CAPACITY PLANNING

- Prashant Jain

Prashant Jain 1
Capacity planning

• Capacity is the maximum output rate of a production

or service facility
• Capacity planning is the process of establishing the
output rate that may be needed at a facility:
– Capacity is usually purchased in “chunks”
– Strategic issues: how much and when to spend
capital for additional facility & equipment
– Tactical issues: workforce & inventory levels, &
day-to-day use of equipment

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Capacity Planning
• Capacity is the upper limit or ceiling on the load
that an operating unit can handle.
• Capacity also includes
– Equipment
– Space
– Employee skills

• The basic questions in capacity handling are:

– What kind of capacity is needed?
– How much is needed?
– When is it needed?

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 Importance of Capacity Decisions
1. Impacts ability to meet future demands
2. Affects operating costs
3. Major determinant of initial costs
4. Involves long-term commitment
5. Affects competitiveness
6. Affects ease of management
7. Globalization adds complexity
8. Impacts long range planning

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Measuring Capacity Examples
• There is no one best way to measure capacity
• Output measures like kegs per day are easier to
understand
• With multiple products, inputs measures work better
Input Measures of Output Measures
Type of Business
Capacity of Capacity
Car manufacturer Labor hours Cars per shift
Hospital Available beds Patients per month
Pizza parlor Labor hours Pizzas per day
Floor space in
Retail store Revenue per foot
square feet
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Capacity
• Design Capacity
– Maximum output rate or service capacity an
operation, process, or facility is designed for
– Can be achieved under ideal conditions
– Its the “throughput,” or number of units a facility
can hold, receive, store, or produce in a period of
time.
– Determines fixed cost
– Also called Peak capacity
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Capacity (contd…)
• Effective Capacity
– Maximum output rate under normal (realistic)
conditions
– Design capacity minus allowances such as
personal time, maintenance, and scrap
– A firm’s capacity with its product mix, methods of
scheduling and standards of quality etc.
– Its the actual capacity that should be used in
planning
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Efficiency and Utilization
Actual Output
• Rate of output actually achieved
• Cannot exceed effective capacity
Utilization
• Measure of planned or actual capacity usage of a
facility, work center, or machine
• Actual output as a percent of design capacity
Efficiency
• Measure of how well a facility or machine is
performing when used
• Actual output as a percent of effective capacity

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Efficiency and Utilization (contd…)
• Measure how much of the available capacity is
actually being used:
• Utilization = Actual Output / Design Capacity
• Efficiency = Actual Output / Effective Capacity
• Both measures are expressed as percentages
Also,
• Expected Output = (Effective Capacity)(Efficiency)

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Efficiency

Measure of how well a facility or machine is

performing when used

Efficiency = Actual output

_______________________
Effective Capacity
Actual output in units
=___________________________
Standard output in units
Average actual time
= ________________________
Standard time
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Utilization

Measure of planned or actual capacity

usage of a facility, work center, or machine

Actual Output
Utilization = ____________________
Design Capacity
Planned hours to be used
________________________________
=
Total hours available

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Efficiency/Utilization Example

Design capacity = 50 trucks/day

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

Actual output 36 units/day

Efficiency = = = 90%
Effective capacity 40 units/ day

Actual output 36 units/day

Utilization = = = 72%
Design capacity 50 units/day

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Bakery Example
Actual production last week = 148,000 rolls
Effective capacity = 175,000 rolls
Design capacity = 1,200 rolls per hour
Bakery operates 7 days/week, 3 - 8 hour shifts
Design capacity per week
= (7 x 3 x 8) x (1,200) = 201,600 rolls
Utilization = 148,000/201,600 = 73.4%
Efficiency = 148,000/175,000 = 84.6%
Also,
If efficiency of new line = 75%
Expected Output = (175,000)(.75)
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= 131,250 rolls 13
Determinants of Effective Capacity
• Facilities
• Product and service factors
• Process factors
• Human factors
• Policy factors
• Operational factors
• Supply chain factors
• External factors

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Strategy Formulation
• Capacity strategy for long-term demand
• Demand patterns
• 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
1. Amount of capacity needed
• Capacity cushion (100% - Utilization)
2. Timing of changes
3. Need to maintain balance
4. Extent of flexibility of facilities

Capacity cushion – extra demand

intended to offset uncertainty

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Steps for Capacity Planning
1. Estimate future capacity requirements
2. Evaluate existing capacity
3. Identify alternatives
4. Conduct financial analysis
5. Assess key qualitative issues
6. Select one alternative
7. Implement alternative chosen
8. 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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Planning Over a Time Horizon
Modify capacity Use capacity

