PRODUCTION AND

OPERATION MANAGEMENT
Capacity Management - Part1

Prof. Eunhee Kim

College of Business Administration, Chonnam National University
Learning Objectives
1. Explain what capacity management is and
why it is strategically important.
2. Understand how to plan capacity.
3. Evaluate capacity alternatives using decision trees.
4. Compare capacity planning in services to capacity
planning in manufacturing.

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Capacity Management in Operations

 Capacity – the ability to hold, receive, store, or

accommodate
 In business, viewed as the amount of output that
a system is capable of achieving
over a specific period of time
 In services, the output is often customers served

 In manufacturing, the output may be units produced

 Capacity management needs to consider both inputs

and outputs
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Capacity Planning Time Durations

Long range
• Greater than one year

Intermediate range
• Monthly or quarterly plans covering the next six to
eighteen months

Short range
• Less than one month
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Objectives of Strategic Capacity Planning

 To provide an approach for determining

the overall capacity level of capital
(intensive resources- facilities, equipment, and
overall labor force size) that
best supports the company’s long range competitive
strategy
 Inadequate capacity
→ lose customers through slow service or
by allowing competitors
 Excessive capacity
→ have to reduce price
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Capacity Utilization

 Capacity – an attainable rate of output

Ex) 480 cars per day
 Capacity utilization rate – a measure of how close the firm
is to its best possible operating level
Capacity Used
Capacity Utilization Rate =
Best Operating Level

 Ex) currently operating at 480 cars per day,

best operating level: 500 cars per day
→ capacity utilization rate: 480/500 = 0.96 (96%)

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 Economies and Diseconomies of Scale

 Economies of scale: as a plant gets larger and volume increases, the

average cost per unit drops
 Partially due to
lower operating and capital costs
 Plants gain efficiency when they become
large enough to fully utilize resources

 At some point, the plant becomes too large

 Diseconomies of scale become a problem
 Maintaining the demand required to keep the large facility busy may require
significant discounting of product
 Even though direct labor to operate the equipment is very low, the labor
required to maintain the equipment is high

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Capacity Flexibility

 Capacity Flexibility – the ability to rapidly increase or

decrease product levels or the ability to shift rapidly from one
product or service to another
 Flexibility comes from the plant, processes, and workers or from strategies
that use the capacity of other organizations

• Ability to quickly adapt to change

Flexible Plants • Zero-changeover time is the goal

• Flexible manufacturing systems

Flexible • Simple, easily setup equipment
Processes • Economies of scope

• Multiple skills (cross training)

Flexible
• Ability to switch from one kind of task to
Workers another quickly 4- 11
Considerations in Changing Capacity

Maintaining System Balance

• Similar capacities at each operation are desired
• Manage bottleneck operations

Frequency of Capacity Additions

• Cost of upgrading too frequently
• Cost of upgrading too infrequently

External Sources of Capacity

• Outsourcing
• Sharing capacity

Decreasing Capacity
• Temporary reductions
• Permanent reductions
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 Frequent vs. Infrequent Capacity Expansions

 Frequency of capacity
additions
 Cost of upgrading too frequently
◼ Expensive: removing, replacing,
training
◼ Purchasing the new >> Selling the
old
◼ Opportunity cost of idling plant
during the changeover period
 Cost of upgrading too
infrequently
◼ Expensive: purchased in large chunks
◼ Overhead until utilized
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 PRODUCTION AND
OPERATION MANAGEMENT
Capacity Management –Part 2

Prof. Eunhee Kim

College of Business Administration, Chonnam National University
 Determining Capacity Requirements

Calculate Project
Use forecasting labor and equipment
labor and equipment
to predict sales availability
requirements
for individual products over the planning
to meet forecasts
horizon

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Determining Capacity Requirements

 Considerations to determine capacity

 Demands for individual product lines
 Individual plant capabilities

 Allocation of resources

1. Use forecasting techniques to predict sales for individual

products
2. Calculate equipment and labor requirements to meet
forecasts
3. Project labor and equipment availability over the planning
horizon

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Example 4.1: Determining Capacity Requirements

 Stewart Company produces two flavors of

salad dressing
 Paul’s and Newman’s
 Each is available in bottles and single-serving bags
 What are the capacity and labor requirements
for the next five years?

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Example 4.1: Determining Capacity Requirements

Step 1: Use forecasting to predict Year

sales for individual products 1 2 3 4 5
Bottles (000s) 60 100 150 200 250
Paul’s
Plastic bags (000s) 100 200 300 400 500
Bottles (000s) 75 85 95
Year 97 98
Newman’s
Plastic bags (000s) 200
1 400
2 600
3 650
4 680
5
Bottles (000s) 135 185 245 297 348
Plastic bags (000s) 300 600 900 1050 1180

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 Example 4.1: Determining Capacity Requirements

Step 2: Calculate equipment and Year

labor requirements 1 2 3 4 5
Bottles (000s) 135 185 245 297 348
Plastic bags (000s) 300 600 900 1050 1180
Bottling Operation Bagging Operation
 Capacity – 450,000 / 1 year  Capacity – 1,250,000 / 1 year
 Machine – 3  Machine – 5
 Operators – 6  Operators – 15
(2 per 1 machine, 6 available) (3 per 1 machine, 15 available)
 Year 1  Year 1
300
135  Capacity utilization = = 0.24
 Capacity utilization = = 0.3 1,250
450
 Machine requirement =
 Machine requirement = 0.3 × 3 = 0.9
0.24 × 5 =1.2
 Labor requirement = 0.9 × 2 = 1.8  Labor requirement = 1.2 × 3 =3.6
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Example 4.1: Determining Capacity Requirements

