Unit 7

Strategic Capacity Planning for

Products and Services

Stevenson (2012) Chapter 5, p.182- 226

Krajewski, Ritzman & Mahotra (2013) Chapter 6, p. 221-233
Heizer & Render (2011) Supplement 7, p.324-326, 330-333

5-1
Capacity Planning
• Capacity
– The upper limit or ceiling on the load that an operating
unit can handle
– Capacity needs include
• Equipment
• Space
• Employee skills

5-2
Measuring Capacity Examples

• There is no one best way to measure capacity

• Output measures like cars 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

5-3
Strategic Capacity Planning
• Goal
– To achieve a match between the long-term supply
capabilities of an organization and the predicted level
of long-run demand
• Overcapacity operating costs that are too high
• Undercapacity strained resources and possible loss of
customers

5-4
Capacity Planning Questions
• Key Questions:
– What kind of capacity is needed?
– How much capacity is needed to match demand?
– When is it needed?
• Related Questions:
– How much will it cost?
– What are the potential benefits and risks?
– Are there sustainability issues?
– Should capacity be changed all at once, or through several smaller
changes
– Can the supply chain handle the necessary changes?

5-5
Capacity Decisions Are Strategic
• Capacity decisions
– impact the ability of the organization to meet future demands
– affect operating costs
– are a major determinant of initial cost
– often involve long-term commitment of resources
– can affect competitiveness
– affect the ease of management
– are more important and complex due to globalization
– need to be planned for in advance due to their consumption of
financial and other resources

5-6
Capacity
Design capacity
– maximum output rate or service capacity an operation, process,
or facility is designed for
Effective capacity
– Design capacity minus allowances such as personal time,
maintenance, and scrap
Actual output
– rate of output actually achieved--cannot
exceed effective capacity.

5-7
Measuring System Effectiveness
• Actual output
– The rate of output actually achieved
– It cannot exceed effective capacity
• Efficiency

actual output
• Utilization Efficiency 
effective capacity

Measured as percentages
actual output
Utilization 
design capacity

5-8
Example– Efficiency and Utilization
• Design Capacity = 50 trucks per day
• Effective Capacity = 40 trucks per day
• Actual Output = 36 trucks per day

actual output 36
Efficiency    90%
effective capacity 40

actual output 36
Utilization    72%
design capacity 50

5-9
Bottleneck

• The capacity of a process is not constant

throughout all operations.
• The capacity of the whole line is limited by the
machine (resource/facility) with the smallest
individual capacity.
• Bottleneck is formed by the resources or
facilities that limit the overall output of a
process.

5-10
 Capacity Bottlenecks

To
Inputs 1 2 3
customers
200/hr 50/hr 200/hr

(a) Operation 2 a bottleneck

5-11
 Capacity Bottlenecks

To
Inputs 1 2 3
customers
200/hr 200/hr 200/hr

(b) All operations bottlenecks

Figure 6.2
5-12
Determinants of Effective Capacity
• Facilities
• Product and service factors
• Process factors
• Human factors
• Policy factors
• Supply chain factors
• External factors

5-13
3 Dimensions of Capacity Strategy
• Sizing capacity cushions
– the amount of reserve capacity that a firm maintains
to handle sudden increases in demand or temporary
losses of production capacity.
• The timing of changes
– whether it is generally best to work with spare capacity
or some shortage.
• The size of change
– whether it is better to have a few large changes or
more small adjustments.

5-14
Capacity Cushion
• Capacity Cushion
– Extra capacity used to offset demand uncertainty
– An additional amount of capacity 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

5-15
Capacity Cushion (cont.)
• Capacity Cushion
– Capacity cushion = 100% - Utilization
– Capacity cushion strategy
• Large cushions is appropriate when demand varies,
future demand is uncertain (particularly if resource
flexibility is low and changing product mix), and supply
uncertainty.
• Argument in favor of small cushions include unused
capacity costs money, they reveal inefficiencies that
may be masked by capacity excess – problems with
absenteeism or unreliable suppliers.

