II Shreeram II

Module 1.2

Notes on capacity management

What is capacity management.

It is necessary to recognize the difference between theoretical capacity and normal capacity.
Theoretical capacity is what can be achieved under ideal conditions for a short period of time. Under
these conditions, there are no equipment breakdowns, maintenance requirements, set up times,
bottlenecks, or worker errors.

However, to an operations manager, this description of Capacity may be quite meaningless., there
have to be allowances made for maintenance, breakdowns, set up times, errors, etc.

Capacity, therefore, is the quantity of output, which is estimated based on normal conditions.

Normal Capacity describes the maximum producible output when plants and equipment are
operated for an average period of time to produce a normal mix of output.

Due to defining capacity in this manner, it is not unusual for a facility to operate at more than 100
per cent capacity. Capacity is mathematically expressed as:

Capacity = (Maximum production rate/Hour) x (Number of hours worked/Period); where,

Production Rate = Number of units produced/Amount of time

Efficiency calculations

Efficiency is a measure of actual output over Effective Capacity

and is expressed as a percentage of the Effective Capacity.

The Rated Capacity is a measure of the maximum usable capacity of a particular facility.

Rated capacity = (Capacity) (Utilization) (Efficiency)

Example: One facility has an efficiency of 90 per cent, and the utilization is 80 per cent.
Three process lines are used to produce the products. The lines operate 6 days a week
and three 8-hour shifts per day. Each line was designed to process 100 standard
products per hour. The rated capacity is:
Rated Capacity = (Capacity) (Utilization)
(Efficiency)
= (100) (3) (144) (0.8) (0.9)
= 31,104 products/week.
 Determinants of Effective Capacity

(What are the factors impacts effective capacity)

Most of the capacity plans are based on the following:

1. Set time and resource allocation to meet demand;
2. Set strategies for meeting new requirements (new demand, competition, time
changes for projects, etc.); and
3. Determine the cost of non-conformance to the plan (waste, time slippage, costs,
variance in quality, etc.).

Determinants of effective capacity are:

1. Facilities
2. Product and service factors
3. Process factors
4. Human factors
5. Operational factors
6. Supply chain factors
7. External Environment
 Determining Capacity Requirements: Planning Capacity

Why capacity planning

capacity planning has to address the external environment of the firm. One needs to assess the
company's situation and think about why the decision to alter capacity should be considered.

1) It can be based on forecasting demand in future

2) It can be based on competitors moves and positioning in the market.

3) New technologies can make you uncompetitive. It is important to understand why you are making
a change in your capacity levels. Management, before taking a decision on capacity, needs to take
the following steps:

A) Forecast demand for individual products within each product line.

B) Calculate the array of assets required to meet product line forecasts.

C) Project availabilities of the existing array of assets over the planning ahorizon

When to do the capacity planning

The timing and sizing of expansion are related. Capacity gap analysis is essential in determining when
demand will exceed Capacity and by how much. Gap analysis tells you what kind of Capacity you
need at given points in time. The temporal dimension of Capacity analysis is important.

Capacity offerings can also yield a competitive advantage. You have to determine whether or not
you will gain a competitive advantage by introducing that kind of capacity at a particular point in
time
 Tactics for matching Capacity to demand: Even with good forecasting and facilities built to that
forecast, there may be a poor match between the actual demand that occurs and the capacity
available.

In the case of seasonal or cyclical pattern of demand, the organization can offer products with
complementing demand patterns, that is, products for which the demand is opposite. With
appropriate complementing products, perhaps the utilization of facility, equipment, and personnel
can be smoothed.
1. Adding people to the production process; if the operation runs two shifts five days a week,
then overtime or another shift could be considered.
2. Increasing the motivation of production employees; by providing incentives, involving people
in the operating problems, improving job satisfaction etc.
3. Adjusting equipment and processes, which may require purchase of additional machinery or
selling or leasing existing equipment.
4. Redesigning the product to facilitate more throughput.
5. Improving the operating rate of equipment; better scheduling, improved operating
procedures, or improved quality of raw materials can increase capacity by increasing product
yield.

How much capacity to be added?