Long-range Add facilities *

Planning Add long lead
time equipment

Intermediate Subcontract Add personnel

-range Add equipment Build or use inventory
Add shifts
Planning

Short-range * Schedule jobs

Planning Schedule personnel
Allocate machinery

* Limited options exist

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Calculating Processing Requirements
Product Annual Standard Processing time
Demand processing time needed (hr.)
per unit (hr.)
#1 400 5.0 2,000
#2 300 8.0 2,400
#3 700 2.0 1,400
---------
5,800

If annual capacity per machine is 2000 hours

Then machines needed to handle the required volume
= 5,800 hours/2,000 hours = 2.90 machines i.e. 3
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Example of Capacity Requirements
A manufacturer produces two lines of mustard, Fancy
Fine and Generic line. Each is sold in small and family-
size plastic bottles.

The following table shows forecast demand for the

next four years.
Year: 1 2 3 4
FancyFine
Small (000s) 50 60 80 100
Family (000s) 35 50 70 90
Generic
Small (000s) 100 110 120 140
Family (000s) 80 90 100 110
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Example of Capacity Requirements (Contd…)
Product from a Capacity Viewpoint

• Question: Are we really

producing two different
types of mustards from
the standpoint of
capacity requirements?
• Answer: No, it’s the
same product just
packaged differently.

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Example of Capacity Requirements (Contd…)
Equipment and Labor Requirements
Year: 1 2 3 4
Small (000s) 150 170 200 240
Family (000s) 115 140 170 200

•Three 100,000 units-per-year machines are available

for small-bottle production. Two operators required
per machine.

•Two 120,000 units-per-year machines are available for

family-sized-bottle production. Three operators
required per machine.
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What are the Year 1 values for capacity, machine, and labor?

Year: 1 2 3 4
Small (000s) 150 170 200 240
Family (000s) 115 140 170 200

Small Mach. Cap. 300,000 Labor 6

Family-size Mach. Cap. 240,000 Labor 6
150,000/300,000=50%
At 1 machine for 100,000, it
Small takes 1.5 machines for 150,000
Percent capacity used 50.00%
Machine requirement 1.50
Labor requirement 3.00 At 2 operators for
Family-size 100,000, it takes 3
Percent capacity used 47.92% operators for 150,000
Machine requirement 0.96
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Labor requirement 2.88 ©The McGraw-Hill Companies, Inc., 2004
 What are the values for year 2, 3 and 4 in the table below?
Year: 1 2 3 4
Small (000s) 150 170 200 240
Family (000s) 115 140 170 200

Small Mach. Cap. 300,000 Labor 6

Family-size Mach. Cap. 240,000 Labor 6

Small
Percent capacity used 50.00% 56.67% 66.67% 80.00%
Machine requirement 1.50 1.70 2.00 2.40
Labor requirement 3.00 3.40 4.00 4.80
Family-size
Percent capacity used 47.92% 58.33% 70.83% 83.33%
Machine requirement 0.96 1.17 1.42 1.67
Labor requirement 2.88 3.50 4.25 5.00
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©The McGraw-Hill Companies, Inc., 2004
Make or Buy
If a given increment of capacity must be added
– “make” – add in-house production capacity
– “buy” – outsource* production

* Outsourcing:
Obtaining a good or service from an external provider

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Make or Buy ? (cotd…)
Factors that affect make-buy decision
– Available capacity, Expertise
– Risk, Costs, Quality
– Intellectual property, core competencies, strategic
direction
– Uncertainty in financial markets,
– Supply chain (risk of disruption, coordination effort,
etc.)
– Flexibility (quantity, technology)
– Market perception (labeling v. production)
– Union considerations
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Break-even Analysis for ‘Make or Buy’ decision
• To find the break-even quantity, Q, at which the total
“make” cost equals the total “buy” cost
– cb = variable cost (per unit) of the buy option
– cm = variable cost (per unit) of the make option
– F = fixed cost of capacity expansion

Cost to buy = cbx

Cost

F Cost to make = F + cmx

0 Q Number of units, x
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Break-even Analysis for ‘Make or Buy’ decision
(contd…)

• At the breakeven point x=Q

• Also F + c m Q = cb Q

• The break-even quantity is Q = F / (cb - cm )

• If capacity required < Q, then “buy”

• If capacity require > Q, then “make”

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Capacity and Strategy
* 10 decisions of operations
• Capacity decisions management
impact all 10 1. Design of goods and
services.
decisions of
2. Quality.
operations 3. The design process and
management* capacity.
as well as other 4. Site selection
functional areas of 5. Design layout.
the organization 6. Human Resources (HR) and
Design work.
• Capacity decisions 7. Supply chain management.
must be integrated 8. Inventory.
into the organization’s 9. Scheduling.
10.Maintenance.
mission and strategy
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Capacity Considerations

