5

Capacity Planning
For Products and
Services- Part 2

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
 Learning Objectives
 Explain the importance of capacity planning.
 Discuss ways of defining and measuring
capacity.
 Describe the determinants of effective
capacity.
 Discuss the major considerations related to
developing capacity alternatives.
 Briefly describe approaches that are useful
for evaluating capacity alternatives

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 5.7 Planning Service Capacity
Capacity planning principles generally apply to both goods
and services. However, planning for services faces unique
challenges. Three key factors to be considered :
 Need to be near customers
 Capacity and location are closely tied
 For example, hotel rooms must be where customers want
to stay; having a vacant room in another city won’t help.
 Inability to store services
 Capacity must be matched with timing of demand
 an unsold seat on an airplane, train, or bus cannot be stored for use on
a later trip.
 Degree of volatility of demand
 Peak demand periods
 For example, banks tend to experience higher volumes of demand on
certain days of the week.
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 5.7 Planning Service Capacity (cont.)

 Capacity strategies
 to cope with peak demand periods, planners might
consider hiring extra workers, hiring temporary
workers, outsourcing some or all of a service
 Demand management strategies can be used to
offset capacity limitations.
 Pricing, promotions, discounts, and similar tactics
can help to shift some demand away from peak
periods and into slow periods, allowing organizations to
achieve a closer match in supply and demand

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 5.8 In-House or Outsourcing
After determining capacity requirements, organizations must
decide whether to produce in-house or outsource. Factors to
be considered:
1. Available capacity
Organizations may opt for in-house production if they have the
equipment, skills, and time, as the additional costs are typically lower
than outsourcing. However, outsourcing offers increased capacity and
flexibility.
2. Expertise
Firm lacks the expertise to do a job satisfactorily, buying/outsourcing
might be a reasonable alternative.
3. Quality considerations
Specialized firms often deliver higher quality than in-house efforts.
However, organizations may choose in-house production to meet
unique quality requirements or maintain closer quality control.
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 5.8 In-House or Outsourcing
4. Nature of demand
If demand is high & steady – consider in-house production for high
Specialists/outsourcing are better suited for fluctuating demand or small
orders by combining multiple orders to achieve higher volumes and
balance variability.
5. Cost
For in-house operation, savings may come from lower production or
transportation costs. However, fixed costs tied to in-house production
must be considered. Outsourcing can help avoid these fixed costs.
6. Risk
Outsourcing involves risks like losing control, sharing proprietary
information, and liability if harm occurs. It can also damage reputation if
suppliers have poor working conditions or cause environmental harm..

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 5.9 Developing Capacity Alternatives
Ways to enhance development of capacity
strategies:
1. Design flexibility into systems
Planning for future expansion in the initial design, such as
considering water lines, land acquisition, equipment layout,
and production scheduling, helps reduce costs and
disruptions when expansion is needed.

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 5.9 Developing Capacity Alternatives
Ways to enhance development of capacity
strategies (cont.)
2. Take stages of life cycle into account
Introduction Phase: Determining market size and share is difficult, so
avoid large, inflexible capacity investments.
Growth Phase: Rapid market growth may require expanding capacity,
but organizations must balance higher costs and complexity with
potential profits. Overcapacity due to competitors' actions can increase
risks.
Maturity Phase: With a stable market, companies can improve profits by
reducing costs and using capacity efficiently. Expanding capacity is
possible if costs are low or the stage lasts long.
Decline Phase: As demand drops, capacity becomes underutilized.
Companies may sell excess capacity, introduce new products, or move
operations to lower-cost areas to maintain profits temporarily.
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 5.9 Developing Capacity Alternatives
Ways to enhance development of capacity
strategies (cont.)
3. Take a “big picture” approach to capacity changes.
When planning capacity changes, consider the entire system and how
different parts & supply chain are interconnected.
 increasing the number of motel rooms may also require additional
parking, entertainment, food services, and housekeeping.
 essential to check if suppliers, transporters, distributors etc. can
handle the increased demand.
 Failing to take a "big picture" approach may lead to system
imbalances, such as bottlenecks.
 A bottleneck* is an operation in the process with lower capacity
than others, limiting the overall capacity of the system.

