LGT 2106

Principles of Operations Management

2023/24, Semester 1

Lecture 2
Capacity Management & Aggregate Planning
Learning Outcomes of Lecture 2
1. Explain what capacity management is and why it is strategically important

2. Learn some capacity concepts

3. Exemplify how to plan capacity

4. Construct aggregate plans and evaluate alternatives

References: Jacobs & Chase, 15th ed, Chapters 5, 19.

Capacity Management in Operations
• Capacity: the ability to hold, receive, store, or accommodate

• In business, viewed as the amount of output that a system is capable of achieving over a specific
period of time
• Restaurant: the number of customers who are served between 11:00am and 1:00pm

• Capacity management needs to consider both inputs and outputs

• Automobile factory: 6,000 production hours/year → 150, 000 two-door models/year, or 120, 000 four-door models/year

• Many industries measure and report capacity in terms of output

• Industries whose product mix is very uncertain often express capacity in terms of inputs
• Hospitals: the number of beds
Factors Affecting Capacity Decisions
• External Factors
• Government regulations, e.g., greenhouse gas emission, aquatic pollution
• Union agreements, e.g., maximum working hours
• Supplier capabilities

• Internal Factors
• Personnel and jobs (worker training, job content)
• Product and service design
• Plant layout and process flow
• Equipment capabilities and maintenance
• Materials management
• Quality control systems
• Management capabilities
Production System Capacity Affects:

• Response rate to market changes

• Overall product cost structure

• Composition of the workforce

• Level of production technology utilized

• Extent of management and staff support

• General inventory strategy

Reference: Davis/Heineke 386-392

Strategic Capacity Planning
• Determining the overall capacity level of capital-intensive resources that best supports
the company’s long-range competitive strategy
• Facilities
• Equipment
• Labor force size

• Capacity level has a critical impact on response rate, its cost structure, its inventory
policies, and its management and staff support requirements
• Too low: the firm will lose customers and encourage competitors
• Too high: firm may have to cut costs or underutilize its capacity
Capacity Planning Concepts
• Capacity implies the output that a system is capable of achieving over a period of time

• Best operating level: the level of capacity for which the process was designed and the
volume of output at which average unit cost is minimized

• Capacity utilization rate: a measure of how close the firm is to its best possible
operating level

𝐶𝑎𝑝𝑎𝑐𝑖𝑡𝑦 𝑢𝑠𝑒𝑑
𝐶𝑎𝑝𝑎𝑐𝑖𝑡𝑦 𝑢𝑡𝑖𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 =
𝐵𝑒𝑠𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑣𝑒𝑙
• The capacity utilization rate is expressed as a percentage and requires the numerator and denominator be measured in the same
units and the same time periods
Capacity Utilization and Service Quality

Source: Adapted from Christopher Lovelock, “Strategies for Managing Capacity-Constrained Services,” Managing
Services: Marketing, Operations Management and Human Resources, 2nd ed. (Englewood Cliffs, NJ: Prentice Hall, 1992).
Capacity Utilization and Service Quality
• Balancing Capacity and Demand (in service operations)

• Demand exceeds maximum capacity, customers are turned away [You receive a busy signal when you
call to make a hotel reservation.]
• Demand exceeds optimum capacity utilization, customers receive poor service. [You have to wait more
than an hour to be seated in a very busy restaurant.]

• Demand equals optimum capacity utilization, customers are serviced properly. [Your wait at the
supermarket checkout is short even though all of the checkout stations are being used.]

• Demand is less than optimum capacity utilization, there is idle capacity. [Your telephone call is
answered immediately or you are seated immediately in a restaurant.]

• Too much remaining capacity—costs rise.

• Too little remaining capacity—customers are lost.
Capacity Utilization and Service Quality
• Optimal levels of utilization are context specific

• Low rates are appropriate when the degree of uncertainty (in demand) is high
and/or the stakes are high (e.g., emergency rooms)

• Higher rates are possible for predictable services or those without extensive
customer contact (e.g., commuter trains, postal sorting)
Economies & Diseconomies of Scale
Economies & Diseconomies of Scale
• Economies of scale: the idea that as a plant gets larger and volume increases, the average
cost per unit tends to drop
• More efficient equipment due to advanced technology
• Lower operating and capital cost due to mass production
• Better use of market information
• Volume discounts from suppliers

