CAPE

MANAGEMENT OF
BUSINESS
UNIT 2
Production and
operation management
CAPACITY
PLANNING
LEARNING OBJECTIVES
At the end of this section you will know the:
1. Importance of capacity utilisation
2. Methods of improving capacity utilisation
3. Advantages a firm gains as it increases in size
4. Limitations that an increase in size can have on the
firm
CAPACITY
Capacity can be defined as the total level of output that a
firm can produce in a given period of time using the same
resources. It refers to the level of output that the current
system is capable of producing in a specified period of
time.
 CAPACITY
The capacity of a production unit (e.g. machine, factory) is
its ability to produce or do that which the customer
requires. In production and operations management, three
types of capacity are often referred to:
Potential Capacity :The capacity that can be made
available to influence the planning of senior management
(e.g. in helping them to make decisions about overall
business growth, investment etc). This is essentially a
long-term decision that does not influence day-to-day
production management
Immediate Capacity: The amount of production
capacity that can be made available in the short-term. This
is the maximum potential capacity - assuming that it is
used productively
Effective Capacity: An important concept. Not all
productive capacity is actually used or usable. It is
important for production managers to understand what
capacity is actually achievable.
 CAPACITY UTILISATION:
Capacity Utilisation: refers to the proportion of full
capacity being produced by the business. Capacity
utilisation measures the extent to which the maximum
capacity of the firm is being used;
i.e. it measures actual output as a percentage of maximum
potential output. Changes in demand and competitors’
actions will affect the extent of capacity utilisation. In order
to minimise the possibility of over- or underutilisation of
capacity, the organisation can measure its capacity
utilisation.
Capacity Utilisation = Current output x 100%
Maximum output
Or
Capacity Utilisation = Actual output per period
Full capacity per period × 100
FACTORS THAT CAN INFLUENCE A COMPANY’S CAPACITY

The actual volume of product that the factory can produce

will depend on:

1. the amount of work involved in production (e.g. does a

product require 1, 5, 10 standard hours?
2. any additional time required in production (e.g. machine
set-up, maintenance)
3. the productivity or effectiveness of the factory

4. the cost to the company

STUDY TEST
1. Which of the following is not a type of capacity?
a) Immediate Capacity
b) Potential Capacity
c) Innovative Capacity
d) Effective Capacity

2 Which of the following is a factor that influence

the capacity of a business?
a) Trend
b) The training and qualification of staff
c) Knowledge of management
d) Additional time required in production
CAPACITY UTILISATION IS IMPORTANT BECAUSE:

a. It allows the firm to gain the benefits of economies of

scale
b. It allows the unit cost of production to fall
c. It enables the selling price to fall
d. In a competitive market, demand for the firm’s output
will increase.
e. It increases the firm’s profit margin
f. There is more capital for research and development, and
to pay better wages, which leads to growth and
expansion.
WHAT REASONS ARE THERE FOR ENSURING CAPACITY
UTILISATION DOES NOT GO TOO HIGH

1. Machines break down and people make mistakes when

they work as hard as they can and for long hours
2. There will be no possibility of increasing output to meet
any special orders
3. Scheduling and planning may be difficult
4. Employees, including managers, may feel under
pressured and become demotivated
Problems of too much capacity?
a) Increasing costs
b) Increased wastages
c) Leads to losses
SELF TEST
Capacity utilisation is important to a firm for all the
following reasons except:
I. The firm can gain the benefits of economy of scales
II. The unit cost of production will fall
III. It increases the firm profit margin
IV. It enables the firm to purchase new equipment
a) I, III
b) II
c) IV
d) I, II, III
METHODS OF IMPROVING CAPACITY UTILISATION
If a firm is producing below its full capacity, it is therefore
not cost-effective. There are a number of strategies the
firm can employ to improve its capacity utilisation.
1. When the supply of output is less than the quantity
demanded by the market the following strategies can
be employed:
a. Employ an additional shift
b. Make better use of resources
c. Train workers where necessary
d. Employ more efficient quality control measures
e. Improve the production process, eliminating any
possible downtime for machinery
METHODS OF IMPROVING CAPACITY UTILISATION CONT;
2. If the firm is closer to full capacity and demand
for the firm’s output is greater than supply the
options are:
a. Expand the firm
b. Purchase additional machinery
c. Employ additional highly qualified staff
d. Train and retrain existing staff
3. If there is excess capacity because potential
supply is greater than demand:
a. The marketing department would develop strategies to
increase demand
b. Lease part of the production area
c. Lay off workers or reduce the hours they work
d. Sell equipment that is not being used.
EXAMPLE
General Motors Manufacture one of it popular brand
motor car at it factory in the USA. The factory has a
maximum output of 10,000 motor cars per month. In Feb
2019 the factory turn out 8,000 motor cars. Calculate the
capacity utilization

