Capacity Planning 2020

Capacity Planning

Capacity of an operating unit is the upper limit or ceiling on the load that the operating unit can
handle. Capacity also includes equipment, space and employee skills.
The capacity of operating equipment is determined by the number of outputs it can produce per
unit time. For instance, the capacity of a rice power mill machine is measured by the number of
kilograms of rice produced per hour by that machine. The capacity of power equipment is
determined by its power output measured in kilowatt hour, generated per hour by this equipment.
This capacity can vary from equipment to equipment.
Capacity of a space means the maximum number of things or persons those can be
accommodated at a particular space. For example, the maximum number of sacks accommodated
at a particular warehouse. Seating capacity of a specific space means the number of people who
can be seated in that space, in terms of both the physical space available, and limitations set by
law. For example, seat capacity of a class room.
Abilities and skills of employees generally represent those physical and intellectual
characteristics that are relatively stable over time and that help determine an
employee's capability to respond to a particular need in a particular time. For instance, the
number of standard quality operations carried out per hour by an employee; the number of
standard quality service provided by a service man.
In Operations Management, capacity planning is the process of determining the
production/service capacity needed by an organization to meet changing demands for
its products/services. It requires effective utilization of resources of an organization for
generating quality outputs in a minimum time. When service organizations use capacity
planning, the goal is to meet demand with the least amount of waste, or by increasing their
utilization rates.
The basic questions in capacity handling are:
What kind of capacity is needed? - Identification of the type of capacity required.
How much is needed? – Identification of the amount of capacity required.
When is it needed? –Identification of the exact time of requirement of the capacity.

Strategic Capacity Planning

In Operations Management, a technique used to identify and measure overall capacity of
production/service needed by an organization is referred to as strategic capacity planning. That
is, balancing of long term supply capabilities and forecasted level of long term demand. It helps
an organization to be more competitive by delivering quality products/services with a minimum
competitive process.
Forecast is the key input in strategic capacity planning because it can identify the changes in
demand, technology and environment, and also the perceived threats and opportunities.

Factors to be considered in capacity planning

Cost – The capacity planning should be carried out by keeping the overall cost as minimum as
possible; otherwise, prices of the concerned products/services would be higher and hence will be
an obstacle in maintaining competitiveness in the market.
Availability of Fund – Availability of fund in time must be ensured; otherwise the cost of
carrying out necessary operations will be delayed and hence the concerned products/services
could not be delivered to customers in appropriate time with competitive prizes.
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Expected return – What kind of profit will be earned by the planned capacity planning should
be thought beforehand. A business organization cannot survive for long without earning a
reasonable profit by selling its product/services to customers. So, high probability of expected
return on investment in this planning should be ensured.
Potential benefits and risks – In every planning there remain some uncertainties of achieving
the goal. If these uncertainties be identified earlier, then proper measures could be adopted to
face these difficulties. Also, potential benefits from this planning in comparison with the cost of
survival from the risks should be justified.
Sustainability issues – These issues referred to the issues which will help an organization to
sustain in business. So, these issues must be identified earlier and analyzed thoroughly.
Rate of capacity addition – An organization needs to understand whether the required capacity
should be built up at the same time or it would be built up gradually.
Timing of capacity addition – Timing of required capacity addition should be scheduled. A
partial capacity addition may lead to addition of another partial capacity; after completion of a
project up to a certain level, it may follow to the addition of capacity to the next level; addition
of capacity may depend on tracing of the completed work of the project.
Supply chain support – The capacity planning could not be materialized without proper
concentration, coordination, cooperation and collaboration of the concerned employees,
components of the original organization, which is termed as supply chain support. So, proper
supply chain support should help in strategic capacity planning.

Importance of Capacity Decisions

1. Impacts on ability to meet future demands – Meeting of future demands of
products/services of an organization may be affected by a capacity decision. It may leads
to earning of more profit by meeting customers’ demand appropriately or to a loss due to
a worse capacity decision.
2. Affects operating costs – Operations are carried out following a capacity decision and
hence operating costs are dependent on a capacity decision.
3. Major determinants of initial costs – Initial cost of initiating a project is dependent on
major determining factors of initiation. These determinants depend on capacity decisions
and hence have effect on initial cost of starting a project.
4. Involves long-term commitment – Long-term commitment is required to materialize a
capacity decision, and hence the capacity decision is very important for an organization.
5. Affects competitiveness (can be a barrier to deter (prevent) in potential new entry- If a
capacity decision for an organization is made properly, it will help satisfying customers’
demand competitively better. On the contrary, poor capacity decision may lead to loss of
business due to dissatisfaction of customers.
6. Globalization adds complexity – Various global factors may affect in global business in a
shorter time, and hence leads to a complexity in carrying out a capacity decision in
business.
7. Impacts long range planning – In a long range planning, environment generally changes
due to emergence of various unexpected factors and hence very difficult to implement a
long term capacity decision.
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Various Capacities
1. Design capacity – Design capacity of an operation, process, or facility is the maximum
output rate or service capacity it is designed for.
2. Effective capacity - Design capacity minus allowances such as personal time,
maintenance, and scrap.
3. Actual output – The rate of output actually achieved and it cannot
exceed effective capacity.

