MANAGEMENT OF BUSINESS - UNIT 2

Module 1 – Production and Operations Management

Topic 4: Capacity Planning

Capacity is very important to the organization, as it needs to be aware of capability of its

production facilities. Capacity refers to the level of output that the current system is capable
of producing in a specified period of time. If the firm is not operating at full capacity or does
not have the ability to produce more output, demand will be greater than its ability to supply and
it may lose customers to competitors. On the flip side of things, if the firm is over utilizing its
capacity then too many products are being produced and it is indicative of the fact that resources
are being wasted. Capacity planning involves long-term and short-term considerations. Long-
term relates to the overall level of capacity. Short-term consideration relates to variations in
capacity requirements due to seasonal, random, irregular fluctuations in demand.

Storage capacity planning is for products and services. The overall objective of strategic
capacity planning is to reach an optimal level where production capabilities meet demand.
Capacity needs include:

 Equipment
 Space
 Employee skills

When production capabilities are not meeting demand, the results are:

 High costs
 Strains on resources
 Customer loss

THREE inputs of capacity planning are:

1. Kind of capacity to be determined

2. How much of the products will be needed?
3. When will the products be needed?

Capacity planning

Production systems design involves planning for the inputs, transformation activities and outputs
of a production operation. Design plays a major role because they entail significant investment
of funds and establish cost and productivity patterns that continue in the future.
The capacity of the manufacturing unit can be expressed in the number of units of output per
period. In some situations, measuring capacity is more complicated when they manufacture
multiple products. In such situations, the capacity is expressed as man-hours or machine hours.

Categories of Capacity Planning

Design Capacity

This refers to the total achievable capacity if equipment and processes are working in
perfect order. Design capacity of a facility is the planned or engineered rate of output of goods
or services under normal or full-scale operating conditions. For example, the designed capacity
of the cement plant is 100 TPD (tons per day). Capacity of the sugar factory is 150 tons of
sugarcane crushing per day. The uncertainty of future demand is one of the most perplexing
problems faced by new facility planners. An organization does not plan for enough regular
capacity to satisfy all their immediate demands. Design for a minimum demand would result in
high utilization of facilities but results in inferior service and dissatisfaction of customers
because of inadequate capacity. The design capacity should reflect management’s strategy for
meeting the demand. The best approach is to plan for some in-between level of capacity.

System/effective capacity
System capacity is the maximum output of the specific product or product mix the system of
workers and machines is capable of producing as an integrated whole OR the estimated capacity

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that would result in the effective operation of the business. It measures the maximum demand
that the production system can manage before it becomes inefficient.
 System capacity is less than design capacity or at the most equal it because of the
limitation of the product mix, quality specification, and breakdowns. The actual is even
less because of the many factors affecting the output such as actual demand, downtime
due to machine/equipment failure, unauthorized absenteeism.
 The system capacity is less than design capacity because of long range and uncontrollable
factors. The actual output is still reduced because of short-term effects such as
breakdown of equipment and inefficiency of labour. The system efficiency is expressed
as ratio of actual measured output to the system capacity.
The different measures of capacity are useful in defining two measures of systems effectiveness:
efficiency and utilization.
1. Efficiency is the ratio of actual output to effective capacity
2. Utilization is the ratio of actual output to design capacity.

