Chapter 3

Capacity Planning
FOR
Products and Services
 Learning Objectives
• Explain the importance of capacity planning.
• Discuss ways of defining and measuring
capacity.
• Describe the determinants of effective
capacity.
• Discuss the major considerations related to
developing capacity alternatives.
• Briefly describe approaches that are useful
for evaluating capacity alternatives
 Definitions
Capacity refers to :
The upper limit or ceiling on the load that
an operating unit can handle

Operating units might be:

•Plant
•Department
•Machine
•Store
•worker
 Definitions
Capacity planning aims to :
Achieve a match between supply
capabilities and the predicted level of
demand

Strategic capacity planning:

It is a long-term capacity planning
Reasons of capacity planning

Changes in
demand

Changes in
Opportunity
technology

capacity
planning

Changes in Perceived
environment threats
 Capacity gap
It is the gap between current capacity (supply) and desired
capacity (demand) if the capacity is out of balance

Current capacity Strained resources

< under capacity and loss of
desired Capacity customer

Current capacity
Operating costs
> over capacity
too high
desired Capacity
The basic questions in capacity handling

How much
is needed?

forecasting

What kind
When is it of capacity
needed? is needed?
 When capacity planning ?

It is made very infrequently and in others, it is

made regularly depends on the following
factors :
➢The stability of demand
➢The rate of technological change of
Equipment and product design
➢ Competitive factors
➢ Others factors
•The type of product and services
•Whether styles changes are important
 Importance of Capacity Decisions

1. Impacts ability to meet future demands

2. Affects operating costs
3. Major determinant of initial costs
4. Involves long-term commitment of resources
5. Affects competitiveness
6. Affects ease of management
7. Globalization adds complexity
8. Impacts long range planning
 Capacity terminology
• Design capacity
– maximum output rate or service capacity an operation,
process, or facility is designed for.
– Under ideal conditions
• Effective capacity
– Design capacity minus allowances such as personal time,
maintenance, and scrap.
– Under ideal conditions
• Actual output
– rate of output actually achieved--cannot
exceed effective capacity.
 Measuring capacity
Actual output
Efficiency =
Effective capacity

Actual output
Utilization =
Design capacity

Both measures expressed as percentages

 Efficiency/Utilization
Example

Design capacity = 50 trucks/day

Effective capacity = 40 trucks/day
Actual output = 36 units/day
Actual output = 36 units/day
Efficiency = = 90%
Effective capacity 40 units/ day

Utilization = Actual output = 36 units/day

= 72%
Design capacity 50 units/day
 Efficiency vs Utilization
100.00%

90.00%
90.00%

80.00%
72.00%
70.00%

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%
Efficiency Utilization
 Determinants of Effective Capacity
• Facilities (size, location, layout, heating, lighting, ventilations)
• Product and service factors (similarity of products)
• Process factors (productivity, quality)
• Human factors (training, skills, experience, motivations, absenteeism, turnover)
• Policy factors (overtime system, no. of shifts)
• Operational factors (scheduling problems, purchasing requirements,
inventory shortages)
• Supply chain factors (warehousing, transportation, distribution)
• External factors (product standards, government agencies, pollution standard)
 Strategy Formulation
Capacity strategy based on assumptions
and prediction about long-term demand
patterns, Technological changes and
Behavior of competitors

This is involve:
•Growth rate and variability of demand
•Cost of building and operating facilities
•Rate and direction of technology changes
•Behavior of competitors
•Availability of capital and other inputs
 Steps for Capacity Planning

1. Estimate future capacity requirements

2. Evaluate existing capacity
3. Identify alternatives
4. Conduct financial analysis
5. Assess key qualitative issues
6. Select one alternative
7. Implement alternative chosen
8. Monitor results
 Calculating Processing Requirements

A necessary piece of information is the capacity

requirements of products, to get this you have to
forecast for the demand of each product and know:

•The standard processing time / unit of product

•The number of workdays / year
•The number shifts that will be used
 Calculating Processing Requirements

A dept. works 8-hour shift, 250 days/year

Standard
Annual processing time Processing time
Product Demand per unit (hr.) needed (hr.)

#1 400 5.0 2,000

#2 300 8.0 2,400

#3 700 2.0 1,400

5,800

annual capacity is 250*8 = 2000 hours,

number of machines required = 5,800 hours/2,000 hours = 2.90 machines
then we need three machines to handle the required volume
 Developing Capacity Alternatives

• Design flexibility into systems

• Take stage of life cycle into account
(initial phase, growth phase, maturity phase, decline phase)

• Take a “big picture” approach to capacity changes

(bottleneck)
• Prepare to deal with capacity “chunks”
(capacity increase in fairly large chunks than smooth increments)
• (

• Attempt to smooth out capacity requirements

• Identify the optimal operating level
 Bottleneck Operation
Bottleneck operation: An operation
in a sequence of operations whose
10/hr capacity is lower than that of the
Machine #1 other operations

10/hr
Machine #2
Bottleneck 30/hr
Operation
Machine #3
10/hr

Machine #4 10/hr
 Bottleneck Operation

Bottleneck

Operation 1 Operation 2 Operation 3

10/hr.
20/hr. 10/hr. 15/hr.

