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Chapter 7S

Capacity Planning

Learning Objectives

When you complete this chapter, you should

be able to:

1. Define capacity
2. Determine design capacity, effective capacity,
and utilization
3. Perform bottleneck analysis
4. Compute break-even
5. Determine the expected monetary value
(EMV) of a capacity decision
6. Compute net present value - NPV 2

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Capacity
 The throughput or the number of units a facility
can hold, receive, store, or produce in a period of
time
 Determines fixed costs
 Determines if demand will be satisfied
 Three time horizons

Planning Over a Time Horizon

Figure S7.1
Time Horizon
Options for Adjusting Capacity

Long-range Add facilities

planning Add long lead time equipment *
Intermediate- Subcontract Add personnel
range Add equipment Build or use inventory
planning Add shifts
(aggregate
planning)
Schedule jobs
Short-range
planning
(scheduling)
* Schedule personnel
Allocate machinery
Modify capacity Use capacity

* Difficult to adjust capacity as limited options exist

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Standard capacity measures

System Standard Measures of Capacity
Hospital Patient days or inmate days /year
Airline Passengers/year, passenger miles/year,
or dollar volume/year
Oil refinery Barrels of oil/ day
Automobile manufacturing Automobiles/ day
Bank Transactions/ day
Gas station Gallons/ day
Restaurant Meals/ week
Truck Cubic yards (volume ) or tonnage
(weight)/day
Computer Computations/second
Production line Units/shift
Storage silo Tons/week
Reservoir Gallons/day
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Design and Effective Capacity

 Design capacity : the maximum

theoretical output of a system
 Normally expressed as a rate
 Effective capacity : the capacity a firm
expects to achieve given current
operating constraints
 Often lower than design capacity (82%)

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Utilization and Efficiency

 Utilization is the percent of design capacity

actually achieved

Utilization = Actual Output/Design Capacity

 Efficiency is the percent of effective capacity

actually achieved
Efficiency = Actual Output/Effective Capacity

Both measures expressed as percentages

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Bakery Example
Utilization = Actual Output/Design Capacity
Efficiency = Actual Output/Effective Capacity

Actual production last week = 148,000 rolls

Effective capacity = 175,000 rolls
Design capacity = 1,200 rolls per hour
Bakery operates 7 days/week, 3 - 8 hour shifts

Design capacity = (7 x 3 x 8) x (1,200) = 201,600 rolls

Utilization = 148,000/201,600 = 73.4%

Efficiency = 148,000/175,000 = 84.6%

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Bakery Example

Actual production last week = 148,000 rolls

Effective capacity = 175,000 rolls
Design capacity = 1,200 rolls per hour
Bakery operates 7 days/week, 3 - 8 hour shifts
Efficiency = 84.6%
Efficiency of new line = 75%

Expected Output = (Effective Capacity)(Efficiency)

= (175,000)(.75) = 131,250 rolls

Note: Expected Output (or Actual output) refers as rated capacity

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Capacity and Strategy

 Capacity decisions
impact all 10 decisions
of operations
management as well as
other functional areas of
the organization
 Capacity decisions must
be integrated into the
organization’s mission
and strategy

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Capacity Considerations

1. Forecast demand accurately

2. Match technology increments and sales
volume
3. Find the optimum
operating size
(volume)
4. Build for change

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Economies and Diseconomies of Scale

(sales per square foot)
Average unit cost

1,300 sq 8,000 sq
ft store 2,600 sq ft store
ft store

Economies Diseconomies
of scale of scale
1,300 2,600 8,000
Number of square feet in store
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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
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Managing Demand
 Demand exceeds capacity
 Curtail demand by raising prices, scheduling
longer lead time
 Long term solution is to increase capacity
 Capacity exceeds demand
 Stimulate market (price reductions or
aggressive marketing)
 Product changes
 Adjusting to seasonal demands
 Produce products with complimentary
demand patterns
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Complementary Demand Patterns