Efficiency = Actual output/Effective capacity

Utilization = Actual output/Design capacity
It is common for managers to focus exclusively on efficiency, but in many instances, this
emphasis can be misleading. This happens when effective capacity is low compared with design
capacity. In those cases, high efficiency would seem to indicate effective use of resources when
it does not.
Capacity Utilization
This is about the use that a business makes from its resources. If a business is not able to
increase output, it is said to be running at full capacity. Its capacity utilization is 100 per cent.
So if a 52 seater bus from Kingston to Montego Bay has 52 passengers it would be operating at
full capacity. If it had 32 passengers it would be operating at less than full capacity and so would
have excess, surplus space or unused capacity. A company is producing 15 000 units a week
when the factory is capable of 20 000 units has a capacity utilization of 75 per cent. Excess
capacity arises when actual production is less than what is achievable or optimal for a firm.
Businesses do not always operate at full capacity. It may my not be possible to keep all
resources and machinery fully employed all the time. Most businesses would wish to be
operating at close to full capacity, such as 90 percent.
In some cases, businesses even choose to operate at less than full capacity in order to be flexible..
For example, they might want to have capacity to cope with increased orders from regular
customers. Without this, a business might let down its customers and risk losing them.
Capacity utilization can be measured by comparing actual or current output with potential output
at full capacity using the formula:

Capacity utilization = Current output x 100

Maximum possible output
Example:
A printing operation might be able to operate for ten hours, six days a week using shifts. If it
only had enough work to operate for 48 hours last week, the capacity utilization could be

Capacity utilization = 48 hours x 100 = 80%

(10 hours x 6 days)

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Printing machine can print 10 000 leaflets in a time period but only prints 9 000.

Capacity utilization + (9 000/ 10 000) x 100 = 90%

In both cases the machine has unused, surplus, excess or spare capacity of 20% and 10%

Importance of Capacity Utilization

When a business increases its capacity utilization, unit or average costs will be lowered. As
some costs are fixed, higher levels of capacity utilization and higher levels of output will make a
business more efficient since fixed costs are spread over many units. Fixed costs are fixed in
relation to output. Therefore, whether capacity utilization is 50% or 100%, fixed costs will not
change.
A business will make better use of its resources if it increases its capacity utilization. Its unit
cost will be lower and profits will be higher.

Example
Actual output (units) 120 000 160 000
Maximum possible output (units) 200 000 200 000
Capacity utilization 60% 80%
Variable costs ($2 per unit) $240 000 $320 000
Fixed costs $50 000 $50 000
Total cost $290 000 $370 000
Unit cost $2.42 $2.31

The utilization of capacity is important to the firm as

 It will result in lower per unit fixed costs
 It will help the firm to cater for the volume needs of the market.
 Idle machinery and equipment can be better use to generate revenue

There are a number of factors that may cause a firm to produce below full capacity. Some of
these are
 Deficient demand due to lack of income or changes in tastes and preferences of
consumers
 The firm may be faced with stiff competition and losing market share
 Seasonal demand may affect the industry’s capacity, for example, in the tourism industry.
 Failed marketing campaign may result in depressed sales and hence low production.
Producing below full capacity may result in some problems for the firm, including
 Inability to cover its fixed costs, which may result in losses
 High per unit cost of production, which may have to be passed onto consumers through
price
 Lower than potential returns on its investment, since the machinery is not generating
enough income

Methods of Improving Capacity

1. Reduced capacity – a business might decide to cut capacity. This might be done
by rationalizing – this involves reducing excess capacity by getting rid of

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 resources that the business can do without, There is a number of measures a
business might take:

 Reducing staff by making people redundant, employing part-time and

temporary staff and offering early retirement.
 Selling off unused fixed assets such as machinery, vehicles, office space,
warehouses and factory space.
 Leasing capacity. Many business places have leased unused floor space in
its stores to other retailers, for example part of a factory could be leased to
another manufacturer. The advantage is that the space may be reclaimed if
demands for the product picks up.
 Moving to smaller premises where costs are lower.
 Mothballing some resources. This means that fixed assets such as
machinery are left unused but are maintained so that they can be brought
back into use if necessary,