Step 3: Project equipment and Year

labor availabilities 1 2 3 4 5
Percentage capacity 30 41 54 66 77
Bottle utilized
Operation Machine requirement 0.9 1.23 1.62 1.98 2.31
Labor requirement 1.8 2.46 3.24 3.96 4.62
Percentage capacity 24 48 72 84 94
Plastic Bag utilized
Operation Machine requirement 1.2 2.4 3.6 4.2 4.7
Labor requirement 3.6 7.2 10.8 12.6 14.1

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Capacity Investment Decisions

 How large a facility should we build?

 When and how much capacity should we add to our existing
facility?
 Should the firm use third-party contract manufacturers?
 How much of a premium will the contract manufacturer charge
for providing flexibility in manufacturing volume?
 How long will it take to bring new capacity on stream?
How does this match with the time that it takes to develop a
new product?
 What will be the impact of not having sufficient capacity in
the supply chain for a promising product?

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 PRODUCTION AND
OPERATION MANAGEMENT
Capacity Management part 3

Prof. Eunhee Kim

College of Business Administration, Chonnam National University
Decision Trees

 A decision tree is
a schematic model of the sequence of steps in a
problem – including the conditions and consequences
of each step
 Decision trees help
analysts understand the problem and
assist in identifying the best solution
 Decision tree components
 Decision nodes – represented with squares
 Chance nodes – represented with circles

 Paths– links between nodes 4- 23

Example 4.2 Decision Tree Analysis
: Hackers Computer Store Case

The owner of Hackers Computer Store is considering what to do with

his business over the next five years. Sales growth over the past
couple of years has been good, but sales could grow substantially if
a major proposed electronics firm is built in his area. Hackers’ owner
sees three options.
The first is to enlarge his current store, the second is to locate at a
new site, and the third is to simply wait and to nothing. The decision
to expand or move would take little time and therefore the store
would not lose revenue.
If nothing were done the first year and strong growth occurred then
the decision to expand would be reconsidered. Waiting longer than
one year would allow competition to move in and would make
expansion no longer feasible 4- 24
Example 4.2 - Assumptions and Conditions

 The owner of Hackers Computer Store is evaluating three

options – expand at current site, expand to a new site, do
nothing
 The decision process includes the following assumptions and
conditions
 Strong growth has a 55% probability
 New site cost is $210,000
◼ Payoffs: Strong growth = $195,000, Weak growth = $115,000
 Expanding current site cost is $87,000 (in either year 1 or 2)
◼ Payoffs: Strong growth = $190,000, Weak growth = $100,000
 Do nothing
◼ Payoffs: Strong growth = $170,000, Weak growth = $105,000

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Example 4.2 - Assumptions and Conditions

1. Strong growth, 55 percent probability

2. New site and strong growth=$195,000 returns/yr

New site and weak growth=$115,000 returns/yr
3. Expansion and strong growth=$190,000 returns/yr
Expansion and weak growth=$100,000 returns/yr
4. Exist with no change and strong growth=$170,000 returns/yr
Exist with no change and weak growth weak=$100,000 returns/yr

5. Expansion costs $87,000

6. Moving costs $210,000
7. Expansion in second year costs $87,000
8. Operating costs equal
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Example 4.2 – Calculate value of each alternatives

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Example 4.2 - Diagram the problem chronologically

Events

Payoffs

Decision
Decision

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Example 4.2 - Calculate value of each brance

 Calculate value of each branch (the payoffs)

$765,000

$365,000

$863,000

$413,000

$843,000

$850,000

$525,000

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 Example 4.2 –
Work backwards to calculate value of each decision

Value = weighted average of outcomes

= $765,000 0.55 + $365,000 0.45
= $585,000
$765,000

$365,000
Do nothing has
$660,500 $863,000 higher value
than expand,
$413,000 so choose to do
nothing
Do nothing = $703,750 $843,000
$703,750 Do nothing = $850,000
Do nothing has higher $850,000
value than expand or
move, so choose to do $525,000
nothing 4- 30
Example 4.2

 Decision tree analysis with net present value

calculations

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Planning Service Capacity

Manufacturing Capacity Service Capacity

Goods can be stored Capacity must be available

for later use when service is needed
– cannot be stored

Goods can be shipped Service must be available

to other locations at customer demand point

Volatility of demand is Much higher demand volatility

relatively low is typical

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Capacity Utilization and Service Quality

 The relationship between service capacity utilization and

service quality is critical
 Utilization is measured by the portion of time servers are busy
 Optimal levels of utilization are context specific
 Low rates are appropriate
when the degree of uncertainty (in demand) is high and/or the stakes
are high (e.g. emergency rooms, fire departments)
 Higher rates are possible for predictable services or those without
extensive customer contact
(e.g. commuter trains, postal sorting)

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 Service Quality

 Rate of service utilization and service quality are directly

linked
Service quality
declines – disruptions
Arrivals exceed services or high arrival levels
– many customers are lead to long wait
never served times

Average # of Service utilization

customers to come
during a specific time period
Sufficient capacity to
provide quality
service
Average # of customers served
during a specific time period

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