Figure S7.3

Combining both
demand patterns
reduces the
variation
4,000 –
Sales in units

Snowmobile
3,000 – motor sales

2,000 –

1,000 – Jet ski

engine
sales

J F MAMJ JAS O N D J FMAM JJAS O N D J

Time (months)
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Tactics for Matching Capacity to Demand

1. Making staffing changes

2. Adjusting equipment
 Purchasing additional machinery
 Selling or leasing out existing equipment
3. Improving processes to increase throughput
4. Redesigning products to facilitate more throughput
5. Adding process flexibility to meet changing product
preferences
6. Closing facilities

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Service Sector Demand and

Capacity Management

 Demand management
• Appointment, reservations, FCFS rule
 Capacity management
• Full time,
temporary,
part-time
staff

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Bottleneck Analysis and

The Theory of Constraints

 Each work area can have its own unique

capacity
 Capacity analysis determines the
throughput capacity of workstations in a
system
 A bottleneck is a limiting factor or constraint
 A bottleneck has the lowest effective capacity
in a system

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Bottleneck Analysis and

The Theory of Constraints
Figure S7.4

A B C

2 min/unit 4 min/unit 3 min/unit

 The bottleneck time is the time of the slowest

workstation (the one that takes the longest) in a
production system
 The throughput time is the time it takes a unit to
go through production from start to end
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Capacity Analysis

 Two identical sandwich lines

 Lines have two workers and three operations
 All completed sandwiches are wrapped

Bread Fill
15 sec/sandwich 20 sec/sandwich
Wrap/
Order Toaster
Deliver
30 sec/sandwich 20 sec/sandwich
Bread Fill 37.5 sec/sandwich

15 sec/sandwich 20 sec/sandwich

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Capacity Analysis
Bread Fill
15 sec 20 sec Wrap/
Order Toaster
Deliver
30 sec 20 sec
Bread Fill 37.5 sec
15 sec 20 sec

 The two lines each deliver a sandwich every

20 seconds
 At 37.5 seconds, wrapping and delivery has
the longest processing time and is the
bottleneck
 Capacity per hour is 3,600 seconds/37.5
seconds/sandwich = 96 sandwiches per hour
 Throughput time is 30 + 15 + 20 + 20 + 37.5
= 122.5 seconds
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Capacity Analysis

 Standard process for cleaning teeth

 Cleaning and examining X-rays can happen
simultaneously

Cleaning

Takes Develops 24 min/unit Check

Check in Dentist
X-ray X-ray out

2 min/unit 2 min/unit 4 min/unit X-ray 8 min/unit 6 min/unit

exam

5 min/unit

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Capacity
Analysis Cleaning

Check Takes Develops 24 min/unit Check

Dentist
in X-ray X-ray out

2 min/unit 2 min/unit 4 min/unit X-ray 8 min/unit 6 min/unit

exam

5 min/unit

 All possible paths must be compared

 Bottleneck is the hygienist at 24 minutes
 Hourly capacity is 60/24 = 2.5 patients
 X-ray exam path is 2 + 2 + 4 + 5 + 8 + 6 = 27 minutes
 Cleaning path is 2 + 2 + 4 + 24 + 8 + 6 = 46 minutes
 Longest path involves the hygienist cleaning the teeth,
patient should complete in 46 minutes
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Theory of Constraints (TOC)

 Five-step process for recognizing and

managing limitations

Step 1: Identify the constraints

Step 2: Develop a plan for overcoming the constraints
Step 3: Focus resources on accomplishing Step 2
Step 4: Reduce the effects of constraints by offloading
work or expanding capability
Step 5: Once overcome, go back to Step 1 and find
new constraints
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Bottleneck Management

1. Release work orders to the

system at the pace of set by
the bottleneck
 Drum, Buffer, Rope
1. Lost time at the bottleneck
represents lost time for the
whole system
2. Increasing the capacity of a
non-bottleneck station is a
mirage
3. Increasing the capacity of a
bottleneck increases the
capacity of the whole system

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Break-Even Analysis

 Technique for evaluating process and

equipment alternatives
 Objective is to find the point in dollars and
units at which cost equals revenue
 Requires estimation of fixed costs, variable
costs, and revenue