Capacity Utilization = Actual output

Maximum output x 100
CAPACITY UTILISATION IS AN IMPORTANT CONCEPT:
1. It is often used as a measure of productive efficiency
2. Average production costs tend to fall as output rises
– so higher utilisation can reduce unit costs, making
a business more competitive
3. So firms usually aim to produce as close to full
capacity (100% utilisation) as possible

Reasons why businesses operate at less than 100%

capacity utilisation:
1. Lower demand:
 General reduction in overall market demand
 Loss of market share
Seasonal variation in demand
2. Increase in capacity not yet matched by increased
demand:
 Possibly new technology introduced
 Provide some "slack“
 Inefficiency (a problem = less competitive unit costs)
 Poor maintenance, quality, employee disruption
When a business is operating at less than 100% capacity,
it is said to have "spare capacity".
Sometimes spare capacity is not the problem – a business
finds itself with excess demand (i.e. it cannot produce
enough to meet demand). In such circumstances, what
can it do to operate at higher than 100% normal capacity?
It can often:

a) Increase workforce hours (e.g. extra shifts; encourage

overtime; employ temporary staff)
b) Sub-contract some production activities (e.g.
assembly of components)
c) Reduce time spent maintaining production equipment
SOME POTENTIAL PITFALLS WITH OPERATING AT
VERY HIGH CAPACITY (I.E. AROUND 100%):