5-16
Capacity Expansion Strategies

5-17
Two General Approaches to Expanding Long-Range Capacity

• All at Once – build the ultimate facility now and

grow into it
• Incrementally – build incrementally as capacity
demand grows

5-18
Two General Approaches to Expanding Long-Range Capacity

• All at Once
– Little risk of having to turn down business due to
inadequate capacity
– Less interruption of production
– One large construction project costs less than several
smaller projects
– Due to inflation, construction costs will be higher in the
future
– Most appropriate for mature products with stable demand

5-19
Two General Approaches to Expanding Long-Range Capacity

• Incrementally
– Less risky if forecast needs do not materialize
– Funds that could be used for other types of
investments will not be tied up in excess capacity
– More appropriate for new products

5-20
Economies of Scale
• Best operating level - least average unit cost
• Economies of scale - average cost per unit
decreases as the volume increases toward the
best operating level
• Diseconomies of scale - average cost per unit
increases as the volume increases beyond the
best operating level

5-21
Economies and Diseconomies of Scale
Average Unit
Cost of Output ($)

Economies Diseconomies
of Scale of Scale

Best Operating Level

Annual Volume (units)

5-22
Best Operating Level for a Hotel

5-23
Optimal Operating Level

Optimal
Output
Rate

5-24
Economies of Scale

- If output rate is less than the optimal level, increasing

the output rate results in decreasing average per unit
costs
- Reasons for economies of scale:
• Fixed costs are spread over a larger number of units
• Construction costs increase at a decreasing rate as
facility size increases
• Processing costs decrease due to standardization
• Production or operating costs do not increase linearly
with output levels
• Quantity discounts are available for material purchases
• Operating efficiency increases as workers gain
experience
5-25
Diseconomies of Scale
• Diseconomies of Scale
– If the output rate is more than the optimal level, increasing the
output rate results in increasing average per unit costs
– Reasons for diseconomies of scale
• Distribution costs increase due to traffic congestion and
shipping from a centralized facility rather than multiple smaller
facilities
• Complexity increases costs
• Inflexibility can be an issue
• Additional levels of bureaucracy

5-26
Diseconomies of Scale

• Occur above a certain level of output

– Diseconomies of Distribution
– Diseconomies of Confusion
– Diseconomies of Bureaucracy
– Diseconomies of Vulnerability

5-27
Diseconomies of Confusion

5-28
Diseconomies of Scale
 Diseconomies of Distribution, Bureaucracy, Confusion,
and Vulnerability will contribute to:
• Increasing inefficiency
• Difficulty in scheduling
• Damaged goods
• Reduced morale
• Increased use of overtime, etc.

5-29
Facility Size and Optimal Operating Level
Minimum cost & optimal operating rate are
functions of size of production unit.

5-30
Steps in Capacity Planning
1. Estimate future capacity requirements
2. Evaluate existing capacity and facilities; identify gaps
3. Identify alternatives for meeting requirements
4. Conduct financial analyses or Assess key qualitative issues
5. Select the best alternative for the long term
6. Implement alternative chosen
7. Monitor results

5-31
Forecasting Capacity Requirements
• Long-term considerations relate to overall level
of capacity requirements
• Short-term considerations relate to probable
variations in capacity requirements

5-32
Calculating Processing Requirements
• Calculating processing requirements requires
reasonably accurate demand forecasts,
standard processing times, and available work
time k
pD i i
NR  i 1
TE
where
N R  number of required machines
pi  standard processing time for product i
Di  demand for product i during the planning horizon
T  processing time available during the planning horizon
E  Efficiency of the resource measured as a percentage
5-33
Manufacturing example
(Input capacity determination – number of resources needed)

A video equipment manufacturer produces DVDs and Blu-

Rays. The manufacturing facility operates two eight-hour
shifts per day for 6 days a week. The unit manufacturing
time is 6 minutes for each DVD and 8 minutes for each
Blu-ray.
a. Given that machine operators work at 80% efficiency,
determine the number of workers needed to produce
5000 DVDs and 2500 Blu-Rays per week.
b. Given that machines have 95% efficiency, determine
the number of machines needed to produce 5000
DVDs and 2500 Blu-Rays per week.

5-34
 Manufacturing example
(Input capacity determination – number of resources
needed)

T  ( 2 shifts )(6 days)(8 hrs. / shift )(60 min. / hr.)  5,760 min . / week
k
a.
pD i i
(6 min.)(5,000)  (8 min.)(2,500)
NW  i 1
  10.88  11 workers
(T )( E ) (5,760)(.80)
k

pD
i 1
i i
(6 min.)(5,000)  (8 min.)( 2,500)
b. NM    9.14  10 machines
(T )( E ) (5,760)(.95)

5-35
Service Capacity Planning
• Service capacity planning can present a number of
challenges related to:
– The need to be near customers
• Convenience
– The inability to store services
• Cannot store services for consumption later
– The degree of demand volatility
• Volume and timing of demand
• Time required to service individual customers

