Chapter 5

Strategic Capacity Planning for

Products and Services

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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

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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

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Supply & Demand

Operations &
Supply Chains

Supply

Sales & Marketing

>

Demand

Supply

<

Demand

Supply

Demand

Wasteful
Costly

Opportunity Loss
Customer
Dissatisfaction

Ideal

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?
Should capacity be changed all at once, or through several
smaller changes
Can the supply chain handle the necessary changes?

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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

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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.

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Measuring System Effectiveness

Actual output
The rate of output actually achieved
It cannot exceed effective capacity

Efficiency

Utilization

actual output
Efficiency
effective capacity
Measured as percentages

actual output
Utilization
design capacity
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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
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Strategy Formulation
Strategies are typically based on assumptions
and predictions about:
Long-term demand patterns
Technological change
Competitor behavior

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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 cost benefit/volume analyses

5.

Select the best alternative for the long term

6.

Implement alternative chosen

7.

Monitor results

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Calculating Processing Requirements

Calculating processing requirements requires
reasonably accurate demand forecasts,
standard processing times, and available work
time k
NR

pD
i

i 1

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
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Example 1
A manager must decide which type of machine to
buy A,B or C machine cost are:
A
40,000
B
30,000
C
80,000

Lecturer: Ahmed El Rawas

5-13

Product forecast and processing time on the

machine are as follows
Product annual demand
processing time(min)
A B
C
1
16,000
3
4
2
2
12,000
4
4
3
3
6,000
5
6
4
4
30,000
2
2
1

Lecturer: Ahmed El Rawas

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Assume that only purchasing costs are being

considered, which machine would have the lowest
total cost ?and how many machine would be
needed? Machine operate 10 hours a day, 250
days a years.

Lecturer: Ahmed El Rawas

5-15

Step (1)
Calculate processing time needed by each machine
Product
A
B
C
1
48,000 64,000 32,000
2
48,000 48,000 36,000
3
30,000 36,000 24,000
4
60,000 60,000 30,000
_____
______ ______
186,000 208,000 122,000
Lecturer: Ahmed El Rawas

5-16

Step (2)
Calculate processing time available by the machines
10 X 250 X 60 = 150,000

Lecturer: Ahmed El Rawas

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Step (3)
Calculating number of needed machine
A= 186,000/ 150,000= 1.2 machine needed
B=

208,000/ 150,000= 1.4 machine needed

C=

122,000/ 150,000=0.8 machine needed

Lecturer: Ahmed El Rawas

5-18

Step (4)
Calculate the machine cost.
A= 2X40,000= 80,000
B= 2X30,000= 60,000
C= 1X80,000= 80,000
We will use machine 2 because it has the lowest
cost.

Lecturer: Ahmed El Rawas

5-19

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

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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

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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

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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

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Resolving Constraint Issues

1. Identify the most pressing constraint
2. Change the operation to achieve maximum benefit,
given the constraint
3. Make sure other portions of the process are supportive
of the constraint
4. Explore and evaluate ways to overcome the constraint
5. Repeat the process until the constraint levels are at
acceptable levels

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Evaluating Alternatives
Alternatives should be evaluated from varying
perspectives
Economic

Cost-volume analysis
Financial analysis
Decision theory
Waiting-line analysis
Simulation

Non-economic
Public opinion

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Cost-Volume Analysis
Cost-volume analysis
Focuses on the relationship between cost, revenue, and volume of
output
Fixed Costs (FC)
tend to remain constant regardless of output volume

Variable Costs (VC)

vary directly with volume of output
VC = Quantity(Q) x variable cost per unit (v)

Total Cost
TC = Q x v

Total Revenue (TR)

TR = revenue per unit (R) x Q

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Break-Even Point (BEP)

BEP
The volume of output at which total cost and total
revenue are equal
Profit (P) = TR TC = R x Q (FC +v x Q)
= Q(R v) FC

QBEP

FC

Rv

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Cost-Volume Relationships

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Cost volume analysis

29

Fixed cost = 1000

Selling price per unit = 15$
Variable cost per unit= 10$
Calculate the break even point, and the profit.
Q= FC/ R-v
1000/ 15-10 = 200
Profit= TR- TC 15*200 1000+ 10*200 = zero
Also calculate the profit when the TR = 6000
6000- 3000= 3000

Lecturer. Ahmed El Rawas

5-29

Financial Analysis
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 flow of an
investment proposal

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Balance sheet:

31

Balance sheet: referred to as statement of

financial position or condition, reports on a
company's assets, liabilities, and net equity as of a
given point in time.
Another definition: is an accountant snapshot of the
firms accounting value on a particular date, as
through the firm stood momentarily still.
The balance sheet shows what assets the firm
controls at a point in time and how it financed the
assets.
Assets= Liabilities + owners equity
Lecturer. Ahmed El Rawas

5-31

Income statement:
Income statement: also referred to as Profit and
Loss statement reports on a company's income,
expenses, and profits over a period of time. Profit
& Loss account provide information on the
operation of the enterprise. These include sale and
the various expenses incurred during the
processing state.
The income statement indicates the flow of sales,
expenses, and earnings during a period of time.
Revenues- Expenses= Income
32
Lecturer. Ahmed El Rawas

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(3)Financial analysis
Financial ratios can be used to estimate systematic
risk.
Financial analysis often assess the firm's:
1. Profitability - its ability to earn income and sustain
growth in both short-term and long-term. A
company's degree of profitability is usually based on
the income statement, which reports on the
company's results of operations;
2. Solvency - its ability to pay its obligation to
creditors and other third parties in the long-term. 33
Lecturer. Ahmed El Rawas

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Financial analysis
3.Liquidity - its ability to maintain positive cash flow,
while satisfying immediate obligations;
4. Stability- the firm's ability to remain in business in
the long run, without having to sustain significant
losses in the conduct of its business. Assessing a
company's stability requires the use of both the
income statement and the balance sheet, as well
as other financial and non-financial indicators.
34
Lecturer. Ahmed El Rawas

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Pay back period

35

The payback, also called pay-off period, is defined

as the period required to recover the original
investment outlay through the accumulated net
profit/loss earned by the project.
Year+ cumulative net cash flow in previous period\
Net cash flow in the next period

Lecturer. Ahmed El Rawas

5-35

Net present value

36

The net present value of a project is defined as the

value obtained by discounting, at a constant
interest rate and separately for each year, the
differences of all annual cash outflows and inflows
accruing throughout the life of a project.
NPV= NCFn\ (1 + r)n
Accept a project if the NPV is greater than Zero
Reject a project if the NPV is less than Zero

Lecturer. Ahmed El Rawas

5-36

Internal rate of return

37

The internal rate of return is the discount rate at

which the present value of cash inflows is equal to
the present value of cash outflows.

Lecturer. Ahmed El Rawas

5-37