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DEVELOPING CAPACITY ALTERNATIVES Design flexibility into systems Take stage of life cycle into account

Growth phase Maturity phase Decline phase

Take a “big picture” approach to capacity changes Bottleneck operations

Prepare to deal with capacity “chunks” Discrete increase in capacity

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DEVELOPING CAPACITY ALTERNATIVES

Attempt to smooth out capacity requirements Under utilization or overutilization of capacity Overtime, subcontract Store during period of low demand and draw

during high Identify the optimal operating level

Economies of scale Vs. Diseconomies of scale

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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

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OPTIMAL RATE OF OUTPUT

Minimumcost

Avera

ge c

ost

per

un

it

0 Rate of output

Production units have an optimal rate of output for minimal cost.

Minimum average cost per unit

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ECONOMIES OF SCALE

Minimum cost & optimal operating rate are functions of size of production unit.

Avera

ge c

ost

per

un

it

0

Smallplant Medium

plant Largeplant

Output rate 35

EVALUATING ALTERNATIVES

Cost-volume analysis Break-even point

Financial analysis Cash flow Present value

Decision theory Waiting-line analysis

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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.

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DECISION THEORY

Helpful tool for financial comparison of alternatives under conditions of risk or uncertainty

Suited to capacity decisions

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WAITING-LINE 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

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