MDP4330

Production Systems Design

Lecture #4
Capacity Planning
 Today’s lecture
• Definition of capacity and related
performance measures
• Break-even analysis for capacity planning
• Decision tree analysis for capacity planning
 Capacity

• The throughput, or the number of units a

facility can produce in a period of time
• Determines fixed costs
• Determines if demand will be satisfied
• Three planning horizons

3
 Design and Effective Capacity
• Design capacity is the maximum theoretical
output of a system
• Normally expressed as a rate
• Effective capacity is the capacity a firm
expects to achieve given current operating
constraints (e.g. taking into consideration
time spent in setup, maintenance, cleaning,
labor allowances…etc)
• Often lower than design capacity
4
 Utilization and Efficiency
Utilization is the percent of design capacity achieved

Utilization = Actual Output/Design Capacity

Efficiency is the percent of effective capacity

achieved
Efficiency = Actual Output/Effective Capacity

5
 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 = (7 x 3 x 8) x (1,200) = 201,600 rolls

6
 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 = (7 x 3 x 8) x (1,200) = 201,600 rolls

7
 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 = (7 x 3 x 8) x (1,200) = 201,600 rolls

Utilization = 148,000/201,600 = 73.4%

8
 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 = (7 x 3 x 8) x (1,200) = 201,600 rolls

Utilization = 148,000/201,600 = 73.4%

9
 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 = (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%

10
 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 = (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%

11
 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’
Efficiency = 84.6%
Efficiency of new line = 75%

Expected Output = (Effective Capacity)(Efficiency)

= (175,000)(.75) = 131,250 rolls

12
 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’
Efficiency = 84.6%
Efficiency of new line = 75%

Expected Output = (Effective Capacity)(Efficiency)

= (175,000)(.75) = 131,250 rolls

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 Capacity Planning Challenges
• Inability to create a steady flow of demand
to fully utilize capacity
• Idle capacity is a reality.
• Demand fluctuates and varies.

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 Capacity Planning Over a Time
Horizon

Long-range Add facilities

planning Add equipment
*
Intermediate- Subcontract Add personnel
range planning Add shifts Build or use inventory

Schedule jobs
Short-range
planning
* Schedule personnel
Allocate machinery

Modify capacity Use capacity

* Limited options exist

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Some Possible Growth/Decline Patterns for Demand
Demand volume

Demand volume
Growth Decline

0 Time 0 Time

Demand volume
Demand volume

Cyclical Stable

0 0
Time Time

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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 complimentary demand patterns

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 Capacity Considerations
 Forecast demand accurately
 Understanding the technology and
capacity increments
 Find the optimal operating level
(volume)
 Build for change

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Approaches to Capacity Expansion
(a) Leading demand with (b) Leading demand with
incremental expansion one-step expansion
New New
capacity capacity
Demand

Demand
Expected Expected
demand
demand

(c) Capacity lags demand with (d) Attempts to have an average

incremental expansion capacity with incremental
New
expansion
capacity New
Demand

Expected Demand capacity Expected

demand demand

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 Cost-Volume Relationships

C
+F
= VC C)
t V
Amount ($)

cos st(
t al
e co
To ia bl
v ar
o tal
T

Fixed cost (FC)

0
Q (volume in units)

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 Cost-Volume Relationships

ue
ven
re
al
Amount ($)

t
To

0
Q (volume in units)

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 Cost-Volume Relationships: Break-even analysis

Amount ($)

0 BEP units
Q (volume in units)

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Break-Even Problem with Multiple Fixed Costs

C =
+ V
FC
TC
= TC
V C
+
FC 3 machines

T C
C =
+ V 2 machines
F C

1 machine

Quantity

Fixed costs and variable costs.

Thick lines are fixed costs.
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Break-Even Problem with Step Fixed Costs

TR

No break
even points Break even
in this range points.

Quantity

Step fixed costs and variable costs.

24
 Decision Tree Analysis
• One tool that can be used in this economic
analysis is the decision tree which is suitable
for taking into consideration the risks
associated with those decisions.

25
 Decision Tree

• A Visual Representation of Choices,

Consequences, Probabilities, and
Opportunities.
• A Way of Breaking Down Complicated
Situations Down to Easier-to-
Understand Scenarios.

Decision Tree

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 Decision Tree Nodes
Time

• Decision (choice) Node

• Chance (event) Node

• Terminal (consequence) node

– Outcome (cost or benefit)
Example – Mary’s Factory
Mary is a manager of a gadget factory. Her factory has been quite successful
the past three years. She is wondering whether or not it is a good idea to
expand her factory this year. The cost to expand her factory is $1.5M. If she
does nothing and the economy stays good and people continue to buy lots of
gadgets she expects $3M in revenue; while only $1M if the economy is bad.
If she expands the factory, she expects to receive $6M if economy is good and
$2M if economy is bad.
She also assumes that there is a 40% chance of a good economy and a 60%
chance of a bad economy, and she neglects time value of money.
(a) Draw a Decision Tree showing these choices.
Decision Tree for Mary’s Factory
40 % Chance of a Good Economy
.4 Profit = $6M
Expand Factory
Cost = $1.5 M .6 60% Chance Bad Economy
Profit = $2M

Good Economy (40%)

.4
Profit = $3M
Don’t Expand Factory
Cost = $0 .6 Bad Economy (60%)
Profit = $1M

NPVExpand = (.4(6) + .6(2)) – 1.5 = $2.1M

NPVNo Expand = .4(3) + .6(1) = $1.8M

$2.1 > 1.8, therefore you should expand the factory

 Mary’s Factory – Discounting

Before Mary takes this to her boss, she wants to account for
the time value of money. The gadget company uses a 10%
discount rate. The cost of expanding the factory is borne in
year zero but the revenue streams are in year one.

(c) Compute the NPV in part (a) again, this time account the time value of
money in your analysis. Should she expand the factory?
Time Value of Money

40 % Chance of a Good Economy

.4 Profit = $6M
Expand Factory
Cost = $1.5 M
.6 60% Chance Bad Economy
Profit = $2M

Good Economy (40%)

.4
Profit = $3M
Don’t Expand Factory
Cost = $0 .6 Bad Economy (60%)
Profit = $1M

Year 0 Year 1
 Time Value of Money
• Recall that the formula for discounting money as a
function of time is: PV = S (1+i)-n
[where i = interest / discount rate; n = number of years /
S = nominal value]

• So, in each scenario, we get the Present Value (PV) of the

estimated net revenues:
a) PV = 6(1.1)-1 = $5,454,454
b) PV = 2(1.1)-1 = $1,818,181
c) PV = 3(1.1)-1 = $2,727,272
d) PV = 1(1.1)-1 = $0.909,091
 Time Value of Money

• Therefore, the PV of the revenue

streams (once you account for the
time value of money) are:
PVExpand =.4(5.5M) + .6(1.82M) = $3.29M
PVDon’t Ex. = 0.4(2.73) + 0.6(.910) = 1.638
• So, should you expand the factory?
Yes, because the cost of the expansion is $1.5M, and
that means the NPV = 3.29 – 1.5 = $1.79 > $1.64