Capacity Planning

Supplement 7

M. Verma: September 25/26, 2006

Faculty of Business Administration, Memorial University of Newfoundland

Capacity
Capacity is the upper limit or ceiling on the load that an operating unit can handle. The basic questions in capacity handling are:
What kind of capacity is needed? How much is needed? When is it needed?

M. Verma: September 25/26, 2006

Faculty of Business Administration, Memorial University of Newfoundland

Importance of Capacity Decisions

1. 2. 3. Impacts ability to meet future demands.
Limits the rate of output possible. Ideally matching demand and capacity should minimize operating costs. Greater the capacity of a productive unit, the greater its cost. Once implemented, difficult to modify without incurring major costs. Excess capacity may serve as barrier to entry. Delivery speed is better, which is a competitive advantage. Appropriate capacity is better than mismatched capacity.

Affects operating costs. Major determinant of initial costs.

4.
5. 6.

Involves long-term commitment.

Affects competitiveness. Affects ease of management.

M. Verma: September 25/26, 2006

Faculty of Business Administration, Memorial University of Newfoundland

Capacity Measures
Refers to an upper limit on the rate of output. Single Product: # of items produced. Multiple Products: availability of inputs.

Business Auto manufacturing Steel mills Oil refinery Farming Restaurant Theatre Retail Sales

Inputs labor hrs, machine hrs. furnace size refinery size # of hectares, # of cows # of tables, seating capacity # of seats square meters of floor space

Outputs # of cars per shift tonnes of steel per day litres of fuel per day bushels of grain per hectare per year, litres of milk per day # of meals served per day # of tickets sold per performance revenue generated per day

Measures of Capacity

M. Verma: September 25/26, 2006

Faculty of Business Administration, Memorial University of Newfoundland

Capacity Definitions
1. Design Capacity (DC):
Maximum output that can possibly be attained. Maximum possible output given a product mix, scheduling difficulties, machine maintenance, quality factors and so on. Rate of output actually achieved.

2.

Effective Capacity (EC):

Actual output (AO):

DC EC AO
Actual Output Efficiency Effective Capacity

Actual Output Utilizatio n Design Capacity

M. Verma: September 25/26, 2006

Faculty of Business Administration, Memorial University of Newfoundland

Efficiency/Utilization Example
Design capacity = 50 trucks/day Effective capacity = 40 trucks/day Actual output = 36 units/day
Actual output Efficiency = Effective capacity Utilization = Actual output = Design capacity 40 units/ day 36 units/day 50 units/day = 72% = 36 units/day = 90%

M. Verma: September 25/26, 2006

Faculty of Business Administration, Memorial University of Newfoundland

Determinants of Effective Capacity

Facilities Factors.
facility design; labor supply; energy sources; environmental factors.

Product / Service Factors.

similar items increase production capacity, since output is uniform.

Human Factors.
training, skill and experience, and motivation of employees.

Operational Factors.
hours of operation; inventory stocking decisions, etc.

External Factors.
pollution standards can reduce effective capacity; government paperwork; union contract limitations.
M. Verma: September 25/26, 2006 Faculty of Business Administration, Memorial University of Newfoundland 7

Developing Capacity Alternatives

1. Design flexibility into systems.
To account for long-term nature and inherent risk of capacity decisions. Mature Product: predictable demand and hence less risky. Excess capacity. New Product: unpredictable and risky demand. Flexibility comes handy. Consider how parts of a system interrelate. Else capacity imbalance, which leads to bottlenecks in the system. Unavailable in smooth increments. Weather and seasonal demand spikes can be handled by: overtime, subcontracting, build finished goods inventory during low demand periods.

2.

Take a big picture approach to capacity changes.

3.
4.

Prepare to deal with capacity chunks.

Attempt to smooth out capacity requirements.

5.

Identify the optimal operating level.

Average cost per unit is the lowest for that production unit.
Faculty of Business Administration, Memorial University of Newfoundland 8

M. Verma: September 25/26, 2006

Optimal Operating Level

Average cost per unit Minimum cost 0

Rate of output

Average cost per unit

Small plant

Medium plant
Large plant

M. Verma: September 25/26, 2006

Faculty of Business Administration, Memorial University of Newfoundland

Output rate

Planning Service Capacity

1. Proximity to customers.
Capacity and location are closely tied. Customer convenience. Capacity must be matched with the timing of demand. Speed of delivery and customer waiting time are very important.

2.

Inability to store services.

3.

Degree of volatility of demand.

Higher for services than for goods. Both the timing of demand and the processing time for each demand are volatile.

Demand Management:
Technique is used to offset capacity limitations. Pricing, promotions, discounts etc. to shift demand from peak to slow periods.
Faculty of Business Administration, Memorial University of Newfoundland 10

M. Verma: September 25/26, 2006

Evaluating Alternatives
1. 2. 3. 4. 5. Calculating Processing Requirements. Break-Even Analysis. Financial Analysis. Decision Theory. Waiting-Line Analysis.

M. Verma: September 25/26, 2006

Faculty of Business Administration, Memorial University of Newfoundland

11

Calculating Processing Requirements

Need to know the capacity requirements of products.
Reasonably accurate demand forecasts for each product. Standard processing time per unit for each product on each alternative. Number of workers per year. Number of shifts.