• Forecast demand accurately

• Understand the technology and capacity
increments
• Find the optimum
operating level
(volume)
• Build for change

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Other Capacity Considerations
• Focused factories
– Small, specialized facilities with limited objectives
• Plant within a plant (PWP)
– Segmenting larger operations into smaller
operating units with focused objectives
• Subcontractor networks
– Outsource non-core items to free up capacity for
what you do well
• Capacity cushions
– Plan to underutilize capacity to provide flexibility
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Capacity An additional amount of capacity
Cushion added onto the expected demand to
allow for:
• greater than expected demand
• demand during peak demand
seasons
• lower production costs
• product and volume flexibility
• improved quality of products and
services
Capacity Cushion =
100% - Utilization rate(%)
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How Much Capacity Is Best?

The Best Operating Level is the output

that results in the lowest average unit cost.

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Economies of Scale
Average cost per unit decreases as the volume increases
toward the best operating level.
Why economies of scale can
drive cost down when output
increases?
• Fixed costs are spread over
more units
• Construction costs are
reduced
• Costs of purchase materials
are cut
• Process advantages are
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Diseconomies of Scale
Average cost per unit increases as the volume
increases beyond the best operating level
Reasons
• Often caused by congestion
(overwhelming the process
with too much work-in-
process) and scheduling
complexity
• Loss of focus
• Inefficiencies that raise the
average unit cost of a product
or service
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 Economies and Diseconomies of Scale
(dollars per room per night)
Average unit cost

25 - room 75 - room
50 - room roadside motel
roadside motel roadside motel

Economies of Diseconomies of
scale scale
25 50 75
Number of Rooms
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Optimal Rate of Output
Production units have an optimal rate of output
for minimal cost.

Average cost per unit Minimum average cost per unit

Minimum
cost

0 Rate of output
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 Economies of Scale
Minimum cost & optimal operating rate are
functions of size of production unit.
Average cost per unit

Small Medium
plant plant
Large
plant

0 Output rate

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Build In Flexibility

Percent of North American Vehicles

Made on Flexible Assembly Lines
100% –

80% –

60% –

40% –
Chrysler

Toyota
Nissan

Honda

Ford
GM
20% –

0–
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Managing Demand

• Demand exceeds capacity

• Curtail demand by raising prices, scheduling
longer lead time
• Long term solution is to increase capacity
• Capacity exceeds demand
• Stimulate market
• Product changes
• Adjusting to seasonal demands
• Produce products with complementary
demand patterns

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Tactics for Matching Capacity to Demand
1. Making staffing changes
2. Adjusting equipment
• Purchasing additional machinery
• Selling or leasing out existing equipment
3. Improving processes to increase throughput
4. Redesigning products to facilitate more
throughput
5. Adding process flexibility to meet changing
product preferences
6. Closing facilities Prashant Jain 42
 Planning Service Capacity
• Need to be in proximity with customers
– Capacity and location are closely tied
• Services can’t be stored
– Capacity must be matched with timing of demand
• Degree of volatility of demand
– Peak demand periods

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Demand and Capacity Management in the
Service Sector

• Demand management
– Appointment, reservations, FCFS rule
• Capacity
management
– Full time,
temporary,
part-time
staff

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Approaches to Capacity Expansion

Leading demand with incremental

expansion

New
capacity
Demand

Expected
demand

1 2 3
Time (years)
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Approaches to Capacity Expansion

Leading demand with one-step

expansion

New
capacity
Expected
Demand

demand

1 2 3
Time (years)
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Approaches to Capacity Expansion

Capacity lags demand with incremental

expansion

New
capacity

Expected
Demand

demand

1 2 3
Time (years)
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Approaches to Capacity Expansion

Attempts to have an average capacity with

incremental expansion

New
capacity

Expected
Demand

demand

1 2 3
Time (years)
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Tools for capacity planning

• Break-Even Analysis
• Present-Value
Analysis
• Computer
Simulation
• Waiting Line Analysis
• Linear Programming
• Decision Tree
Analysis

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 Evaluating Alternatives

• Cost-volume analysis
– Break-even point
• Financial analysis
– Cash flow
– Present value
• Decision theory
• Waiting-line analysis

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Break-Even Analysis

• Technique for evaluating process and

equipment alternatives
• Objective is to find the point in dollars and
units at which cost equals revenue
• Requires estimation of fixed costs, variable
costs, and revenue

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Break-Even Analysis (contd…)

• Fixed costs are costs that continue even if no

units are produced
• Depreciation, taxes, debt, mortgage
payments
• Variable costs are costs that vary with the
volume of units produced
• Labor, materials, portion of utilities
• Contribution is the difference between
selling price and variable cost

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Cost-Volume Relationships

Amount ($)

Fixed cost (FC)

0
Q (volume in units)

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Cost-Volume Relationships

Amount ($)

0
Q (volume in units)

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Cost-Volume Relationships

Amount (Rs.)