5-36
Demand Management Strategies
• Strategies used to offset capacity limitations and
that are intended to achieve a closer match
between supply and demand
– Pricing
– Promotions
– Discounts
– Other tactics to shift demand from peak periods into
slow periods

5-37
Strategies for Adjusting Capacity
• Level production • Overtime and under-time
– Producing at a constant rate and – Increasing or decreasing working
using inventory to absorb hours
fluctuations in demand • Subcontracting
• Chase demand – Let outside companies complete
– Hiring and firing workers to the work
match demand • Part-time workers
• Peak demand – Hiring part time workers to
– Maintaining resources for high- complete the work
demand levels • Backordering
– Providing the service or product
at a later time period

14-385-38
Expansion of Long-Term Capacity
• Subcontract with other companies
• Acquire other companies, facilities, or resources
• Develop sites, construct buildings, buy
equipment
• Expand, update, or modify existing facilities
• Reactivate standby facilities

5-39
In-House or Outsource?
• Once capacity requirements are determined, the organization
must decide whether to produce a good or service itself or
outsource
• Factors to consider:
– Available capacity
– Expertise
– Quality considerations
– The nature of demand
– Cost
– Risks

5-40
Subcontractor Networks
A viable alternative to larger-capacity facilities is to
develop subcontractor and supplier networks.
– “Farming out” or outsourcing your capacity needs to your
suppliers
– Developing long-range relationships with suppliers of parts,
components, and subassemblies
– Relying less on backward vertical integration
– Requiring less capital for production facilities
– More easily varying capacity during slack or peak demand
periods

5-41
Outsourcing Service Functions
– Building maintenance
– Data processing
– Delivery
– Payroll
– Bookkeeping
– Customer service
– Mailroom
– Benefits administration
– … and more

5-42
Constraint Management
• Constraint
– Something that limits the performance of a process or system in
achieving its goals
– Categories
• Market
• Resource
• Material
• Financial
• Knowledge or competency
• Policy

5-43
Evaluating Alternatives
• Alternatives should be evaluated from varying
perspectives
– Economic
• Cost-volume analysis √
• Financial analysis √
• Decision theory or Decision tree analysis √
• Linear Programming or Transportation Tableau √
• Waiting-line analysis √
• Simulation Ҳ
– Non-economic
• Public opinion
• Relative-Aggregate-Scores Approach √
5-44
Cost-Volume Analysis – ALT 1
(Stevenson)

• Cost-volume analysis is a viable tool for comparing

capacity alternatives if certain assumptions are satisfied
– One product is involved*
– Everything produced can be sold
– The variable cost per unit is the same regardless of volume
– Fixed costs do not change with volume changes, or they are
step changes
– The revenue per unit is the same regardless of volume
– Revenue per unit exceeds variable cost per unit

*Multiproduct case – refer Heizer & Render

5-45
Cost-Volume Relationships

Total cost of small

plant
$20,000 —

Total cost of large

plant
$15,000 —

$10,000 —

Choose small Choose large

plant plant
$5,000 —
| | | |
1000 2000 3000 4000 Units

Point of indifference = 2,667 Units

5-46
Financial Analysis – ALT 2
(Stevenson; Heizer & Render)

Cash Flow - the difference between cash

received from sales and other sources, and
cash outflow for labor, material, overhead, and
taxes.
Present Value - the sum, in current value, of all
future cash flows of an investment proposal.
After-Tax Payback Period, and etc.

5-47
Decision Tree Analysis – ALT 3
(Stevenson; Heizer & Render)

• Decision Trees analysis tool is:

– a modeling tool for evaluating sequential
decisions which,
– identifies 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)

5-48
Decision Tree Analysis – ALT 3 (cont.)
• Structures complex multiphase decisions,
showing:
– What decisions must be made
– What sequence the decisions must occur
– Interdependence of the decisions
• Allows objective evaluation of alternatives
• Incorporates uncertainty
• Develops expected values

5-49
Decision tree diagrams
• Diagramming technique which uses
– Decision points – points in time when decisions are
made, squares called nodes
– Decision alternatives – branches of the tree off the
decision nodes
– Chance events – events that could affect a decision,
branches or arrows leaving circular chance nodes
– Outcomes – each possible alternative listed

5-50
Decision tree diagrams
• Decision trees developed by
– Drawing from left to right
– Use squares to indicate decision points
– Use circles to indicate chance events
– Write the probability of each chance event in bracket
(sum of associated chances = 100%)
– Write each alternative outcome in the right margin

5-51
 Example 1: 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 .70

• The likelihood of demand being low is .30
• Large expansion yields profits of $300K(high dem.) or $50k(low dem.)
• 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

5-52
Evaluating the Decision Tree
(working from right to left)

• Decision tree analysis utilizes expected value analysis

(EVA)
• EVA is a weighted average of the chance events
– Probability of occurrence * chance event outcome
• Refer to Figure
– 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

5-53
 Evaluating the Decision Tree - continued

• 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!