E.g.: A department works one eight-hour shift, 250 days a year, and has these figures for usage of a machine that is currently being considered:
Product #1 #2 #3 Annual Demand 400 300 700 Std. Processing Time per Unit (Hr.) 5.0 8.0 2.0 Processing Time Needed (Hr.) 2,000 2,400 1,400

M. Verma: September 25/26, 2006

Faculty of Business Administration, Memorial University of Newfoundland

12

Break-Even Analysis
Focuses on relationships between costs, revenue, and volume of output. Estimates profit of an organization under different operating conditions. Useful for comparing capacity alternatives. Fixed Cost (FC): remain constant regardless of volume of output. Variable Cost (VC): varies directly with volume.

TC FC VC VC Q v
Q quantity or volume of output. v variable cost per unit.

TR Q R
Q quantity or volume of output. R revenue per unit.

M. Verma: September 25/26, 2006

Faculty of Business Administration, Memorial University of Newfoundland

13

Break-Even Point (BEP) is the volume where total cost = total revenue.

P Q( R v) FC

Multiproduct Case

P FC Q Rv FC QBEP Rv

QBEP

FC Vi [(1 ) (Wi )] Pi

i each product

Amount ($)

Fixed cost (FC)

0 Q (volume in units)

Amount ($) 0

BEP units Q (volume in units)

14

M. Verma: September 25/26, 2006

Faculty of Business Administration, Memorial University of Newfoundland

Examples
1. The owner of Old-Fashioned Berry Pies, S. Simon, is contemplating adding a new line of pies, which will require leasing new equipment for a monthly payment of $6,000. Variable costs would be $2.00 per pie, and pies would retail for $7.00 each.
a) b) c) How many pies must be sold in order to break even? What would the profit (loss) be if 1,000 pies are made and sold in a month? How many pies must be sold to realize a profit of $4,000?

2.

A manager has the option of purchasing one, two, or three machines. Fixed costs and potential volumes are as follows:
Number of Machines 1 2 3 Total Annual Corresponding Fixed Costs Range of Output $9,600 0 to 300 $15,000 301 to 600 $20,000 601 to 900

Variable cost is $10 per unit, and revenue is $40 per unit.
Determine the break-even point for each range. If projected annual demand is between 580 and 660 units, how many machines should the manager purchase?
Faculty of Business Administration, Memorial University of Newfoundland 15

M. Verma: September 25/26, 2006

Other Techniques
Financial Analysis:
Payback Period: length of time to recover an investment. Ignores time value of money. Present Value: summarizes cash inflow and outflow from an investment. Internal Rate of Return: PV is zero.

Decision Theory: Management Science (CRN # 4401). Waiting-Line Analysis:

Next Topic in this course (CRN # 3401).

M. Verma: September 25/26, 2006

Faculty of Business Administration, Memorial University of Newfoundland

16

Examples
1. A producer of pottery is considering the addition of a new plant to absorb the backlog of demand that now exists. The primary location being considered will have fixed costs of $9,200 per month and variable costs of 70 cents per unit produced. Each item is sold to retailers at a price that averages 90 cents.
a) b) c) d) e) What volume per month is required in order to break-even? What profit would be realized on a monthly volume of 61,000? 87,000 units? What volume is needed to obtain a profit for $16,000 per month? What volume if needed to provide a revenue of $23,000 per month? Plot the total cost and total revenue lines.

M. Verma: September 25/26, 2006

Faculty of Business Administration, Memorial University of Newfoundland

17

Examples
2. A small firm intends to increase the capacity of a bottleneck operation by adding a new machine. Two alternatives, A and B, have been identified, and the associated costs and revenues have been estimated. Annual fixed costs would be $40,000 for A and $30,000 for B; variable costs per unit would be $10 for A and $12 for B; and revenue per unit would be $15 for A and $16 for B.
a) b) c) Determine each alternatives break-even point. At what volume of output would the two alternatives yield the same profit? If expected annual demand is 12,000 units, which alternative would yield the higher profit?

M. Verma: September 25/26, 2006

Faculty of Business Administration, Memorial University of Newfoundland

18

Examples
3. A real estate agent is considering purchasing a cell phone and phone service plan. There are three billing plans to choose from, all of which involve a weekly charge of $20. Plan A has a cost of $0.45 a minute for daytime calls and $0.20 a minute for evening calls. Plan B has a charge of $0.55 a minute for daytime calls and a charge of $0.15 a minute for evening calls. Plan C has a flat rate of $80 with 200 minutes of calls allowed per week and a cost of $0.40 per minute beyond that, day or evening.
a) b) c) Determine the total charge, under each plan for this case: 120 minutes of daytime calls and 40 minutes of evenings calls in a week. Prepare a graph that shows total weekly daytime cost for each plan versus daytime call minutes. If the agent plans to use the service for only daytime calls, over what range of call minutes will each plan be optimal?

M. Verma: September 25/26, 2006

Faculty of Business Administration, Memorial University of Newfoundland

19

Examples
4. Information for Le Bistro, a French-style deli, follows. Fixed costs are $3,500 per month. Find the break-even point.
ITEM Sandwich Soft drink Baked potato Tea Salad bar PRICE $2.95 $0.80 $1.55 $0.75 $2.85 COST $1.25 $0.30 $0.47 $0.25 $1.00 Annual Sales Forecast 7000 7000 5000 5000 3000

M. Verma: September 25/26, 2006

Faculty of Business Administration, Memorial University of Newfoundland

20