Capacity - actual output as a percentage of design capacity

- Is the “throughput,” or the number of units a facility can hold, receive, store, or Efficiency
produce in a given time. - actual output as a percentage of effective capacity
- Capacity decisions often determine capital requirements and therefore a
large portion of fixed cost. DETERMINING CAPACITY, UTILIZATION AND EFFICIENCY
- Determines whether demand will be satisfied or whether facilities will be idle. Example no.1
Capacity planning can be viewed in three time horizons Sara James Bakery has a plant for processing deluxe breakfast rolls and wants
 Long- range capacity (greater than 3 years) to better understand its capability. Last week the facility produced 148,000 rolls. The
- is a function of adding facilities and equipment that have a long lead time effective capacity is 175,000 rolls. The production line operates 7 days per week, with
 Intermediate range (3 to 36 months) three 8-hour shifts per day. The line was designed to process the nut-filled, cinnamon-
- includes adding equipment, personnel, and shifts flavored deluxe roll at a rate of 1,200 per hour. Determine the design capacity,
- Sub-contract occurs utilization, and efficiency for this plant when producing this deluxe roll.
-build or use inventory SOLUTION
-this is the “aggregate planning” task Design capacity = (7 days * 3 shifts * 8 hours) * (1,200 rolls per hour) = 201,600 rolls
 Short run (up to 3 months) Utilization = Actual output>Design capacity = 148,000>201,600 = 73.4
- Primarily concerned with scheduling jobs and people, as well as allocating Efficiency = Actual output>Effective capacity = 148,000>175,000 = 84.6
machinery
- modifying capacity in the short run is difficult, as we are usually constrained EXPANDING CAPACITY
by existing capacity. The manager of Sara James Bakery now needs to increase production of the
increasingly popular Deluxe roll. To meet this demand, she will be adding a second
production line. The second line has the same design capacity (201,600) and effective
capacity (175,000) as the first line; however, new workers will be operating the second
line. Quality problems and other inefficiencies stemming from the inexperienced
workers are expected to reduce output on the second line to 130,000 (compared to
148,000 on the first). The utilization and efficiency were 73.4% and 84.6%, respectively,
on the first line. Determine the new utilization and efficiency for the deluxe roll
operation after adding the second line.
SOLUTION
Design capacity = 201,600 X 2 =403,200 rolls
Effective capacity = 175,000 X 2 = 350,000 rolls
Actual output = 148,000 + 130,000 = 278,000 rolls
Utilization = Actual output /Design capacity = 278,000 / 403,200 =68.95%
Efficiency = Actual output /Effective capacity = 278,000 / 350,000 =
79.43%
Design and Effective Capacity
Design capacity Capacity and Strategy
- is the maximum theoretical output of a system in a given period under ideal Capacity Considerations
conditions Four special considerations for a good capacity decision:
- normally expressed as a rate, such as the number of tons of steel that can be 1. Forecast demand accurately
produced per week, per month, or per year 2. Match technology increments and sales volume
- it is the maximum number of units the company is capable of producing in a 3. Find the optimum operating size and volume
specific time. 4. Build for change
Effective capacity
- the capacity a firm can expect to achieve, given its product mix, methods of
scheduling, maintenance, and standards of quality
Utilization
 Each industry develops its own
approaches to matching demand and
capacity. Other more aggressive
approaches to demand management
include many variations of discounts:
“early bird” specials in restaurants,
discounts for matinee performances or
for seats at odd hours on an airline, and
cheap weekend hotel rooms.
Capacity Management
When managing demand is not feasible, then managing capacity through changes in
full-time, temporary, or part-time staff may be an option. This is the approach in many
services.
Managing Demand
Even with good forecasting and facilities built to accommodate that forecast, there BOTTLENECK ANALYSIS AND THE THEORY OF CONSTRAINTS
may be a poor match between the actual demand that occurs and available Capacity analysis involves determining the throughput capacity of workstations in a
capacity. system and ultimately the capacity of the entire system.
Demand Exceeds Capacity Bottleneck is an operation that is the limiting factor or constraint. The term bottleneck
When demand exceeds capacity, the firm may be able to curtail demand simply by refers to the literal neck of a bottle that constrains flow or, in the case of a production
raising prices, scheduling long lead times, and discouraging marginally profitable system, constrains throughput. A bottleneck has the lowest effective capacity of any
business. However, because inadequate facilities reduce revenue below what is operation in the system and thus limits the system’s output.
possible, the long-term solution is usually to increase capacity. Process time of a station is the time to produce a unit (or a specified batch size of
Capacity Exceeds Demand units) at that workstation.
When capacity exceeds demand, the firm may want to stimulate demand through For example, if 16 customers can be checked out in as supermarket line every 60