0 BEP units
Q (volume in units)

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Break-Even Analysis
–
Total revenue line
900 –

800 –
Break-even point Total cost line
700 – Total cost = Total revenue
Cost in dollars

600 –

500 –

400 – Variable cost

300 –

200 –

100 – Fixed cost

–
| | | | | | | | | | | |
0 100 200 300 400 500 600 700 800 900 1000 1100
Volume (units
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Break-Even Analysis (contd…)
BEPx = break-even x = number of units
point in units produced
BEP$ = break-even TR = total revenue = Px
point in dollars F = fixed costs
P = price per unit V = variable cost per
(after all unit
discounts) TC = total costs = F + Vx
Break-even point
occurs when
TR = TC
or F
BEPx =
Px = F + Vx P-V
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Break-Even Analysis (contd…)
BEPx = break-even x = number of units
point in units produced
BEP$ = break-even TR = total revenue = Px
point in dollars F = fixed costs
P = price per unit V = variable cost per
(after all unit
discounts) TC = total costs = F + Vx
BEP$ = BEPx P
F
= P Profit = TR - TC
P-V
F = Px - (F + Vx)
=
(P - V)/P = Px - F - Vx
F = (P - V)x - F
=
1 - V/P Prashant Jain 58
Break-Even Example
Fixed costs = $10,000 Material = $.75/unit
Direct labor = $1.50/unit Selling price = $4.00 per unit

F $ 10,000
BEP$ = ------------ = --------------------------------------
1 – (V/P) 1 – [(1.50 + 0.75) / 4.00)]

$ 10,000
= ------------- = $ 22, 857.14
0.4375

F $ 10,000
BEPx = ------- = ----------------------- = 5, 714
P-V 4 – (1.50 + 0.75)
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 Break-Even Problem with Step Fixed Costs

3 machines

2 machines

1 machine
Quantity
Step fixed costs and variable costs.

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 Break-Even Problem with Step Fixed Costs

$
BEP
3
TC
BEP 2
TC
3
TC
2

1
Quantity
Multiple break-even points

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Break-Even Analysis : Assumptions
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
7. Costs and revenue are linear functions
• We actually know these costs
• There is no time value of money
Generally not the case in the real world.
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Making Capacity Planning Decisions

• The three-step procedure for making capacity

planning decisions is as follows:
– Step 1: Identify Capacity Requirements
– Step 2: Develop Capacity Alternatives
– Step 3: Evaluate Capacity Alternatives

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Determining Capacity Requirements

• Forecast sales within each individual product line

• Calculate equipment and labor requirements to meet

the forecasts

• Project equipment and labor availability over the

planning horizon

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 Developing Capacity Alternatives

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

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Evaluating Capacity Alternatives

• Could do nothing, or expand large now, or expand

small now with option to add later
• Use Decision Trees analysis tool:
– A modeling tool for evaluating sequential decisions
– Identify the alternatives at each point in time
(decision points)
– Estimate probable consequences of each decision
(chance events) & the ultimate outcomes (e.g.:
profit or loss)
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Using Decision Trees: Example
A restaurant owner has determined that she needs to expand
her facility. The alternatives are to expand large now and risk
smaller demand, or expand on a smaller scale now knowing
that she might need to expand again in three years. Which
alternative would be most attractive?
• The likelihood of demand being high is 0.70
• The likelihood of demand being low is 0.30
• Large expansion yields profits of $300K(high demand) or
$50k(low demand)
• Small expansion yields profits of $80K if demand is low
• Small expansion followed by high demand and later
expansion yield a profit of $200K at that point. No expansion
at that point yields profit of $150K
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Decision Tree: Example

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Evaluating the Decision Tree
• At decision point 2, choose to expand to maximize profits
($200,000 > $150,000)
• Calculate expected value of small expansion:
– EVsmall = 0.30($80,000) + 0.70($200,000) = $164,000
• Calculate expected value of large expansion:
– EVlarge = 0.30($50,000) + 0.70($300,000) = $225,000
• At decision point 1, compare alternatives & choose the
large expansion to maximize the expected profit:
– $225,000 > $164,000
• Choose large expansion despite the fact that there is a 30%
chance it’s the worst decision:
– Take the calculated risk!
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