Maximum output rate

limited by bottleneck
 Economies of Scale
• Economies of scale
– If the output rate is less than the optimal level,
increasing output rate results in decreasing
average unit costs
• Diseconomies of scale
– If the output rate is more than the optimal level,
increasing the output rate results in increasing
average unit costs
 Optimal Rate of Output
Production units have an optimal rate of output for minimal cost.
Average cost per unit

Minimum average cost per unit

Minimum
cost

0 Rate of output
 Economies of Scale
Minimum cost & optimal operating rate are
Average cost per unit functions of size of production unit.

Small
plant Medium
plant Large
plant

0 Output rate
 Evaluating Alternatives

• Cost-volume analysis
– Break-even point
• Financial analysis
– Cash flow
– Present value
• Decision theory
• Waiting-line analysis
Cost-Volume Relationships

Amount ($)

Fixed cost (FC)

0
Q (volume in units)
Cost-Volume Relationships

Amount ($)

0
Q (volume in units)
Cost-Volume Relationships

Amount ($)

0 BEP units
Q (volume in units)
Break-Even Problem with Step
Fixed Costs

3 machines

2 machines

1 machine
Quantity
Step fixed costs and variable costs.
Break-Even Problem with Step Fixed
Costs

$
BEP
3
TC
BEP 2
TC
3
TC
2

1
Quantity
Multiple break-even points
 Cost-Volume Analysis

Total Profit(TP) = Total Revenue(TR) – Total Cost(TC)

Total Revenue(TR) = Quantity(Q) * Unit Price (p)
Total Cost(TC) = Fixed Cost(FC) + Variable Cost(VC)
Variable Cost = Quantity(Q) * Unit Cost(c)

At break even point

 Breakeven Analysis
EX: The owner of Old-Fashioned Berry Pies, S. Simon, is contemplating adding a new line
of pies, which will appear leasing new equipment for a monthly payment of $6000. variable
costs would be $2 per pie, and pies would retail for $7 each.
I. How many pies must be sold in order to break even ?
II. What would be profit (loss) be if 1000 pies are made and sold in a month?
III. How many pies must be sold to realize a profit of $4000 ?
IV. If 2000 can be sold, and a profit target is $5000, what price should be charged per pie ?
FC = $6000 c = $2 p = $7
Qbep = FC / ( p - c ) = 6000 / ( 7 – 2 ) = 1200 pies / month

For Q = 1000 TP = TR – TC = p*Q - FC - c*Q

TP = Q(p – c ) - FC = 1000*(7 – 2 ) - 6000 = - 1000 $ loss
For TP = 4000 Q = (TP + FC ) / (p – c) = (4000 + 6000) / ( 7 - 2 ) = 2000 pies

For Q = 2000 and TP = 5000 TP = Q(p – c ) - FC

5000 = 2000 ( p - 2 ) - 6000
p = 7.5 $
 Breakeven Analysis

EX: A manager has the option of purchasing one, two, or three

machines. Fixed costs and potential volumes are as follows:

Number of machines Total annual fixed cost $ Corresponding range of output

1 9600 000 To 300

2 15000 301 To 600
3 20000 601 To 900

Variable cost is $ 10 per unit, and revenue is $ 40 per unit

I. Determine the break even point for each range

II. If projected annual demand is between 580 and 660 units, how many
machines should the manager purchase
 Solution
a. Compute the break even point for each range
For one machine: Q = 9600/(40 – 10) = 320 units (not in
the range, so there is no break even point)
For two machines: Q = 15000/(40-10) = 500 units
For three machines: Q = 20000/(40-10) = 666.67 units
b. Comparing the projected demand to the two ranges for
which a break even point occurs, you can see that the
break point is 500, which is in the range 301 to 600.
this means that even if demand is at the low end of
the range, it would be above the break even point and
thus yield a profit. That is not true of range 601 to 900.
at the top end of projected demand, the volume
would still be less than break even point for that range,
so there would be no profit. Hence, the manager
should choose two machines
 Breakeven Analysis
300 600 900

1
 Make or Buy
In-House or Outsourcing
Outsource: obtain a good or service
from an external provider
1. Available capacity (equip.,skills,time)
2. Expertise
3. Quality considerations (labs, inspect.)
4. Nature of demand (high, steady)
5. Cost (fixed, savings)
6. Risk
Break even point and make or by decision

Cost Buy

Make

Buy is better Make is better

Quantity
Break even
quantity
 Example: Make or Buy
• A computer company buy monitors for $1000 each.
The company thinking about building a new
production line for monitors with $150,000 fixed cost
and $250 as a variable cost per unit. Determine if it is
better to make or buy the monitors.
Solution
Break even point is:
150,000 + 250 Q = 1000 Q
750 Q = 150,000
Q = 200 monitors
This means, if the company need more than 200
monitors a year, it is better to make it, otherwise it is
better to buy.
 Assumptions
of Cost-Volume Analysis
1.One product is involved
2.Everything produced can be sold
3.Variable cost per unit is the same regardless
of volume
4.Fixed costs do not change with volume
5.Revenue per unit constant with volume
6.Revenue per unit exceeds variable cost per
unit