price reductions or aggressive marketing, or it may accommodate the market through minutes, then the process time at that station is 3.75 minutes per customer (= 60/16).
product changes. When decreasing customer demand is combined with old and (Process time is simply the inverse of capacity, which in this case is 60 minutes per
inflexible processes, layoffs and plant closings may be necessary to bring capacity in hour/3.75 minutes per customer which is equal to 16 customers per hour.)
line with demand. To determine the bottleneck in a production system, simply identify the station
Adjusting to Seasonal Demands with the slowest process time. The Bottleneck time is the process time of the slowest
A seasonal or cyclical pattern of demand is another capacity challenge. In such workstation (the one that takes the longest) in a production system.
cases, management may find it helpful to offer products with complementary For example, the flowchart in figure S7.4 shows a simple assembly line. Individual
demand patterns—that is, products for which the demand is high for one when low for station process times are 2, 4, and 3 minutes, respectively. The bottleneck time is 4
the other. minutes. This is because station B is the slowest station. Even if we were to speed up
By Combining Products That Have Complementary Seasonal Patterns, Capacity Can station A, the entire production process would not be faster. Inventory would simply
Be Better Utilized pile up in front of station B even more than now. Likewise, if station C could work faster,
we could not tap its excess capacity because station B will not be able to feed
Tactics for Matching Capacity to Demand products to it any faster than 1 every 4 minutes.
1. Making staffing changes
2. Adjusting equipment
3. Improving processes to increase throughput
4. Redesigning products to facilitate more throughputs
5. Adding process flexibility to better meet changing product preferences Figure S7.4Three-Station Assembly Line
6. Closing facilities The throughput time, on the other hand, is the time it takes a unit to go through
Demand Management production from start to end, with no waiting. (Throughput time describes the
When demand and capacity are fairly well matched, demand management can behavior in an empty system. In contrast, flow time describes the time to go through a
often be handled with appointments, reservations, or a first-come, first- served rule. production process from beginning to end, including idle time waiting for stations to
finish working on other units.) The throughput time to produce a new completed unit in
Figure S7.4 is 9 minutes (= 2 minutes + 4 minutes + 3 minutes).
EXAMPLE 1: SOLUTION:
CAPACITY ANALYSIS WITH PARALLEL PROCESSES The bottleneck in this system is the hygienist cleaning operation at 24 minutes per
Howard Kraye’s sandwich shop provides healthy sandwiches for customers. patient, resulting in an hourly system capacity of 60 minutes>24 minutes per patient =
Howard has two identical sandwich assembly lines. A customer first places an order, 2.5 patients. The throughput time is the maximum of the two paths through the system.
which takes 30 seconds. The order is then sent to one of the two assembly lines. Each The path through the X-ray exam is 2 + 2 + 4 + 5 + 8 + 6 = 27 minutes, while the path
assembly line has two workers and three operations: (1) assembly worker 1 retrieves through the hygienist cleaning operation is 2 + 2 + 4 + 24 + 8 + 6 = 46 minutes. Thus a
and cuts the bread (15 seconds/sandwich), (2) assembly worker 2 adds ingredients patient should be out the door after 46 minutes (i.e., the maximum of 27 and 46).
and places the sandwich onto the toaster conveyor belt (20 seconds/sandwich), and Theory of Constraints
(3) the toaster heats the sandwich (40 seconds/sandwich). Finally, another employee TOC is a body of knowledge that deals with anything that limits or constrains an
wraps the heated sandwich coming out of the toaster and delivers it to the customer organization’s ability to achieve its goals. Constraints can be physical (e.g., process or
(37.5 seconds/sandwich). A flowchart of the process is shown below. Howard wants to personnel availability, raw materials, or supplies) or nonphysical (e.g., procedures,
determine the bottleneck time and throughput time of this process. morale, and training).
5 steps process
STEP 1: Identify the constraints.
STEP 2: Develop a plan for overcoming the identified constraints.
STEP 3: Focus resources on accomplishing Step 2.
STEP 4: Reduce the effects of the constraints by off-loading work or by expanding
capability. Make sure that the constraints are recognized by all those who can have
SOLUTION: an impact on them.
Because each of the three assembly-line operations uses a separate resource STEP 5: When one set of constraints is overcome, go back to Step 1 and identify new
(worker or machine), different partially completed sandwiches can be worked on constraints.
simultaneously at each station. Thus, the bottleneck time of each assembly line is the Bottleneck Management
longest process time of each of the three operations. In this case, the 40-second A crucial constraint in any system is the bottleneck, and managers must focus
toasting time represents the bottleneck time of each assembly line. Next, the significant attention on it.
bottleneck time of the combined assembly line operations is 40 seconds per two Four principles of bottleneck management:
sandwiches, or 20 seconds per sandwich. Therefore, the wrapping and delivering 1. Release work orders to the system at the pace set by the bottleneck’s capacity:
operation, with a process time of 37.5 seconds, appears to be the bottleneck for the The theory of constraints utilizes the concept of drum, buffer, rope to aid in the
entire operation. The capacity per hour equals 3,600 seconds per hour/37.5 seconds implementation of bottleneck and non-bottleneck scheduling.
per sandwich = 96 sandwiches per hour. The throughput time equals 30 + 15 + 20 + 40  Drum is the beat of the system. It provides the schedule—the pace of
+ 37.5 = 142.5 seconds (or 2 minutes and 22.5 seconds), assuming no wait time in line to production.
begin with.  Buffer is the resource, usually inventory, which may be helpful to keep the
EXAMPLE 2: bottleneck operating at the pace of the drum.
CAPACITY ANALYSIS WITH SIMULTANEOUS PROCESSES  Rope provides the synchronization or communication necessary to pull units
Dr. Cynthia Knott’s dentistry practice has been cleaning customers’ teeth for through the system. The rope can be thought of as signals between
decades. The process for a basic dental cleaning is relatively straightforward: (1) the workstations.
customer checks in (2 minutes); (2) a lab technician takes and develops X-rays (2 and 2. Lost time at the bottleneck represents lost capacity for the whole system:
4 minutes, respectively); (3) the dentist processes and examines the X-rays (5 minutes) This principle implies that the bottleneck should always be kept busy with work.
while the hygienist cleans the teeth (24 minutes); (4) the dentist meets with the patient Well-trained and cross-trained employees and inspections prior to the bottleneck can
to poke at a few teeth, explain the X-ray results, and tell the patient to floss more often reduce lost capacity at a bottleneck.
(8 minutes); and (5) the customer pays and books her next appointment (6 minutes). A 3. Increasing the capacity of a no bottleneck station is a mirage:
flowchart of the customer visit is shown below. Dr. Knott wants to determine the Increasing the capacity of non-bottleneck stations has no impact on the
bottleneck time and throughput time of this process. system’s overall capacity. Working faster on a non-bottleneck station may just create
extra inventory, with all of its adverse effects. This implies that non-bottlenecks should
have planned idle time. Extra work or setups at non-bottleneck stations will not cause
delay, which allows for smaller batch sizes and more frequent product changeovers at Notably, costs and revenue are shown as straight lines. They are shown to increase
non-bottleneck stations. linearly—that is, indirect proportion to the volume of units being produced. However,
4. Increasing the capacity of the bottleneck increases capacity for the whole system: neither fixed costs nor variable costs (nor, for that matter, the revenue function) need
Managers should focus improvement efforts on the bottleneck. Bottleneck be a straight line. For example, fixed costs change as more capital equipment or
capacity may be improved by various means, including offloading some of the warehouse space is used; labor costs change with overtime or as marginally skilled
bottleneck operations to another workstation increasing capacity of the bottleneck workers are employed; the revenue function may change with such factors as volume
(adding resources, working longer or working faster), subcontracting, developing discounts.
alternative routings, and reducing setup times.
Single-Product Case
Break-Even Analysis The formulas for the break-even point in units and dollars for a single product are
-is the critical tool for determining the capacity a facility must have to achieve shownbelow.
profitability. A means of finding the point in dollars and units, at which costs equal Let:
revenues. It is based on categorizing production costs between those which are BEPx= break-even point in units TR = total revenue = Px
"variable" (costs that change when the production output changes) and those that BEP+ = break-even point in dollars F = fixed costs
are "fixed" (costs not directly related to the volume of production). P = price per unit (after all discounts)
THREE ELEMENTS OF BREAK-EVEN ANALYSIS V = variable costs per unit
1. Fixed Cost are costs that continue even if no units are produced. In other words, x = number of units produced
even if the business has a zero output or high output, the level of fixed costs will remain TC = total costs = F + Vx
broadly the same. The break-even point occurs where total revenue equals total costs. Therefore:
Example of Fixed Cost TR = TC or Px = F + Vx
-Rent and rates
-Depreciation Using these equations, we can solve directly for break-even point and profitability. The
-Research and Development two break-even formulas of interest are:
-Marketing Cost
-Administration Cost ( )
2. Variable Cost are those that vary with the volume of units produced. They represent
( )
payment output-related inputs such as raw materials, direct labor, fuel and revenue-
related costs such as commission.
Example of Variable Cost Example:
-Labor Cost SINGLE-PRODUCT BREAK-EVEN ANALYSIS
-Utility Cost
-Commissions Stephens, Inc. wants to determine the minimum dollar volume and unit volume
-Cost of Raw Materials needed at its new facility to break even.
3. Revenue Function
APPROACH: The firm first determines that it has fixed costs of $10,000 this period. Direct
labor is $1.50 per unit and material is $.75 per unit. The selling price is $4.00 per unit.