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 Bottleneck Operation-example
Figure 5.2
Bottleneck operation: An operation
in a sequence of operations whose
capacity is lower than that of the
other operations
Bottleneck Operation example

Bottleneck

Maximum output rate

limited by bottleneck

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 5.9 Developing Capacity Alternatives
Ways to enhance development of capacity
strategies (cont.)
4. Prepare to deal with capacity “chunks”
 Capacity increase doesn't always align smoothly with the desired
level
 Capacity increases are often in large increment
 Ex: if a system needs 55 units per hour but each machine produces only
40 units per hour, one machine falls short by 15 units, while two
machines create an excess of 25 units.
 This imbalance more pronounced in larger systems
 furnaces or airplanes, where the.

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 5.9 Developing Capacity Alternatives
Ways to enhance development of capacity
strategies (cont.)
5. Attempt to smooth out capacity requirements
 Uneven capacity demands can cause underuse or overuse of
resources.
 For example, public transportation demand rises in bad weather but drops in good
weather, creating inefficiencies. Adding buses or subway cars may solve high-
demand issues but leads to excess capacity and higher costs during slow periods.
 To manage this, instead of increasing capacity, managers often:
 Use overtime work during peak times.
 Subcontract tasks to handle extra demand.
 Use inventory to meet high demand and restock during slower periods.
 These strategies help balance demand without increasing fixed costs
or reducing flexibility.

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 5.9 Developing Capacity Alternatives
Ways to enhance development of capacity strategies
(cont.)
6. Identify the optimal operating level
 Production units have optimal level (lowest unit cost of output).
 If the output rate is less than the optimal level, increasing the output rate
results in decreasing average unit costs (economies of scale).
 At low output, unit costs are high because few units absorb the fixed
costs of facilities and equipment. As output increases, fixed costs are
spread over more units, reducing unit costs.
 If output increases beyond the optimal level, average unit costs will
become increasingly larger.
 This is known as diseconomies of scale. Unit costs rise due to factors
like worker fatigue, equipment breakdowns, reduced flexibility, and
difficulties in coordinating operations

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 Optimal Rate of Output
Figure 5.4
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
Figure 5.5

• The optimal operating rate and

Minimum cost & optimal operating rate are minimum cost depend on the
functions of size of production unit. unit's capacity.
• Larger plants generally have
Average cost per unit

higher optimal output rates and

lower minimum costs
Small compared to smaller plants.
plant Medium • In choosing the capacity of an
plant Large
operating unit, management
plant
must also take into account the
availability of financial and
other resources and forecasts
0 Output rate of expected demand.

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 5.9 Developing Capacity Alternatives

Ways to enhance development of capacity

strategies (cont.)
7. Choose a strategy if expansion is involved.
 Have to decide between incremental expansion or a
single-step approach
 consider factors like competitive pressure, market
opportunities, costs, funding availability, operational
disruptions, and training needs.

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 5.11 Evaluating Alternatives
 Organizations must evaluate future capacity options from
multiple perspectives:
 Economic Feasibility: Consider costs, implementation timelines,
operating and maintenance expenses, lifespan, and compatibility
with current operations and staff.
 Public Impact: Decisions like building power plants can face public
backlash due to concerns about disruption, environmental effects, or
job relocations. New facilities may require moving employees,
retraining, or even job losses, which can cause community
discontent.
 Community Reaction: Resistance may arise in new locations if the
company is seen as disruptive (e.g., noise, traffic, pollution).
Balancing economic goals with public sentiment is crucial to avoid
negative reactions. Simulation

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 5.11 Evaluating Alternatives
 Several methods can help evaluate capacity
alternatives economically:
 Cost-Volume Analysis: Examines costs at different output
levels. ( covered in this chapter)
 Financial Analysis: Assesses financial feasibility (briefly
mentioned here).
 Decision Theory: Covers structured decision-making
under uncertainty (Will be covered in OR).
 Waiting-Line Analysis: Studies queue systems to
optimize capacity (Will be covered in OR)

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 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 is constant with
volume
6. Revenue per unit exceeds variable
cost per unit