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Break-Even Analysis

 Fixed costs are costs that continue even if no

units are produced
 Depreciation, taxes, debt, mortgage
payments
 Variable costs are costs that vary with the
volume of units produced
 Labor, materials, portion of utilities
 Contribution is the difference between
selling price and variable cost
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Break-Even Analysis

 Revenue function begins at the origin

and proceeds upward to the right,
increasing by the selling price of each
unit
 Where the revenue function crosses
the total cost line is the break-even
point

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Break-Even Analysis

–
Total revenue line
900 –

800 –
Break-even point Total cost line
700 – Total cost = Total revenue
Cost in dollars

600 –

500 –

400 – Variable cost

300 –

200 –

100 – Fixed cost

|– | | | | | | | | | | |
0 100 200 300 400 500 600 700 800 900 1000 1100
Volume (units per period) 29

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Break-Even Analysis

Assumptions
 Costs and revenue are linear functions
 Generally not the case in the real world
 We actually know these costs
 Very difficult to verify
 Time value of money is often ignored

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Break-Even Analysis

BEPx = break-even point x = number of units

in units produced
BEP$ = break-even point TR = total revenue = Px
in dollars F = fixed costs
P = price per unit V = variable cost per unit
(after all TC = total costs = F + Vx
discounts)
Break-even point occurs when

TR = TC
or F
BEPx =
Px = F + Vx P–V

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Break-Even Analysis

BEPx = break-even point x = number of units

in units produced
BEP$ = break-even point TR = total revenue = Px
in dollars F = fixed costs
P = price per unit V = variable cost per unit
(after all TC = total costs = F + Vx
discounts)
F Profit = TR - TC
BEP$ = BEPx P = P
P–V = Px – (F + Vx)
F = Px – F – Vx
= (P – V)/P
= (P - V) x – F
F
BEP$ =
1 – V/P
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Break-Even Example

Fixed costs = $10,000 Material = $.75/unit

Direct labor = $1.50/unit Selling price = $4.00 per unit

F $10,000
BEP$ = =
1 – (V/P) 1 – [(1.50 + .75)/(4.00)]
$10,000
= = $22,857.14
.4375

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Break-Even Example

Fixed costs = $10,000 Material = $.75/unit

Direct labor = $1.50/unit Selling price = $4.00 per unit

F $10,000
BEP$ = =
1 – (V/P) 1 – [(1.50 + .75)/(4.00)]
$10,000
= = $22,857.14
.4375

F $10,000
BEPx = = = 5,714
P–V 4.00 – (1.50 + .75)

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Break-Even Example

50,000 –

40,000 – Revenue
Break-
30,000 – even Total
Dollars

point costs
20,000 –

10,000 –
Fixed costs

–
| | | | | |
0 2,000 4,000 6,000 8,000 10,000
Units

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Break-Even Example

Multiproduct Case
Break-even F
point in dollars =
éæ V ö ù
(BEP$) åêç P ÷ i úú
ê 1- i
´ W ( )
ëè i ø û

where V = variable cost per unit

P = price per unit
F = fixed costs
W = percent each product is of total dollar
sales
expressed as a decimal
i = each product 36

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Multiproduct Example

Fixed costs = $3,000 per month

ITEM PRICE COST ANNUAL FORECASTED SALES UNITS
Sandwich $5.00 $3.00 9,000
Drink 1.50 .50 9,000
Baked potato 2.00 1.00 7,000

1 2 3 4 5 6 7 8
ANNUAL WEIGHTED
SELLING VARIABLE FORECASTED % OF CONTRIBUTION
ITEM (i) PRICE (P) COST (V) (V/P) 1 - (V/P) SALES $ SALES (COL 5 X COL 7)