• Diseconomies of scale: at some point, the plant becomes too large and average cost per
unit begins to increase
• Poor communication, lack of motivation
• Company size becomes too large to manage efficiently
• Higher labor costs
• Higher resource costs
Capacity & Demand Management

• Capacity Management • Demand Management

➢Vary staffing ❖Vary prices

➢Subcontracting/ ❖Vary promotion
joint ventures ❖Change lead times
➢Change equipment & processes (e.g., backorders)
➢Change methods ❖Offer complementary products
➢Redesign the product for faster
processing
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
➢ Product changes

❖ Adjusting to seasonal demands

➢ Produce products with complementary demand patterns
Reference: Heizer/Render 314-320
Complementary Demand Patterns

4,000 –
Sales in units

3,000 –

2,000 –

1,000 – Jet ski engine sales

JFMAMJJASONDJFMAMJJASONDJ
Time (months)
Complementary Demand Patterns

Sales in units

4,000 –
Snowmobile motor sales
3,000 –

2,000 –

1,000 –

JFMAMJJASONDJFMAMJJASONDJ
Time (months)
Complementary Demand Patterns

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

JFMAMJJASONDJFMAMJJASONDJ
Time (months)
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

© 2011 Pearson
Education
Demand and Capacity Management in the Service Sector
• Demand management
• Appointment, reservations, FCFS rule

• Capacity management
• Full time, temporary, part-time staff

© 2011 Pearson
Education
Capacity Flexibility
The ability to rapidly (with short lead times) increase or decrease production levels, or to
shift quickly from one product or service to another

Flexible Plants • Ability to quickly adapt

• Zero-changeover time

Flexible • Flexible manufacturing systems

Processes • Simple, easily set up equipment

• Ability to switch from one kind of task to

Flexible Workers another quickly
• Multiple skills (cross training)

Use of External • Subcontracting

Capacity • Shared capacity
Flexibility Designs
Dedicated system Long chain Full flexibility

1 A 1 A 1 A

2 B 2 B 2 B

3 C 3 C 3 C

4 D 4 D 4 D

William C. Jordan and Stephen C. Graves. 1995. Principles on the Benefits of Manufacturing Process Flexibility. Management Science.
• Performance: dedicated system ≪ long chain ≈ full flexibility
• Adding a little flexibility, if configured in a right way, can lead to extremely effective performance in dealing with demand uncertainty
Considerations in Changing Capacity
Maintaining System Balance

• Similar capacities desired at each operation

• Manage bottleneck operations, add buffer inventories, duplicate or increase the facilities of one
department on which another is dependent

Frequency of Capacity Additions

• Cost of upgrading too frequently

• Cost of upgrading too infrequently

External Sources of Capacity

• Outsourcing, e.g., Dell computer uses a Chinese company to assemble notebooks

• Sharing capacity, e.g., airline sharing routes

Decreasing Capacity

• Temporary reductions, e.g., scheduling an extended shutdown period

• Permanent reductions, e.g., sale/liquidation of facility
Strategies for Adding Capacity: Proactive Strategy
Strategies for Adding Capacity: Reactive Strategy
Strategies for Adding Capacity: Neutral Strategy
Capacity Planning
Determining which level of capacity to operate at to meet customer demand in a
cost-efficient manner.

Typical steps for long-range planning

1. Forecast sales for each product line.

2. Forecast sales for individual products within each line.
3. Calculate labor and equipment requirements to meet product line forecasts.
4. Project labor and equipment availabilities over the planning horizon.
Example: Determining Capacity Requirements
• Stewart Company produces two flavors of salad dressings: Paul’s and Newman’s
• Each is available in bottles and single-serving bags
• Have 3 machines, and each machine can package 150,000 bottles each year
• Each machine requires 2 operators
• Have 5 machines, and each machine can package 250,000 plastic bags per year
• Each machine requires 3 operators
• What are the capacity and labor requirements for the next five years?

