CAPACITY PLANNING

5
Intended Learning Outcomes
By the end of the learning experience, students must be able to:
1. Explain the importance of capacity planning.
2. Discuss ways of defining and measuring capacity.
3. Describe the factors that determine effective capacity alternatives.
4. Discuss the major considerations related to developing capacity alternatives.
5. Briefly describe approaches that are useful for evaluating capacity alternatives.

IMPORTANCE OF CAPACITY DECISIONS

a. Capacity decisions have a real impact on the ability of the organisation to meet future
demands for products and services; capacity essentially limits the rate of output
possible. Having capacity to satisfy demand can allow a company to take advantage of
tremendous opportunities.
b. Capacity decisions affect operating costs. Ideally, capacity and demand requirements
will be matched, which will tend to minimize operating costs. In practice, this is not
always achieved because actual demand either differs from expected demand or tends
to vary (e.g., cyclically). In such cases, a decision might be made to attempt to balance
the costs of over and under capacity.
c. Capacity is usually a major determinant of initial cost. Typically, the greater the
capacity of a productive unit, the greater its cost. This does not necessarily imply a one
for-one relationship; larger units tend to cost proportionately less than smaller units.
d. Capacity decisions often involve long-term commitment of resources and the fact that,
once they are implemented, it may be difficult or impossible to modify those decisions
without incurring major costs.
e. Capacity decisions can affect competitiveness. If a firm has excess capacity, or can
quickly add capacity, that fact may serve as a barrier to entry by other firms. Then too,
capacity can affect delivery speed, which can be a competitive advantage.
f. Capacity affects the ease of management; having appropriate capacity makes
management easier than when capacity is mismatched.

DEFINING AND MEASURING CAPACITY

Capacity often refers to an upper limit on the rate of output. Even though this seems
simple enough, there are subtle difficulties in actually measuring capacity in certain cases.
These difficulties arise because of different interpretations of the term capacity and problems
with identifying suitable measures for a specific situation.
In selecting a measure of capacity, it is important to choose one that does not require
updating. Where only one product or service is involved, the capacity of the productive unit
may be expressed in terms of that item. However, when multiple products or services are
involved, as is often the case, using a simple measure of capacity based on units of output can
be misleading. No single measure of capacity will be appropriate in every situation. Rather, the
measure of capacity must be tailored to the situation.
Two useful definitions of capacity:
1) Design Capacity: the maximum output that can possibly be attained under ideal
conditions.
2) Effective Capacity: the maximum possible output given a product mix, scheduling
difficulties, machine maintenance, quality factors, and so on.
These different measures of capacity are useful in defining two measures of system
effectiveness: efficiency and utilization. Efficiency is the ratio of actual output to effective
capacity. Utilization is the ratio of actual output to design capacity.
Efficiency =

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 Utilization =

Sample Problem 5.1:

Compute the efficiency and utilization of the vehicle repair department:
Design Capacity = 50 trucks per day
Effective Capacity = 40 trucks per day
Actual Output = 36 trucks per day
Solution
Efficiency = = = 90%
Utilization = = = 72%
Sample Problem 5.2:
The design capacity for engine repair in our company is 80 trucks per day. The effective
capacity is 40 engines per day and the actual output is 36 engines per day. Calculate the
utilization and efficiency of the operation. If the efficiency for next month is expected to be
82%, what is the expected output?

Solution
Efficiency = = = 90%
Utilization = = = 45%
Expected Output = (Effective capacity)(Efficiency)
= (40)(0.82) = 32.8 engines per day