SOLUTION: The break-even point in dollars is computed as follows:

The break-even point in units is:

Multiproduct Case APPROACH: Using the data in Example S6 , we take the forecast sandwich sales of
62.1% times the
daily break-even of $245.50 divided by the selling price of each sandwich ($5.00).

SOLUTION: At break-even, sandwich sales must then be:

MULTIPRODUCT BREAK-EVEN ANALYSIS

Le Bistro, like most other restaurants, makes more than one product and would like to REDUCING RISK WITH INCREMENTAL CHANGES
know its breakeven point in dollars. Information for Le Bistro follows. Fixed costs are When demand for goods and services can be forecast with a reasonable
$3,000 per month. degree of precision, determining a break-even point and capacity requirements can
rather be straightforward. But, more likely, determining the capacity and how to
achieve it will be complicated, as many factors (technology, competitors, building
restrictions, cost of capital, human resource options) are difficult to measure and
quantify. The contradiction between the demand growth and capacity additions
adds to the capacity decision risk. To reduce risk, incremental changes that hedge
demand forecasts may be a good one.
FOUR APPROACHES TO NEW CAPACITY
1. Leading demand with an incremental expansion.
Leads capacity—that is, acquires capacity to stay ahead of demand until the
beginning of period 1. This capacity handles increased demand until the
beginning of period 2. At the beginning of period 2, new capacity is again
acquired, allowing the organization to stay ahead of demand until the
beginning of period 3.
2. Leading demand with a one-step expansion.
Managers can elect to make a larger increase at the beginning of period 1— Applying Expected Monetary Value (EMV) to Capacity Decisions
an increase that may satisfy expected demand until the beginning of period 3. Determining expected monetary value (EMV) requires specifying alternatives and
various states of nature.
 For capacity-planning situations, the state of nature usually is future demand or
market favourability.
 By assigning probability values to the various states of nature, we can make
decisions that maximize the expected value of the alternatives.

EMV APPLIED TO CAPACITY DECISION .