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 Cost–Volume Relationships
• Cost–volume analysis examines the
relationship between cost, revenue, and
output volume to estimate an organization’s
income under different operating conditions.
• Helpful for comparing capacity options.
• Total Cost (TC) :
• Fixed Costs (FC): These stay constant regardless
of output (e.g., rent, property taxes, equipment,
heating, and administrative expenses).
• Variable Costs (VC): These change directly with
output (e.g., materials and labor).
VC = Quantity (Q) × Variable cost per unit (v)
• Assumptions: variable costs per unit remain
constant and all output is sold.
TC = FC + VC
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 Cost–Volume Relationships

TC = FC + VC
Amount ($)

• Fixed Costs (FC):

Stay constant (e.g., rent,
property taxes, equipment,
heating, and administrative
expenses).
• Variable Costs (VC):
Change directly with
output (e.g., materials and
labor).
VC = Q x v
Fixed cost (FC)
• Assumptions:
Variable costs per unit
0 remain constant and all
Q (volume in units) output is sold.

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 Cost–Volume Relationships
• Revenue per unit is assumed to remain constant regardless of output
quantity. Total revenue has a linear relationship with output.
Total Revenue (TR) = Revenue (R) × Quantity (Q)

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 Cost–Volume Relationships
Combining both:
Total Cost (TC) & Total Revenue (TR) curves
•Profit occurs if output is above the
(Beak-even quantity) QBEP.
•The further output deviates from the
BEP, the greater the profit or loss.
Amount ($)

•Profit (P) is calculated as:

P = TR − TC = R × Q − (FC + v × Q)
Where:
•TR = Total Revenue
•TC = Total Cost
•R = Revenue per unit
•Q = Quantity of output
•FC = Fixed Costs
•v = Variable cost per unit
•This formula highlights how profit
QBEP units
depends on output, fixed costs,
0 variable costs, and unit revenue.
Q (volume in units)

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Cost–Volume Relationships
• The profit formula can be rearranged as:
P = Q(R − v) − FC
• R − v - the contribution margin,
the difference between revenue per
unit (R) and variable cost per unit
(v).
• To find the required output volume (Q)
for a specified profit (P), the formula is:
• Q = (P + FC) / (R − v)
• A special case of this is the break-even
point (BEP or QBEP), where profit (P)
equals zero. The QBEP formula is:
QBEP = FC / (R − v)
• This shows how fixed costs and the
contribution margin determine the
volume needed to cover total costs.

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Cost–Volume Relationships

• Different options can be compared

by plotting their profit lines
• The indifference point is the output
level where two alternatives result in
the same profit.
• Below this point, Alternative B is
better because it has higher profits.
• Above this point, Alternative A is
better because it generates more
profit.
• The indifference point helps
decision-makers choose the best
alternative based on expected
output.

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 Break-Even Problem with Step
Figure 5.7A Fixed Costs
• Capacity alternatives can include step costs,
which increase in steps as volume grows.
• For example, buying one, two, or three
machines increases fixed costs, but not 3 machines
necessarily in a linear way. Each
machine adds capacity and cost at 2 machines
different levels..
• This means fixed costs and capacity depend
1 machine
on the number of machines purchased.
• There can be multiple break-even Quantity
points, with each corresponding to a
Step fixed costs and variable costs
specific range of capacity and costs.

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 Break-Even Problem with Step
Figure 5.7A 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
• The total revenue line might not intersect the fixed-cost
line in a particular range, meaning that there would be no
break-even point in that range.
To decide how many
machines to purchase,
must consider projected
annual demand (volume)
relative to the multiple
break-even points and
choose the most
appropriate number of
machines.

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 Financial Analysis
 Operations personnel must understand financial analysis to make
decisions about allocating limited funds. A common method is ranking
investment options while considering the time value of money.
 Key terms:
 Cash flow: The difference between cash received (e.g., sales, selling old
equipment) and cash spent (e.g., labor, materials, taxes).
 Present value: The current value of all future cash flows from an
investment.
 Three common financial analysis methods are:
 Payback: Time to recover the investment.
 Present value: Evaluates cash flows considering their current worth.
 Internal rate of return (IRR): The rate at which the investment breaks even.

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END OF CHAPTER

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