DETERMINANTS OF EFFECTIVE CAPACITY

a. Facilities. The design of facilities, including size and provision for expansion, is key.
Locational factors, such as transportation costs, distance to market, labor supply,
energy sources, and room for expansion, are also important. Likewise, layout of the
work area often determines how smoothly work can be performed, and environmental
factors such as heating, lighting, and ventilation also play a significant role in
determining whether personnel can perform effectively or whether they must struggle
to overcoat poor design characteristics.
b. Products or service. Product or service design can have a tremendous influence on
capacity. Generally speaking, the more uniform the output, the more opportunities
there are for standardization of methods and materials, which leads to greater
capacity. The particular mix of products or services rendered must also be considered
since different items will have different rates of output.
c. Processes. The quantity capability of a process is an obvious determinant of capacity. A
more subtle determinant is the influence of output quality. For instance, if quality of
output does not meet standards, the rate of output will be slowed by the need for
inspection and rework activities.
d. Human considerations. The tasks that make up ajob, the variety of activities involved,
and the training, skill, and experience required to perform a job all have an impact on
the potential and actual output. In addition, employee motivation has a very basic
relationship to capacity, as do absenteeism and labor turnover.
e. Operations. Scheduling problems may occur when an organization has differences in
equipment capabilities among alternative pieces of equipment or differences in job
requirements. Inventory stocking decisions, late deliveries, acceptability of purchased
materials and parts, and quality inspection and control procedures also can have an
impact on effective capacity. Inventory shortages of even one component of an
assembled item (e.g., computers, refrigerators, automobiles) can cause a temporary
halt to assembly operations until new components become available. This can have a
major impact on effective capacity. Thus, insufficient capacity in one area can affect
overall capacity.
f. External forces. Product standards, especially minimum quality and performance
standards, can restrict management's options for increasing and using capacity. Thus,

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 pollution standards on products and equipment often reduce effective capacity, as
does paperwork required by government regulatory agencies by engaging employees
in non-productive activities. A similar effect occurs when a union contract limits the
number of hours and type of work an employee may do.
Determining Capacity Requirements
Capacity planning decisions involve both long-term and short-term considerations.
Long-term considerations relate to overall level of capacity, such as facility size; short-term
considerations relate to probable variations in capacity requirements created by such things as
seasonal, random, and irregular fluctuations in demand.

DEVELOPING CAPACITY ALTERNATIVES

a. Design flexibility into systems. The long-term nature of many capacity decisions and
the risks inherent in long-term forecasts suggest potential benefits from designing
flexible systems. Other considerations in flexible design involve layout of equipment,
location, equipment selection, production planning, scheduling, and inventory policies.
b. Differentiate between new and mature products or services. Mature products or
services tend to be more predictable in terms of capacity requirements, and they may
have limited life spans. New products tend to carry higher risk because of the
uncertainty often associated with predicting the quantity and duration of demand.
That makes flexibility appealing to managers.
c. Take a "big picture" approach to capacity changes. When developing capacity
alternatives, it is important to consider how parts of the system interrelate.
d. Prepare to deal with capacity "chunks." Capacity increases are often acquired in fairly
large chunks rather than smooth increments, making it difficult to achieve a match
between desired capacity and feasible capacity.
e. Attempt to smooth out capacity requirements. Unevenness in capacity requirements
also can create certain problems.
f. Identify the optimal operating level. Production units typically have an ideal or
optimal level of operation in terms of unit cost of output. At the ideal level, cost per
unit is the lowest for that production unit; larger or smaller rates of output will result in
a higher unit cost.

PLANNING SERVICE CAPACITY

Three very important factors in planning service capacity are (1) the need to be near
customers, (2) the inability to store services, and (3) the degree of volatility of demand.
Convenience for customers is often an important aspect of service. Generally, a service must be
located near customers. Capacity must also be matched with the timing of demand. Unlike
goods, services cannot be produced in one period and stored for use in a later period. Similarly,
inventories of goods allow customers to immediately satisfy wants, whereas a customer who
wants a service may have to wait. This can result in a variety of negatives for an organization
that provides the service. Thus, speed of delivery, or customer waiting time, becomes a major
concern in service capacity planning. Demand volatility presents problems for capacity
planners. Demand volatility tends to be higher for services than for goods, not only in timing of
demand, but also in the time required to service individual customers.