Sandwich $5.00 $3.00 .60 .40 $45,000 .621 .248

Drinks 1.50 0.50 .33 .67 13,500 .186 .125

Baked
potato 2.00 1.00 .50 .50 14,000 .193 .097

$72,500 1.000 .470

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Multiproduct Example
F
BEP$ =
éæ Vi ö ù
Fixed costs = $3,000 per month åêêç1- P ÷ ´ (W )úú i
ëè i ø û
ITEM PRICE COST $3,000 x 12 SALES UNITS
ANNUAL FORECASTED
= = $76,596
Sandwich $5.00 $3.00 .47
9,000
Drink 1.50 .50 9,000
$76,596
Daily
Baked potato 2.00 1.00 =
sales 3127,000 = $245.50
days

1 2 3 4 5 6 x $245.50
.621 7 8
ANNUAL = 30.5WEIGHTED
 31
SELLING VARIABLE $5.00 % OF Sandwiches
FORECASTED CONTRIBUTION
ITEM (i) PRICE (P) COST (V) (V/P) 1 - (V/P) SALES $ SALES (COL 5 X COL 7)
each day
Sandwich $5.00 $3.00 .60 .40 $45,000 .621 .248

Drinks 1.50 0.50 .33 .67 13,500 .186 .125

Baked
potato 2.00 1.00 .50 .50 14,000 .193 .097

$72,500 1.000 .470

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Reducing Risk with

Incremental Changes
Figure S7.6
(a) Leading demand with (b) Leading demand with
incremental expansion one-step expansion
New New
capacity capacity
Demand

Demand
Expected
Expected
demand
demand

(c) Capacity lags demand with (d) Attempts to have an average

incremental expansion capacity with incremental
New
expansion
capacity New

Demand
Demand

Expected capacity Expected

demand demand

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Reducing Risk with

Incremental Changes
(a) Leading demand with incremental
expansion
Figure S7.6

New
capacity
Demand

Expected
demand

1 2 3
Time (years) 40

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Reducing Risk with

Incremental Changes
(b) Leading demand with one-step
expansion

New
capacity
Expected
Demand

demand

1 2 3
Time (years) 41

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Reducing Risk with

Incremental Changes
(c) Lagging demand with incremental
expansion

New
capacity

Expected
Demand

demand

1 2 3
Time (years) 42

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Reducing Risk with

Incremental Changes
(d) Attempts to have an average capacity
with incremental expansion

New
capacity
Demand

Expected
demand

1 2 3
Time (years) 43

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Applying Expected Monetary Value

(EMV) and Capacity Decisions

 Determine states of nature

• Future demand
• Market favorability
 Assign probability values to states of
nature to determine expected value

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EMV Applied to Capacity Decision

 Southern Hospital Supplies capacity expansion
Market favorable (.4)
$100,000

Market unfavorable (.6)

-$90,000

Market favorable (.4)

$60,000
Medium plant
Market unfavorable (.6)
-$10,000

Market favorable (.4)

$40,000

Market unfavorable (.6)

-$5,000

$0
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EMV Applied to Capacity Decision

Market favorable (.4)

$100,000

Market unfavorable (.6)

-$90,000

Market favorable (.4)

$60,000
Medium plant
Large Plant Market unfavorable (.6)
-$10,000

EMV = (.4)($100,000) Market favorable (.4)

+ (.6)(-$90,000) $40,000

Market unfavorable (.6)

EMV = -$14,000 -$5,000

$0
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EMV Applied to Capacity Decision

 Southern Hospital Supplies capacity expansion

EMV (large plant) = (.4)($100,000) + (.6)(–$90,000)

= –$14,000
EMV (medium plant) = (.4)($60,000) + (.6)(–$10,000)
= +$18,000
EMV (small plant) = (.4)($40,000) + (.6)(–$5,000)
= +$13,000
EMV (do nothing) = $0

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EMV Applied to Capacity Decision

-$14,000
Market favorable (.4)
$100,000

Market unfavorable (.6)

-$90,000
$18,000
Market favorable (.4)
$60,000
Medium plant
Market unfavorable (.6)
-$10,000
$13,000
Market favorable (.4)
$40,000

Market unfavorable (.6)

-$5,000

$0
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Strategy-Driven Investment

