Capacity Planning For Products and Services: Prepared By: Gurpreet Singh

Capacity Planning
For Products and Services
Prepared By: Gurpreet Singh

Capacity Planning
Capacity is the upper limit or ceiling on the load that an operating
unit can handle.
It refers to availability of I/Ps.
The load might be in terms of the number of physical units produces
(E.g. Bicycles assembled per hour) or the number of services
performed (E.g. Computers upgraded per hour) etc.
Capacity also includes:
Equipment
Space
Employee skills etc.
Capacity Planning…
Organizations become involved in capacity planning for
various reasons:
Changes in Demand
Changes in Technology
Changes in Environment
Threats or Opportunities etc.
Overcapacity causes operating costs that are too high, while

undercapacity causes strained resources and possible loss of
customers.

The basic questions in capacity handling are:
What kind of capacity is needed?
Depends upon on the products & services that management intends
to produce or provide.
How much is needed?

When is it needed?
Forecasting is done for how much and when it is needed.

Importance of Capacity Decisions
1. Impacts ability to meet future demands
2. Affects operating costs (actual dd differs from expected dd)
3. Major determinant of initial costs (greater capacity = high cost)
4. Involves long-term commitment of resources
5. Affects competitiveness (a firm that can add capacity quickly)
6. Affects ease of management (appropriate capacity makes it)
7. Globalization adds complexity (far-flung supply chain/markets )
8. Impacts long range planning (plan in advance)
Design capacity
Effective capacity
Actual output

Design capacity:
Maximum output rate or service capacity an operation, process, or
facility is designed for i.e. maximum rate of O/P achieved under
ideal conditions.
Effective capacity:
Design capacity minus allowances such as personal time,
maintenance, and scrap i.e. the capacity which is usually less than
design capacity due to changing product mix, lunch/coffee breaks,
regular equipment maintenance, scheduling problems etc.
Actual output:
Rate of output actually achieved i.e. it cannot exceed effective
capacity and is often less than because of machine breakdowns,
absenteeism, shortage of materials and quality problems as well
as factors that are outside the control of the operations managers.

Efficiency and Utilization
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
A Note
It is important to recognize that the benefits of high
utilization are realized only in instances where there is
demand for the O/P.
When demand is not there, focusing exclusively on
utilization can be counterproductive, because excess O/P
not only results in additional variable costs but generates
the costs of having to carry the O/P as inventory.

Determinants of Effective Capacity
Facilities
Product and service factors
Process factors
Human factors
Policy factors
Operational factors
Supply chain factors
External factors
Determinants of Effective Capacity…
Facilities:
The design of facilities including size and provision for expansion.
Locational factors like: Transportation costs, Distance to Market, Energy
sources etc.
Layout of the work area determines how smooth work can be performed.
Environmental factors like: Heating, Lighting, Ventilation etc.
Product and service factors:

More uniform the O/P (standardization) = more opportunities = greater
capacity.
E.g. A Restaurant that offers a limited menu can usually prepare and serve
meals at a faster rate than a restaurant with extensive menu.
Process factors:
Quality O/P increases capacity.
E.g. If quality of O/P doesn’t meet standards, the rate of O/P will be
slowed by the need for inspection and rework activities.
Human factors:
Factors like: Variety of activities involved, Training, Skill, Experience etc.
have an impact on the potential and actual O/P.
E.g. Employee motivation has a very basic relationship to capacity as do
absenteeism and labor turnover.
Policy factors:
Management Policy factors like: Overtime etc. have an impact on capacity
Operational factors:
Scheduling problems may occur when an organization has differences in
equipment capabilities among alternative pieces of equipment etc.
Inventory stocking decisions, Late deliveries, Quality inspection, Control
procedures also have an impact on effective capacity.
E.g. Inventory shortage of even 1 component can halt assembly operation.
Supply chain factors: Also hampers capacity.

External factors:
Product standards, Safety regulation, Unions, Pollution control standards
and even paperwork required by govt. regulatory agencies by engaging
employees in nonproductive activities can have an impact on capacity.
Strategy Formulation
Capacity strategy for long-term demand.
Demand patterns.
Growth rate and variability.
Facilities:
Cost of building and operating.
Technological changes:
Rate and direction of technology changes.
Behavior of competitors.
Availability of capital and other inputs.
Key Decisions of Capacity Planning
1. Amount of capacity needed:
• Capacity Cushion= (100% - Utilization)
• Extra demand intended to offset uncertainty.
• Greater the degree of demand uncertainty = greater the amount of
cushion used.
2. Timing of changes.
3. Need to maintain balance throughout the system.
4. Extent of flexibility of facilities and the workforce.

Steps for Capacity Planning
1. Estimate future capacity requirements
2. Evaluate existing capacity and facilities and identify gaps
3. Identify alternatives for meeting requirements
4. Conduct financial analysis of each alternative
5. Assess key qualitative issues for each alternative
6. Select the alternative to pursue that will be best in the long run
7. Implement the selected alternative
8. Monitor results.