The decision about how much capacity to be added is again critical. It is complicated by the
uncertainly in the estimates of future demand and technological changes. There can be two
extreme strategies:
1) Expansionist strategy, which involves large, infrequent jumps in capacity :
- The expansionist strategy, which stays ahead of demand, minimizes the chance of sales
lost to insufficient capacity.
- The expansionist strategy or economic approach generally results in economies of scale
and a faster rate of learning.
- It also can help increase the firm's market share by preempting competition.
2) Wait-and-see strategy, which involves smaller, more frequent incremental jumps.
- Smaller capacity enhancement projects as per the time and requirement
Developing Capacity Alternatives

1. 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.
2. Take stage of life cycle into account: Capacity requirements are often closely linked to the
stage of the life cycle that a product or service is in.
3. Take a "big-picture" (i.e., Systems) approach to capacity changes:When developing capacity
alternatives, it is important to consider how parts of the system interrelate.
4. 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.
5. Attempt to smooth out capacity requirements: Unevenness in capacity requirements also can
create certain problems.
6. Identify the optimal operating level: Production units typically have an ideal or optimal level of
operation in terms of unit cost of output.
- Economies of Scale: Economies of scale can also be realized as a result of the company's
geographical location. Thus all industries located in the same area could benefit from
lower transportation costs and a skilled labour force. Moreover, ancillary industries may
then begin to develop, and support such industries.
- External economies of scale can also be obtained if the industry shares technology or
managerial expertise. For example, this can lead to the creation of standards within an
industry. Just as there are economies of scale, there are also diseconomies of scale.

CVP Analysis

- Cost-volume-profit (CVP) analysis is a technique that examines changes in profits in

response of changes in sales volumes, costs, and prices. Firms perform CVP analysis to
plan future levels of operating activity and provide information about:
- Which products or services to emphasize
- The volume of sales needed to achieve a targeted level of profit
- The amount of revenue required to avoid losses
- Whether to increase fixed costs
- How much to budget for discretionary expenditures
- Whether fixed costs expose the organization to an unacceptable level of risk CVP analysis
begins with the basic profit equation.
 - Profit = Total revenue – Total costs
- Separating costs into variable and fixed categories, we express profit as: Profit = Total
revenue – Total variable costs – Total fixed costs
- The contribution margin is total revenue minus total variable costs. Similarly, the
contribution margin per unit is the selling price per unit minus the variable cost per unit.
Both contribution margin and contribution margin per unit are valuable tools when
considering the effects of volume on profit. Contribution margin per unit tells us how
much revenue from each unit sold can be applied toward fixed costs. Once enough units
have been sold to cover all fixed costs, then the contribution margin per unit from all
remaining sales becomes profit.
- If we assume that the selling price and variable cost per unit are constant, then total
revenue is equal to price times quantity, and total variable cost is variable cost per unit
times quantity. We then rewrite the profit equation in terms of the contribution margin
per unit.

Profit = P*Q – V *Q – F = (P – V) – Q – F
Where, P is the Selling price per unit V is the Variable cost per unit
(P – V) is the Contribution margin per unit
Q is the Quantity of product sold (units of goods or services) F is the
Total fixed costs
We use the profit equation to plan for different volumes of operations. CVP analysis can be
performed using either:
1. Units (quantity) of product sold
2. Revenues (in Rupees)

Summary of Topic Capacity

 Capacity planning should be solely based on the principle of maximizing the value
delivered to the customer.
 Theoretical capacity is what can be achieved under ideal conditions for a short period of
time. Under these conditions, there are no equipment breakdowns, maintenance
requirements, set up times, bottlenecks, or worker errors.
 Normal Capacity describes the maximum producible output when plants and equipment
are operated for an average period of time to produce a normal mix of output.
 Top management often finds it desirable to express addition to new capacity in terms of
money value of sales.
 No matter how broadly we may define capacity, in the final analysis, in manufacturing, it
has to come down to capacity of individual machines.
 To estimate Capacity, you must first select a yardstick to measure it. The first major task
in Capacity Measurement is to define the unit of output.
 Whatever the measure, the Capacity decision is critical to the management of an
organization because everything from cost to customer service is measured on the basis
of the Capacity of the process, once the Capacity is determined.
 Capacity planning has to address the external environment of the firm. One needs to
assess the company's situation and think about why the decision to alter capacity should
be considered.
 The timing and sizing of expansion are related. Capacity gap analysis is essential in
determining when demand will exceed Capacity and by how much.
 When capacity exceeds demand, the firm may want to simulate demand through price
reductions or aggressive marketing, or accommodate the market through product
changes.
 Decision Trees are most commonly used in capacity planning. They are excellent tools for
helping choose between several courses of action.
 Processes underlie all activities and hence are found in all organizations and functions. In
addition, processes create an inter-connected set of linkages, which connect the external
and internal linkages.
 Despite their differences, the concepts of determining system capacity and finding
bottlenecks apply to service as well. The principles are the same but in some cases the
application is different.
 Cost-volume-profit (CVP) analysis is a technique that examines changes in profits in
response to changes in sales volumes, costs, and prices.