 Operations manager may have to

decide among various financial
options (ROI, ROA)
 Analyzing capacity alternatives
should include capital investment,
variable cost, cash flows, and net
present value

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Net Present Value (NPV)

In general:
F = P(1 + i)N
where F = future value
P = present value
i = interest rate
N = number of years

Solving for P:
F
P=
(1 + i)N
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Net Present Value (NPV)

In general:
F = P(1 + i)N
where F = future value
P While
= present value this works fine,
i = interestitrate
is cumbersome for
N = number of larger
years values of N

Solving for P:
F
P=
(1 + i)N
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NPV Formula

• A higher NPV is better

• Higher the discount
rate lower the NPV

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NPV Using Factors

F
P= = FX
(1 + i)N
where X = a factor from Table S7.1 defined as =
1/(1 + i)N and F = future value

TABLE S7.1 Present Value of $1

YEAR 6% 8% 10% 12% 14%
1 .943 .926 .909 .893 .877
2 .890 .857 .826 .797 .769
3 .840 .794 .751 .712 .675
4 .792 .735 .683 .636 .592
Portion of
5 .747 .681 .621 .567 .519 Table S7.1

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Present Value of an Annuity

An annuity is an investment which

generates uniform equal payments

S = RX
where X = factor from Table S7.2
S = present value of a series of uniform
annual receipts
R = receipts that are received every year
of the life of the investment

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Present Value of an Annuity

TABLE S7.2 Present Value of and Annuity of $1

YEAR 6% 8% 10% 12% 14%
1 .943 .926 .909 .893 .877
2 1.833 1.783 1.736 1.690 1.647
3 2.676 2.577 2.487 2.402 2.322
4 3.465 3.312 3.170 3.037 2.914
5 4.212 3.993 3.791 3.605 3.433

Portion of
Table S7.2

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Present Value of an Annuity

▶River Road Medical Clinic equipment investment

$7,000 in receipts per for 5 years

Interest rate = 6%
From Table S7.2
X = 4.212

S = RX
S = $7,000(4.212) = $29,484

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Present Value With Different

Future Receipts

Investment A’s Investment B’s Present Value

Year
Cash Flow Cash Flow Factor at 8%

$10,000 $9,000 1 .926

9,000 9,000 2 .857

8,000 9,000 3 .794

7,000 9,000 4 .735

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Present Value With Different

Future Receipts
Investment A’s Investment B’s
Year
Present Values Present Values
1 $9,260 = (.926)($10,000) $8,334 = (.926)($9,000)

2 7,713 = (.857)($9,000) 7,713 = (.857)($9,000)

3 6,352 = (.794)($8,000) 7,146 = (.794)($9,000)

4 5,145 = (.735)($7,000) 6,615 = (.735)($9,000)

Totals $28,470 $29,808

Minus initial
investment -25,000 -26,000

Net present value

$3,470 $3,808
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Limitations

1. Investments with the same NPV may have

different projected lives and salvage
values
2. Investments with the same NPV may have
different cash flows
3. Assumes we know future interest rates
4. Payments are not always made at the end
of a period

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Questions?

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Assignment 6- Capacity Planning

I Multichoice: Delivered in advance in syllabus

II. Problems:
P1: Given the following data, calculate: a) BEPx, b) BEP$ and c) at 100,000 units
P= $8/unit V= $4/unit F= $50,000
P2: The three station work cell at a manufacturer is illustrated below. It has two machines at work station in
parallel
a) What is the process cycle time of this work cell?
b) What is the system process time of this work cell?
c) If the company operates 8 hours/ day, 6 days/week, what is the weekly capacity of this work cell?
Station 1
Machine A
20 min/unit Station 2 Station 3
Station 1
Machine B 12 min/unit 8 min/unit
20 min/unit
P3: You are considering opening a copy center in the student union of IU. You estimate your fixed cost at
$15,000 and the variable cost of each copy sold at $0,01. You expect the selling price to average %0.05.
Calculate:
a) What is the break-even point in dollars?
b) What is the break-even point in units?
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