Forecasting Capacity Requirements
It involves Long-term vs. short-term capacity considerations.
Long-term considerations relates to overall level of capacity
such as facility size, trends, cycles, etc. i.e. forecasting demand
over a long time horizon.
Short-term considerations relates to variations in capacity
requirements from seasonal, random, and irregular
fluctuations in demand i.e. forecasting demand over a short
time horizon.

Examples of Seasonal Demand Patterns
Year: Toy sales, Beer sales, Clothing, Sports/Recreation
Gasoline consumption, Education etc.
Month: Bank Transactions, Welfare/Social security checks
etc.
Week: Restaurant meals, Retail sales, Automobile traffic
etc.
Day: Telephone calls, Power usage, Automobile traffic,
Restaurant meals, Retail sales etc.

Calculating Processing Requirements
A department works one 8-hour shift, 250 days a year and has
these figures for a usage of a machine:
#1 400 5 .0 2 ,0 0 0
#2 300 8 .0 2 ,4 0 0
#3 700 2 .0 1 ,4 0 0
5 ,8 0 0
If annual capacity is 2000 hours, then we need three machines to handle the
required volume: 5,800 hours/2,000 hours = 2.90 machines
Planning Service Capacity
Need to be near customers:
Capacity and location are closely tied i.e. service must be located near
customers. E.g. Hotel rooms must be where customer wants to stay.
Inability to store services:
Capacity must be matched with timing of demand i.e. services cannot
be produced in one period and stored for use in later period. E.g. Unsold
Airplane/Train/Bus seat cannot be stored for use on a later trip etc.
Degree of volatility of demand:
Peak demand periods i.e. higher for services than goods. E.g. Banks
tends to experience high volumes of demand on certain days of the week
and number of transactions etc.
In-House or Outsourcing/Make or Buy
Organization must decide whether to produce a good/service
itself or to Outsource from another organization.
Organizations buy parts or contract out services for a variety of
reasons:
1. Available capacity
2. Expertise
3. Quality considerations
4. Nature of demand
5. Cost
6. Risk
In-House or Outsourcing/Make or Buy…
1. Available capacity:
If an organization has the equipment, necessary skills and time
available then produce item or perform a service in-house, which will
result in less additional costs as compare to buy items or subcontract
services.
2. Expertise:
If a firm lacks the expertise to do a job satisfactorily buying might be a
reasonable option.

In-House or Outsourcing/Make or Buy…
3. Quality considerations:
Firms that specialize can offer higher quality than an org. can attain
itself.
4. Nature of demand:
When demand for item is high and steady then perform job itself.
5. Cost:
Buying or making costs must be weighed against preceding factors.
Cost savings can be from item itself or transportation cost etc.
6. Risk:
Outsourcing may involve certain risks.
Developing Capacity Alternatives
1. Design flexibility into systems
2. Take stage of life cycle into account
3. Take a “big picture” approach to capacity changes
4. Prepare to deal with capacity “chunks”
5. Attempt to smooth out capacity requirements
6. Identify the optimal operating level
7. Choose a strategy if expansion is involved

Developing Capacity Alternatives…
1. Design flexibility into systems:
E.g. Provisions for future expansion in the original design of a structure
can be obtained at a small price compared to what it would cost to

remodel an existing structure that did not have such a provision.
E.g. If future expansion of a restaurant seems likely, water lines, power
hookups and waste disposal lines can be put initially so that if expansion
becomes a reality, modification to existing structure can be minimized.

2. Take stage of life cycle into account:
Introduction phase = Org. should be cautious about making large
and/or inflexible capacity investments.

Growth phase = Offer different product than competitors.
Maturity phase = Reduce cost and make full use of capacity.
Decline phase = Sell excess capacity of introduce new products/services
or transfer capacity to a location that has lower labor costs etc.

3. Take a “big picture” approach to capacity changes:
E.g. When making a decision to increase the number of rooms in
a motel, one should also take into account probable increased

demands for parking, entertainment and food and housekeeping
i.e. the “big picture”.
It also results in bottleneck operation:
An operation in a sequence of operations whose capacity is lower
than the capacities of the other operations in the sequence.

Bottleneck Operation example
10/hr
Machine #1
10/hr
Machine #2
Bottleneck 30/hr
Operation
Machine #3
10/hr
Machine #4 10/hr
Bottleneck Operation example
Bottleneck
Operation 1 Operation 2 Operation 3

10/hr.
20/hr. 10/hr. 15/hr.
Maximum output rate

limited by bottleneck
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.
E.g. The desired capacity of a certain operation may be 55 units per
hour but suppose that machines used for this operation are able to
produce 40 units per hour each. One machine by itself would cause
capacity to be 15 units per hour short of what is needed but two
machines would result in an excess capacity of 25 units per hour.

5. Attempt to smooth out capacity requirements:
Unevenness in capacity requirements creates problems.
E.g. During periods of inclement weather public transport ridership
tends to increase substantially relative to periods of pleasant weather.
So the system tends to alternate between underutilization and
overutilization. Increasing the number of buses will reduce the burden
during heavy demand periods but this will result in the problem of
overcapacity at other times as well as cost of operating the system.
One way to overcome this issue is through the use of overtime work.
Another way is to subcontract some of the work etc.