2. Increased sales --- for businesses to sell more it must produce more. Hence,
capacity utilization will increase.
3. Increased usage – discounts are normally offered for off-peak hours to boost
demand. During rush hour for transportation service, there is normally 100%
capacity utilization. However, off peak hours may fall to as low as 10%. Such
businesses would like to increase capacity utilization during the off peak hours.
4. Subcontracting – capacity utilization vary considerably within a business.
Where capital equipment has low utilization rates, it might be more efficient for
the business to subcontract or outsource the work. This means hiring or
contracting another business to do the work that was previously done in-house.
For instance, the business might run a small fleet of delivery vans, which on
average are on the road for four hours per day. It is likely that it would be
cheaper for the business to sell the vans and employ a company to make the
deliveries. There would be cost savings in terms of staff, maintenance costs. The
delivery business would be operating a specialized service. It should operate the
delivery service more efficiently than a business with few vans and little
knowledge of the industry.
5. Redeployment – If the business has too many resources, in one part, it may be
possible to deploy them to another part
There are problems with producing at full capacity, including:
 The firm may find it difficult to meet any unexpected increase in demand.
 There will be limited time, if any, available for plan maintenance.
 If the factory space becomes limited or overcrowded, diseconomies of scale may set in,
which will lead to increased costs.
 Pressuring staff to produce at full capacity can result in high staff turnover rate,
especially where employees are not receiving incentives for doing so or feel that they are
being overburdened.

Economies and Diseconomies of Scale

Economies of Scale
This relates to benefits that a firm or an industry receives because of its scale or size of
production. As the output of firms increase, the costs per unit are likely to fall because of the
benefits gained from large scale production. There are two kinds of economies of scale –
internal economies and eternal economies.
Internal Economies of scale
This relates to benefits that firm receive because they produce goods on a very large scale.

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 1. Technical - these are benefits that come from increased output through greater division
of labour as each worker becomes an expert in his or her job resulting in lower costs of
production. Large firms can employ more specialist workers and large machines that
goods and services can be produced and provided faster. This is not possible in small
firms that cannot afford to purchase expensive machinery or pay specialist workers.
Large firms can also cover the costs of engaging in research and development fostering
new and faster methods of production and new products. The cost of production in these
areas may be high but is spread over large outputs.

2. Financial – the large firm is in a more favourable position to raise finance to engage in
expansion than a smaller firm. This is because it is large, well-known and a better credit
risk than a smaller firm. Large firms can offer better security to bankers because they
may be well known. The large firms may also raise money at lower costs since potential
investors have confidence in or prefer shares which can readily be sold on the stock
exchange. Large firms benefit from their goodwill or corporate image and financial
institutions compete to offer them soft loans at lower interest rates and or a longer time
period in which to repay .them,

3. Managerial – large firms can afford to employ managers for different functions,
allowing them to maximize their expert skills in their area of work. Production managers
can concentrate on finding new and creative ways to increase production while
minimizing costs.

4. Marketing and Commercial – Large firms benefit from commercial or marketing

economies as they are able to purchase raw materials in large quantities and also get
trader’s discounts. Cash discounts are also open to them because of prompt payment.
Their orders are large and often attract large discounts. Large firms can afford extensive
high quality advertising as well as sell their products more cheaply and gain more sales
which would be impossible for smaller firms selling similar product.

5. Risk bearing – Large firms are better able to spread their risks than small firms as they
produce in large quantities and often sell in many markets. This means that if there is a
fall in the demand for their product in one market, they can switch to other markets.
Large firms on a whole do not stick to one product line. Through diversification they
make a number of different products so that when there is a fall in demand for one, they
will concentrate on the production and marketing of others.

Internal Diseconomies of Scale

Diseconomies of scale are the inefficiencies that become evident due to the size of the firm.
As the firm grows, it creates a bureaucracy. When the firm started small all employees were
hired personally. As the firm grows, a foreman will do the hiring and even as it gets large
employment will be done by the Human Resource Manager.

1. Maintaining large equipment – large machine and equipment are difficult to maintain.
Where demand fluctuates especially in areas such as construction, the overhead costs of
idle specialized equipment are heavy and burdensome for these firms.