EVALUATING ALTERNATIVES
a. Calculating Processing Requirements. When evaluating capacity alternatives, a
necessary piece of information is the capacity requirements of products that will be
processed with a given alternative. To get this information, one must have reasonably
accurate demand forecasts for each product, and know the standard processing time per
unit for each product on each alternative machine, the number of workdays per year,
and the number of shifts that will be used.
Samples Problem 5.3
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 Annual Demand Standard Processing Time
Processing Time Needed (Hr)
per Unit (Hr)

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 #1 400 5.0 2,000
#2 300 8.0 2,400
#3 700 2.0 1,400
5,800
Working one eight-hour shift, 250 days a year provides an annual capacity of 8 x
250 = 2,000 hours per year. We can see that three machines would be needed to
handle the required volume:
= 2.90 machines
b. Cost-Volume Analysis. Cost-volume analysis focuses on relationships between cost,
revenue, and volume of output. The purpose of cost-volume analysis is to estimate the
income of an organization under different operating conditions. It is particularly useful
as a tool for comparing capacity alternatives. Use of the technique requires
identification of all costs related to the production of a given product. These costs are
then designated as fixed costs or variable costs.
 Fixed Costs tend to remain constant regardless of volume of output. Examples
include rental costs, property taxes, equipment costs, heating and cooling
expenses, and certain administrative costs.
 Variable costs vary directly with volume of output. The major components of
variable costs are generally materials and labor costs. We will assume that
variable cost per unit remains the same regardless of volume of output.
 The total cost associated with a given volume of output is equal to the sum of
the fixed cost and the variable cost per unit times volume:
TC = FC + VC
VC = Q X v
Where; TC = Total Cost
VC= Variable Cost
Q = Quantity of Output
v = Variable Cost per Unit
 Total Revenue is computed as:
TR = R x Q
Where; TR = Total Revenue
R = Revenue per Unit
Q = Quantity of Output
 Break-even Point (BEP). The volume at which total cost and total revenue are
equal is referred to as the break-even point (BEP). When volume is less than the
break-even point, there is a loss; when volume is greater than the break-even
point, there is a profit. The greater the deviation from this point, the greater the
profit or loss. Total profit can be computed using the formula:
P = TR – TC = R X Q – (FC + v x Q)
P = Q(R – v) – FC
Q=
QBEP =
Sample Problem 5.4:
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 cost would be $2.00 per pie, and would retail for
$7.00 each.
a) How many pies must be sold in order to break even?
b) What would the profit (loss) be if 1,000 pies are made and sold in a
month?
c) How many pies must be sold to realize a profit of $4,000?
FC = $6,000; VC = $2 per pie; Rev = $7 per pie
Solution
a) QBEP = = = 1,200 pies/month
b) For Q = 1,000, P = Q(R-v) – FC = 1,000 ($7-$2) - $6,000 = - $1,000
c) P = $4,000; solve for Q:

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 Q= = = 2,000 pies
 Cost-volume analysis can be a valuable tool for comparing capacity alternatives
if certain assumptions are satisfied:
1. One product is involved.
2. Everything produced can be sold.
3. The variable cost per unit is the same regardless of the volume.
4. Fixed costs do not change with volume changes, or they are step changes.
5. The revenue per unit is the same regardless of volume.
6. Revenue per unit exceeds variable cost per unit.
c. Financial Analysis. Aproblem that is universally encountered by managers is how to
allocate scarce funds. A common approach is to use financial analysis to rank investment
proposals.
Two Important Terms in Financial Analysis:
 Cash Flow refers to the difference between the cash received from sales (of
goods or services) and other sources (e.g., sale of old equipment) and the cash
outflow for labor, materials, overhead, and taxes.
 Present value expresses in current value the sum of all future cash flows of an
investment proposal.

Three Most Commonly Used Methods of Financial Analysis:

 Payback is a crude but widely used method that focuses on the length of time it
will take for an investment to return its original cost.
 The present value (PV) method summarizes the initial cost of an investment, its
estimated annual cash flows, and any expected salvage value in a single value
called the equivalent current value, taking into account the time value of money
(i.e., interest rates).
 The internal rate of return (IRR) summarizes the initial cost, expected annual cash
flows, and estimated future salvage value of an investment proposal in an
equivalent interest rate. In other words, this method identifies the rate of return
that equates the estimated future returns and the initial cost.
d. Decision Theory. Decision theory is a helpful tool for financial comparison of alternatives
under conditions of risk or uncertainty. It is suited to capacity decisions and to a wide
range of other decisions managers must take.
 Causes of Poor Decisions.
1. Decision process. Managers may skip a step or not devote enough effort to
completing it before jumping to the next step.
2. Bounded rationality. The limitations on decision making caused by costs,
human abilities, time, technology, and availability of information.
3. Suboptimization. The result of different departments each attempting to
reach a solution that is optimum for that department.
 Decision Environments. The three basic categories of decision environment based on
the degree of certainty:
 Certainty. Environment in which relevant parameters have known
values.
 Risk. Environment in which certain future events have probable
outcomes.
 Uncertainty. Environment in which it is impossible to assess the
likelihood of various future events.
 Decision Making under Certainty. When it is known for certain which of the possible
future conditions will actually happen, the decision is usually relatively straightforward:
Simply choose the alternative that has the best payoff under that state of nature.
 Decision Making under Uncertainty. At the opposite extreme is complete uncertainty:
no information is available on how likely the various states of nature are. Under those
conditions, four possible decision criteria are maximin, maximax, Laplace, and
minimax regret.
 Maximin. Choose the alternative with the best of the worst possible
payoffs.

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  Maximax. Choose the alternative with the best possible payoff.
 Laplace. Choose the alternative with the best possible payoff.
 Minimax Regret. Choose the alternative that has the least of the worst
regrets.
Sample Problem 5.5
Referring to the table below, determine which alternative would be
chosen under each of these strategies.

a) Maximin
b) Maximax
c) Laplace
Solution:
a) Using maximin, the worst payoffs for the alternatives are:
Small Facility: $10 million
Medium Facility: 7 million
Large Facility: - 4 million
Hence, since $10 million is the best, choose to build the
small facility using maximin strategy.
b) Using maximax, the best payoffs are:
Small Facility: $10 millon
Medium Facility: 12 million
Large Facility: 16 million
The best overall payoff is $16 million in the third row.
Hence, the maximax criterion leads to building a large
facility.
c) For the Laplace criterion, first find the row totals, and then divide each of those
amounts by the number of states of nature (three in this case).
Because the medium facility has the highest average, it
would be chosen under the Laplace criterion.
 Decision Making under Risk. A widely used approach under such circumstances is the
expected monetary value criterion. Expected value is the sum of the payoffs for an
alternative where each payoff is weighted by the probability for the relevant state of
nature. Thus, the approach is:
 Expected MonetaryValue (EMV) criterion – determine payoff of each
alternative, and choose the alternative that has the best expected payoff.
Sample Problem 5.6
Using the expected monetary value criterion, identify the best alternative
for the previous payoff table for these probabilities: low = .30, moderate =
.50, and high = .20. Find the expected value of each alternative by
multiplying the probability of occurrence for each state of nature by the
payoff for that state of nature and summing them:
EVSMALL = .30($10) + .50($10) + .20($10) = $10
EVMEDIUM = .30($7) + .50($12) + .20($12) = $10.5
EVLARGE = .30(-4) + .50($2) + .20($16) = $3
Hence, choose the medium facility because it has the highest
expected value.
 Decision Trees. A decision tree is a schematic representation of the alternatives
available to a decision maker and their possible consequences. The term gets its name
from the treelike appearance of the diagram. The diagram below shows an example of
a decision tree:

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 e. Waiting Line Analysis. Analysis of lines is often useful for designing service systems.
Waiting lines have tendency to form a wide variety of service systems. The lines are
symptoms of bottleneck operations. Analysis is useful in helping managers choose a
capacity level that will be cost-effective through balancing the cost of having customers
wait with the cost of providing additional capacity. It can be aid in the determination of
expected cost for various levels of service capacity.

References
Stevenson, W.J. 2012. Operations Management. McGraw-Hill Companies Inc. New York, 11th
Edition
Stevenson, W.J. 2002. Operations Management. McGraw-Hill Companies Inc. New York, 7th
Edition
Kumar, A. S. & Suresh, N. 2009. Operations Management. New Age International (P) Limited,
Publishers. New Delhi

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