5-54
 Example2: Good Eats Café
• Decision Tree Analysis
Good Eats Café is about to build a new restaurant.
An architect has developed three building designs
(differ in capacity), each with a different seating
capacity. Good Eats estimates that the average
number of customers per hour will be 80, 100, or 120
with respective probabilities of 0.4, 0.2, and 0.4. The
payoff table showing the profits for the three designs
is on the next slide.

5-55
 Example2: Good Eats Café

• Payoff Table

Average Number of Customers Per Hour

c11 = 80 c22 = 100 c33 = 120

Design A $10,000 $15,000 $14,000

Design B $ 8,000 $18,000 $12,000
Design C $ 6,000 $16,000 $21,000

5-56
 Example2: Good Eats Café

Expected Value Approach
Calculate the expected value for each decision.
The decision tree on the next slide can assist in this
calculation. Here d11, d22, d33 represent the decision
alternatives of designs A, B, C, and c11, c22, c33 represent
the different average customer volumes (80, 100, and
120) that might occur.

5-57
 Example2: Good Eats Café

Decision Tree Payoffs
c1 (.4) 10,000
c2 (.2)
2 15,000
c3 (.4)
d1 14,000
c1 (.4)
d2 8,000
11 c2 (.2)
3 18,000
d3 c3 (.4)
12,000
c1 (.4)
6,000
c2 (.2)
4
c3 16,000
(.4)
21,000
5-58
 Example2: Good Eats Café

Expected Value For Each Decision
EV = .4(10,000) + .2(15,000) + .4(14,000)
d1 = $12,600
22
Design A
EV = .4(8,000) + .2(18,000) + .4(12,000)
Design B d2 = $11,600
1 3

d3
Design C
EV = .4(6,000) + .2(16,000) + .4(21,000)
= $14,000
44

Choose the design with largest EV -- Design C.

5-59
General Linear Programming (LP) Model – ALT 4

• LP gives an optimal solution, but demand and

costs must be linear
• Let
– Wt = workforce size for period t
– Pt =units produced in period t
– It =units in inventory at the end of period t
– Ft =number of workers fired for period t
– Ht = number of workers hired for period t

14-605-60
 LP MODEL
Minimize Z = $100 (H1 + H2 + H3 + H4)
+ $500 (F1 + F2 + F3 + F4)
+ $0.50 (I1 + I2 + I3 + I4)
+ $2 (P1 + P2 + P3 + P4)
Subject to
P1 - I1 = 80,000 (1)
Demand I1 + P2 - I2 = 50,000 (2)
constraints I2 + P3 - I3 = 120,000 (3)
I3 + P4 - I4 = 150,000 (4)
Production 1000 W1 = P1 (5)
constraints 1000 W2 = P2 (6)
1000 W3 = P3 (7)
1000 W4 = P4 (8)
100 + H1 - F1 = W1 (9)
Work force W 1 + H2 - F2 = W 2 (10)
constraints W 2 + H3 - F3 = W 3 (11)
14-615-61
 Quarter Unused Total
Alternatives
1 2 3 4 Capacity Capacity

Quarter
Beginning 0 h 2h 3h 4h
inventory
I0

Transportation
Regular r r+h r+2h r+3h u
time
R1
c c+h c+2h c+3h 0
1 Overtime

Tableau Subcontract
s s+h s+2h s+3h 0 O1

-ALT 5
Regular r+b r r+h r+2h u S1
time

c+b c c+h c+2h 0

2 Overtime R2

s+b s s+h s+2h 0

Subcontract O2

Regular r+2b r+b r r+h u

time S2
c+2b c+b c c+h 0
3 Overtime
R3
s+2b s+b s s+h 0
Subcontract
O3
Regular r+3b r+2b r+b r u
time
c+3b c+2b c+b c 0
S3
4 Overtime

s+3b s+2b s+b s 0 R4

Subcontract

O4
Requirements D1 D2 D3 D4 + I4 U

S4
5-62
Simulation - ALT 6

 An attempt to duplicate the

features, appearance, and
characteristics of a real system
1. To imitate a real-world situation
mathematically
2. To study its properties and
operating characteristics
3. To draw conclusions and make
action decisions based on the
results of the simulation
5-63
THE END…….

5-64