2. Training expenses – training workers to operate and maintain specialized equipment may
prove expensive over time. If demand for the products produced by these machines falls,
then the cost for training these workers may not be realized.

3. Rising marketing costs – marketing costs may increase as firms compete to sell their
products. Advertising and other methods of promoting sales may be too costly and may
not be effective in maximizing sales may add burden to firms.

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 4. Rising managerial costs – over expansion may affect management in that managers may
not be in touch with the realities existing within the firm and may make decisions.
Decisions may also not be implemented fast enough, resulting in loss of valuable
production time that adds costs to the firm.

5. Rising labour costs – labour cost may rise due to extensive specialization and
competition from firms for scarce trained labour. Specially trained workers may demand
higher wages due to the demand for their skills as well as competition from firms for their
specialist skills that may also increase the price of their labour and eventually the cost of
production within these firms.

External Economies of Scale

These are benefits to large well organized industries or benefits firms may receive from being
part of a large well organized industry. External economies of scale are the benefits or
advantages in the firm of lower average costs that a firm gains from the growth of the
industry. These are crucial especially where all the firms in an industry are located in the same
area, for example, most hotels are situated in Ocho Rios, Negril and Montego Bay in the tourism
area of Jamaica.
1. Skilled labour force – firms that are involved in the same line of production and located
near to each other can employ and train those who live in the area in the skills that the
firms need. New firms entering the industry can benefit from the skilled labour force that
emerges.

2. Common service such as marketing organizations – firms may cooperate in making

good marketing arrangements where they can purchase inputs and sell their finished
products. Trade fairs are a good example of how firms in an industry may cooperate in
promotion and sell their products.

3. Ancillary firms supplying specialized materials – where firms producing a similar

product such as cars or compute located near to each other, other firms may spring up
within the area to cater to the needs of these industries for raw materials. For example,
ancillary firms producing car parts and accessories will locate near car manufacturing
firms or firms producing computer parts will locate near to firms making computers.

4. Technical schools catering for the local industry – government or private sector may set
up schools to cater to the demand for skills within large industries. For example, in an
effort to provide skilled employees for the tourism sector, the government of Jamaica and
Barbados set up schools to train workers. The Hospitality Institute of the Barbados
Community College in Hastings and HEART Hotel and Training Institute in Runaway
Bay, Jamaica are two such examples.

5. Product reputation – the product may benefit from positive endorsements leading to
greater sales. Many firms benefit due to the impact of cooperative advertisements done
for the industry. For example. A many firms within the hotel industry get help from
cooperative or generic advertisements of the industry done internationally.

6. Government incentives – firms may benefit from special incentives like tax relief or
subsidies from government to encourage growth in the industry.

7. Research and development – large well organized industries can cooperate in doing
research to improve operation within these industries.

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External Diseconomies of Scale
External diseconomies of scale are the disadvantages that arise due to over concentration
and over-production as a result of an increase in the number of firms in an industry. There
are a number of factors which might give rise to external diseconomies of scale.

 The concentration of similar firms in an area, may lead to increase in demand for raw
materials used by the firm. This will cause the process of raw materials to increase
provided the supply of the raw materials remain unchanged. This consequently would
increase the cost of production in the industry.
 The localization of firms in an area results in urbanization problems such as traffic
congestion. This slows the movement of labour, goods and raw materials and thereby
retarding the rate at which goods and services are produced. This increases the cost of
production in the industry.
 As the industry grows, demand for skilled labour mainly needed in the industry increase.
Wage rates will tend to increase as forms begin to compete for the service of the skilled
workers.
 Problems of waste disposal may arise. Firms may be compelled to employ costly waste
disposal methods in order to keep the area clean.
 Competitive advertisement would have to be resorted to and more money will have to be
spent on that if each firm is to maintain its position
 Structural unemployment may be created as the size of the industry grows. This may be
due to changes in taste and preference. This may create declining industry,