6. Identify the optimal operating level:
Production units have an ideal/optimal level of operation in
terms of unit cost of O/P.

At the ideal level, cost per unit is the lowest for that production
unit.
It results in:
Economies of Scale
Diseconomies of Scale

• Optimal Rate of Output:
• Production units have an optimal rate of output for minimal cost.
Average Minimum average cost per unit

cost
per unit
Minimum
cost
0 Rate of output
6. Identify the optimal operating level:
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

• Economies of Scale:
• Minimum cost & optimal operating rate are functions of size
of production unit.
Average cost per unit
Small
plant Medium
plant Large
plant
0 Output rate
Reasons for Economies of Scale:
Fixed costs are spread over more units, reducing fixed cost per unit.
Construction costs increase at a decreasing rate w.r.t. size of facility to be built.
Processing costs decrease as O/P increase because operations become more
standardized which reduces unit costs.
Reasons for Diseconomies of Scale:

Distribution costs increase due to shipping from one large centralized facility
instead of several smaller decentralized facilities.

Complexity increases costs, control & communication become more problematic.
Inflexibility can be an issue.

7. Choose a strategy if expansion is involved:
Consider whether incremental expansion or single step is more
appropriate.
Decide whether to lead or follow competitors.

Evaluating Alternatives
Cost-volume analysis
Break-even point
Financial analysis
Cash flow
Present value
Decision theory
Waiting-line analysis

Evaluating Alternatives…
Cost-volume analysis:
It focuses on relationships between Cost, Revenue and Volume of
data.
Its purpose is to estimate the income of an organization under
different operating conditions.
It includes:
Break-even Point (BEP):
The volume of O/P at which total cost and total revenue are
equal.
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)
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

Financial Analysis:
How to allocate scarce resources? = Financial Analysis i.e.
To rank investment proposals taking into A/C the time value
of money.
2 important terms are:
Cash Flow: The difference between cash received from sales (of
goods/services) and other sources (sale of old machinery), and cash
outflow for labor, material, overhead, and taxes.
Present Value: The sum, in current value, of all future cash flows of
an investment proposal.
Financial Analysis: 3 most common methods are:
Payback
Present Value (PV)
Internal Rate of Return (IRR)
These techniques are appropriate when there is high

degree of certainty associated with estimates of future cash
flows.

Decision Theory:
When the conditions of Risk or Uncertainty are present
Decision Theory if applied i.e. it is a helpful tool for

financial comparison of alternatives under conditions of risk
or uncertainty.
It is suited to capacity decisions and to wide range of other
decision managers.

Waiting-Line Analysis:
It is useful for designing or modifying service systems.
Waiting-lines occur across a wide variety of service systems
(e.g. Airport ticket counters, hospital emergency rooms etc.).

Waiting-lines are caused by bottlenecks in the process.
Helps managers plan capacity level that will be cost-effective
by balancing the cost of having customers wait in line with

the cost of additional capacity.

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

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Capacity Planning

For Products and Services

Prepared By: Gurpreet Singh

Threats or Opportunities etc.

Overcapacity causes operating costs that are too high, while

Prepared By: Gurpreet Singh

How much is needed?

Prepared By: Gurpreet Singh

Prepared By: Gurpreet Singh

Prepared By: Gurpreet Singh

Both measures expressed as percentages

Prepared By: Gurpreet Singh

Actual output = 36 units/day

Utilization = Actual output = 36 units/day

Prepared By: Gurpreet Singh

Product and service factors:

Supply chain factors: Also hampers capacity.

Prepared By: Gurpreet Singh

Prepared By: Gurpreet Singh

Prepared By: Gurpreet Singh

Prepared By: Gurpreet Singh

Prepared By: Gurpreet Singh

Prepared By: Gurpreet Singh

can be obtained at a small price compared to what it would cost to

Prepared By: Gurpreet Singh

and/or inflexible capacity investments.

Maturity phase = Reduce cost and make full use of capacity.

Decline phase = Sell excess capacity of introduce new products/services

or transfer capacity to a location that has lower labor costs etc.

Prepared By: Gurpreet Singh

a motel, one should also take into account probable increased

Prepared By: Gurpreet Singh

Operation 1 Operation 2 Operation 3

Maximum output rate

Prepared By: Gurpreet Singh

Prepared By: Gurpreet Singh

terms of unit cost of O/P.

Prepared By: Gurpreet Singh

Average Minimum average cost per unit

Prepared By: Gurpreet Singh

Construction costs increase at a decreasing rate w.r.t. size of facility to be built.

Processing costs decrease as O/P increase because operations become more

standardized which reduces unit costs.

Reasons for Diseconomies of Scale:

instead of several smaller decentralized facilities.

Inflexibility can be an issue.

Prepared By: Gurpreet Singh

Prepared By: Gurpreet Singh

Prepared By: Gurpreet Singh

different operating conditions.

Fixed cost (FC)

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

Prepared By: Gurpreet Singh

To rank investment proposals taking into A/C the time value

Present Value (PV)

Internal Rate of Return (IRR)

These techniques are appropriate when there is high

Prepared By: Gurpreet Singh