1. Negative effect on quality (possibly)

a) Production is rushed
b) Less time for quality control

2.. Employees suffer

a) Added workloads & stress
b) De-motivating if sustained for too long

3. Loss of sales
a) Less able to meet sudden or unexpected increases in
demand
b) Production equipment may require repair
 DEALING WITH SHORT TERM EXCESS CAPACITY
Advantages Diadvantages
Option 1: Maintain • no part-time unsuitable for
output and produce working for staff perishable stocks or
for stocks ■ job security for staff those that go out-of-
■ no need to change date quickly
production schedules ■ stock-holding costs
or orders from can be very
suppliers substantial
■ stocks may be sold at ■ demand may not
times of rising increase as expected
demand the goods may have
to be sold at a
substantial discount
Option 2: Introduce Production can be Staff may be
greater flexibility into reduced during slack demotivated by not
the production process periods and increased having full-time,
■ part-time or when demand is high permanent contracts
temporary labour ■ other products can be ■ fully flexible and
contracts produced that may adaptable equipment
■ flexible equipment follow a different can be expensive
that can be switched demand pattern ■ staff may need to be
to making other ■ avoids stock build-up trained in more than
products one product may add
■ short-term working, to costs
e.g. all staff on
three-day week
CAPACITY TERMS
Capacity shortage: when the demand for a business’s
products exceeds production capacity.
Excess capacity: exists when the current levels of
demand are less than the full capacity output of a
business – also known as spare capacity.
Full capacity: when a business produces at maximum
output.
Rationalisation: reducing capacity by cutting
overheads to increase efficiency of operations, such as
closing a factory or off ice department, oft en involving
redundancies.
Capacity utilisation: the proportion of maximum
output capacity currently being achieved.
ECONOMIES OF SCALE
This refers to the cost saving advantages that a business
can exploit by expanding their scale of production. Thus
making things cheaper because they are bigger. The effect
is to reduce the long run average cost of production over a
range of output.
Economies of scale are divided into internal and
external economies of scale
INTERNAL ECONOMIES OF SCALE
Internal economies of scale arises from the growth of the
firm itself. Thus the average cost will decrease as the firm
employees more capital and labour
a)Purchasing Economies of Scale
Large firms receive discounts when they buy raw
materials in bulk. Thus the cost of acquiring raw
materials will decrease leading to a fall in the unit cost/
average cost. A 5% trade discount will lead to a 5%
decrease in the cost of production and the cost per unit
b)Marketing Economies of Scale
A large firm can spread its advertising and marketing
budget over a large output. Advertising is charged per
total time on airplay (TV/ Radio) or space (Newspaper)
not on the size of the business. As the firm grows in size,
the average marketing cost will decrease
c)Financial Economies of Scale
Large businesses may be able to access finance at lower
interest rates because of the growth of the business.
Large businesses are usually rated by the financial
markets to be more ‘credit worth’ and have access to
credit facilities with favourable rates of borrowing
d)Managerial Economies of Scale
Large scale manufacturers can afford to employ skilled
workers to supervise and to carry out production.
Effective leadership can also lead to an improvement in
worker motivation. Skilled workers will also help reduce
wastages. Employees also become experts due to the
length of experience in a market and the cost per unit will
decrease
e)Technical Economies of Scale
Large scale businesses can afford to invest in very
expensive and specialist capital machinery. For example,
a National Chain Supermarket can invest in technology
that improves stock control and helps to control costs. It
would not be viable or cost efficient for a small corner
shop to buy this technology.
f)Risk Bearing Economies of Scale
A large firm is able to provide a wide range of products in
different markets. This lowers the risk of putting all eggs
in one basket. McDonalds hamburgers and French fries
share the use of food storage and preparation facilities.
EXTERNAL ECONOMIES OF SCALE
External economies of scale exist when the long term
expansion of an industry leads to the development of
ancillary (something additional) services which benefit all
or some of the businesses in the industry. External
economies partly explain the tendency for firms to cluster
geographically.
SOURCES OF EXTERNAL ECONOMIES OF SCALE
a)Supply of raw materials- as the industry grows,
suppliers of raw materials will be willing to locate
themselves close to the manufacturers. This will reduce
transport costs to the manufacturers in a given industry.
b)Better transport network- as the industry grows, there
will be massive infrastructural development in the area.
The development of transport networks cut costs and also
saves time.
c)Research and Development Facilities- businesses can
benefit from researches done by local universities
d)Economies of information- business in the same
industry may share vital information about the market or
about the economy in general. This reduces the cost of
acquiring information to a single business.
e)Trade Magazines- enables all firms in an industry to
advertise and disseminate information cheaply.
 DISECONOMIES OF SCALE
Diseconomies of scale leads to a rise in the long run
average cost. Average cost rises due to firms expanding
beyond their optimum scale (Optimum-right size)

SOURCES OF INTERNAL DISECONOMIES OF

SCALE
a)Managerial Diseconomies of Scale- monitoring the
productivity and quality of output from thousands of
employees in big corporations is imperfect and costly.
b)Administrative Diseconomies of Scale- these are
associated with the bureaucratic structures of large firms
where long channels of communication and complex
administrative procedures delay effective action.
Instructions from the top management may be partly or
completely distorted if they are to follow a long channel of
communication down the organogram.
c)Over-specialisation- workers in large firms my feels a
sense of alienation and subsequent loss of morale. If they
do not consider themselves to be an integral part of the
business, their productivity may fall leading to wastage of
factor inputs and higher costs.
 EXTERNAL DISECONOMIES OF SCALE
This refers to a rise in the average costs which is independent
of the firm’s output. They arise due to the growth of the whole
industry. These occur when too many firms have located in one
area.

SOURCES OF EXTERNAL DISECONOMIES OF SCALE

a) Shortage of Labour- as the industry grows, shortage .of
labour may crop up. Firms have to bid wages higher to attract
and retain new workers As the wage rises due to labour
shortages, the cost of production to all firms in an industry will
increase.
b) Formation of Trade Unions- growth of an industry may lead
to the formation of industrial unions. Such Trade unions may
ask for higher wages for their members which then increases
the production costs.
c) Pressure on Raw materials- increased demand on raw
materials and other components may lead to a rise in the unit
cost. Geographical concentration of firms in an area may lead to
a rise in the rentals, interest rates.
d) Disposal of Waste material becomes costly- when the
industry grows, dumping sites will be shifted to the peripheries
of a town or business centre. Firms can also be forced to acquire
more advanced equipment to reduce and dispose waste. The
government can also increase pollution taxes as the industry
grows