PROBLEM 1
Southern Hospital Supplies, a company that makes hospital gowns, is
considering capacity expansion. Sothern’s major alternatives are to do nothing, build
a small plant, build a medium plant, or build a large plant. The new facility would
3. Lagging demand with incremental expansion. produce a new type of gown, and currently the potential or marketability for this
Option that lags capacity, using overtime or subcontracting to accommodate product is unknown. If a large plant is built and a favorable market exists, a profit of
excess demand. $100,000 could be realized. An unfavorable market would yield a $90,000 loss.
However, a medium plant would earn a $60,000 profit with a favorable market. A
$10,000 loss would result from an unfavorable market. A small plant, on the other hand,
would return $40,000 with favorable market conditions and lose only $5,000 in an
unfavorable market. Of course, there is always the option of doing nothing.
Recent market research indicates that there is a 0.4 probability of a favorable
market, which means that there is also a 0.6 probability of an unfavorable market. With
this information, the alternative that will result in the highest expected monetary value
(EMV) can be selected.
SOLUTION: Compute the EMV for each alternative:
EMV (large plant) = (0.4) ($100,000) + (0.6) (-$90,000) = - $14,000
EMV (medium plant) = (0.4) ($60,000) + (0.6) (-$10,000) = + $18,000
EMV (small plant) = (0.4) ($40,000) + (0.6) (-$5,000) = + $13,000
EMV (do nothing) = + $0
4. Attempts to have an average capacity that straddles demand with Answer: Based on EMV criteria, Southern should build a medium plant.
incremental expansion.
Straddles demand by building capacity that is “average”, sometimes lagging If a new estimate of the loss from a medium plant in an unfavorable market increases
demand and sometimes leading it. Both the lag and straddle option have the to –$20,000, what is the new EMV for this alternative?
advantage of delaying capital expenditure. EMV (large plant) = (0.4) ($100,000) + (0.6) (-$90,000) = - $14,000
EMV (medium plant) = (0.4) ($60,000) + (0.6) (-$20,000) = + $12,000
EMV (small plant) = (0.4) ($40,000) + (0.6) (-$5,000) = + $13,000
EMV (do nothing) = + $0
Answer: $12,000, which changes the decision because the small plant EMV is now
higher.

PROBLEM 2
James Lawson’s Bed and Breakfast, in a small historic Mississippi town, must decide
how to subdivide (remodel) the large old home that will become its inn. There are
three alternatives: Option A would modernize all baths and combine rooms, leaving
the inn with four suites, each suitable for two to four adults. Option B would modernize
only the second floor; the results would be six suites, four for two to four adults, and two ( )
for two adults only. Option C (the status quo option) leaves all walls intact. In this case, The previous equations are used to determine the present value of one future
there are eight rooms available, but only two are suitable for four adults, and four cash amount, but there are situations in which an investment generates a series of
rooms will not have private baths. Below are the details of profit and demand patterns uniform and equal cash amount. This type of investment is called an annuity.
that will accompany each option: ( )
[ ]
( )
Example: River Road Medical Clinic is thinking of investing in a sophisticated new
piece of medical equipment. It will generate $7000 per year in receipts for 5 years.
Determine the present value of this cash flow; assume an interest rate of 6%.
( )
[ ]
( )
When deciding among investment alternatives, you pick the investment with
the highest net present value. Similarly, when making several investments those with
higher net present values are preferable to investments with lower net present values.
EMV (modernize all) = (0.5) ($90,000) - (0.5) ($25,000) = $32,500
Although net present value is one of the best approaches to evaluating
EMV (modernize 2nd) = (0.4) ($80,000) - (0.6) ($70,000) = - $10,000 investment alternatives, it does have its fault. Limitations of the net present value
EMV (status quo) = (0.3) ($60,000) - (0.7) ($55,000) = - $20,500 approach include the following:
EMV (do nothing) = + $0 1. Investment with the same net present value may have significantly different
Answer: Based on EMV criteria, James Lawson’s Bed and Breakfast should modernize
projected lives and different salvages values.
all baths and combine rooms.
2. Investment with the same net present value may have different cash flows.
Different cash flows may make substantial differences in the company’s ability
APPLYING INVESTMENT ANALYSIS TO STRATEGY DRIVEN INVESTMNETS to pay its bills.
Once the strategy implications of potential investments have been considered, 3. The assumption is that we know future interest rates, which we do not.
traditional investment analysis is appropriate. 4. Payments are always made at the end of the period (week, month, or year),
INVESTMENT, VARIABLE COST, AND CASH FLOW
which is not always the case.
Because capacity and process alternatives exist, so do options regarding
capital investment and variable cost. Managers must choose from among different
financial options as well as capacity and process alternatives. Analysis should show the
capital investment, variable cost, and cash flow as well as net present value for each
alternative.
NET PRESENT VALUE
Determining the discount value of a series of future cash receipts is known as
net present value.
Example: You invest $100 in a bank at 5% for 2 years.
100(1+0.05)2 = $110.25
In general:
( )
Where: F = future value (such as $110.25)
P = present value (such as $100.00)
i = interest rate (such as 0.05)
N = number of years (such as 2 years)
Solving for P