Efficiency = Actual output/ Effective capacity,

Utilization = Actual output/Design capacity
Both of which are expressed in percentage.

Efficiency/Utilization Example - Design capacity = 50 units/day

Effective capacity = 40 units/day
Actual output = 36 units/day

Efficiency = Actual output/ Effective capacity = 36/40 = 90%,

Utilization = Actual output/Design capacity = 36/50 = 72%

Capacity Utilization Strategy: Key to improving capacity utilization is to increase effective

capacity by correcting quality problems, maintaining equipment in good operating condition,
fully training employees, and fully utilizing bottleneck equipment.

Steps for Capacity Planning:

1. Estimate future capacity requirements
2. Evaluate existing capacity
3. Identify alternatives capacities
4. Conduct financial analysis for all the alternative capacities.
5. Assess key qualitative issues in each of the alternatives
6. Select the best alternative
7. Implement alternative chosen
8. Monitor results

Sometimes capacity planning can be difficult due to the complex influence of various market
forces and technologies.

Planning Service Capacity requires the followings:

 Need to be near customers
 Capacity and location are closely tied – Building up a service capacity in a
particular location closely related with this location. So, the customers at that
location must be consulted before planning the capacity of that service.
 Inability to store services
 Capacity must be matched with timing of demand – The service capacity must be
planned in a way that it must match with the timing of demand of that service.
 Degree of volatility (instability) of demand
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 Peak demand periods - Peak demand periods should be taken into consideration
when planning a service capacity.

 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: A production plant has an optimal rate of output for the minimal cost
per unit, which is shown in the figure below:

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

Average cost per unit

Small Plant

Medium Large Plant

Plant
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0 Output rate
Factors contributing to Economies of Scale:
 Fixed costs spread over more units (products or customers), reducing the fixed cost per
unit.
 Construction costs increase at a decreasing rate with respect to the increase in size of the
facility.
 Processing costs decrease as output increases because operations become more
standardized over time which reduces unit costs.

Financial Analysis
 BEP – Break Even Point
 Volume of output needed for total revenue equaling total cost
 Production below BEP quantity results in loss
 Production above BEP quantity results in profit
 Production at BEP quantity: no profits, no loss.
 Point of Indifference
 the quantity at which a decision maker would be indifferent between two
competing alternatives
 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.

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

Cost-Volume symbols:
FC = Fixed cost
VC = Total variable cost
v = variable cost per unit
TC = Total cost
TR = Total revenue
R = Revenue per unit
Q = Quantity or volume of output
QBEP = Break-even quantity
P = profit
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Cost-Volume Relationships

An Example problem on cost-volume analysis

The owner of Old-Fashioned Berry Pies 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 per
pie, and pies would retail for $7 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?

Answer: Here FC = $6000, VC = $2 per pie, R = $7 per pie

a. RQBEP = VCQBEP + FC, which implies QBEP = FC/(R – VC) = 6000/(7 – 2) = 1200 pies
per month.
So, 1200 pie is the break-even point.

b. Total revenue from 1000 pies is 7x1000 = 7000

 Capacity Planning 2020

Total cost for making 1000 pies is 6000 + 1000x2 = 8000

Total profit = Total revenue – Total cost = 7000 – 8000 = -1000
So, total loss is $1000.

c. Profit = Total revenue – Total cost, which implies

4000 = 7Q – (FC + 2Q) = (7 – 2)Q – FC, which
implies 5Q = 4000 + FC = 4000 + 6000 = 10000, which implies Q = 2000
So, 2000 pies must be sold to make a profit of $4000.

d. Total profit = Total revenue – Total cost, which implies

5000 = Rx2000 – (FC + vx2000) implies 5000 = 2000R – FC – 2x2000, which implies
5000 + FC +4000 = 2000R implies 5000 + 6000 + 4000 = 2000R implies 15000 = 2000R
implies R = 7.5.
So, price per pie should be $7.5.

Break-Even Problem with Step Fixed Costs

Evaluating Alternatives
An example problem:
Number of Machines Total Annual Fixed Cost Corresponding Range of Output
1 $9000 0 to 300
2 $15,000 301 to 600
3 $20,000 601 to 900

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?
Answer:
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a. For one machine, QBEP = FC/(R – VC) = 9600/(40 – 10) = 9600/30 = 320 units, not
belongs to the range.
For two machines, QBEP = FC/(R – VC) = 15000/(40 – 10) = 15000/30 = 500 units.
For three machines, QBEP = FC/(R – VC) = 20000/(40 – 10) = 20000/30 = 666.67 units.

b. Projected demand is between 580 and 660 units. BEP for 2 machines is 500, so 2
machines are suitable for demand up to 600. However, BEP for 3 machines is 666.67,
but the annual demand is no more than 660. So 3 machines is not a feasible option.
We should opt for 2 machines and supply up to 600 units.

The scenario is shown in the following figure.

Decision Theory
 Helpful tool for financial comparison of alternatives under conditions of risk or
uncertainty
 Suited to capacity decisions

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