Predicted Sales for Individual Products in the next 5 years

Step 1: Use Forecasting to Predict Sales for Individual Products
Step 2: Calculate Equipment and Labor Requirements

Bottling Operation Bagging Operation

• Capacity: 450,000 • Capacity: 1,250,000
• 150,000 x 3 • 250,000 x 5
• Operators: 6 • Operators: 15
• 2x3 • 3x5
• Year 1 • Year 1
135 300
• 𝐶𝑎𝑝𝑎𝑐𝑖𝑡𝑦 𝑢𝑡𝑖𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 = 450 = 0.3 • 𝐶𝑎𝑝𝑎𝑐𝑖𝑡𝑦 𝑢𝑡𝑖𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 = = 0.24
1,250

• 𝑀𝑎𝑐ℎ𝑖𝑛𝑒 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡 = 0.3 × 3 = 0.9 • 𝑀𝑎𝑐ℎ𝑖𝑛𝑒 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡 = 0.24 × 5 = 1.2

• 𝐿𝑎𝑏𝑜𝑟 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡 = 0.9 × 2 = 1.8 • 𝐿𝑎𝑏𝑜𝑟 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡 = 1.2 × 3 = 3.6
Step 3: Project Equipment and Labor Availabilities over the
Planning Horizon
Overview of Operational Planning Activities

• The process that companies use to keep demand and supply in balance by
coordinating manufacturing, distribution, marketing and financial plans
• Require an integrated effort with cooperation from sales, distribution and logistics, operations,
finance and product development

• Long-Range Planning
• Focuses on strategic issues relation to capacity, process selection, and plant location

• Intermediate-Range Planning
• Focuses on tactical issues pertaining to aggregate workforce and material requirements for the
coming year

• Short-Range Planning
• Addresses day-to-day issues of scheduling workers on jobs at assigned work stations
Reference: Davis/Heineke 478-489
Overview of Manufacturing Planning Activities
Intermediate-Range Planning
• Aggregate Production Planning
• Translates annual and quarterly business plans into broad labor and output plans for the intermediate
term.
• The process for determining the most cost effective way to match supply and demand over the next 3–
18 months.

• Master Production Scheduling (MPS)

• Short-term scheduling of specific end product requirements for the next several quarters.

• Rough-Cut Capacity Planning

• Determining that adequate production capacity and warehousing are available to meet demand.
Aggregate Operations Plan
• The main purpose of aggregate operations plan is to specify the optimal combination of production
rate, workforce level, and inventory on hand
• Production Rate
• The capacity of output per unit of time (such as units per day or units per week)
• Workforce Level
• Number of workers required to provide a specified level of production
• Inventory on Hand
• The surplus of units that results when production exceeds demand in a given time period
Example: Units on hand=100, Demand=80.
Then: Inventory = 100-80 = 20
• Backlog (or Stockout)
• The deficit in units that results when demand exceeds the number of units produced in a given
time period.
Example: Units on hand=100, Demand=120.
Then: Unsatisfied demand = 120-100 = 20 (backlog or lost sales)
Aggregate Planning Problems
• Given the demand forecast 𝐹𝑡 for period t in the planning horizon that extends over T periods,
determine the production level 𝑃𝑡 , inventory level 𝐼𝑡 , and workforce level 𝑊𝑡 for periods 𝑡 =
1,2, … , 𝑇 that minimize the relevant costs over the planning horizon
• Basic production costs
• The fixed and variable costs incurred in producing a given product type in a given time period
• Costs associated with changes in the production rate
• Hiring, training, and laying off personnel
• Inventory holding costs
• Capital, storing, insurance, taxes, spoilage, and obsolencence
• Backorder costs
• Hard to measure
• Loss of goodwill
• Loss of sales revenues
Required Inputs to the Production Planning System

Exhibit 19.2
Production Planning Strategies
• Chase Strategy
• Matching the production rate to exactly meet the order rate by hiring and laying off workers as the order rate
varies

• Stable Workforce—Variable Work Hours

• Varying output by varying the number of hours worked through flexible schedules or overtime

• Level Strategy
• Maintain a stable workforce working at constant output rate; absorb demand variations with inventory,
backlogs, or lost sales
Production Planning Strategies (cont’d)
• Pure Strategy
• A simple strategy that uses just one option, such as hiring and firing workers, for meeting demand

• Mixed Strategy
• A more complex strategy that combines options for meeting demand

• Mixed strategies are more widely applied in industry

 January February March April May June Totals
Demand Forecast (units) 2250 1450 1100 900 1100 1600 8400
Number of Working Days by Month 22 19 21 21 22 20 125

Costs
Materials cost $100.00 per unit
Inventory holding cost $1.50 per unit per month
Forecasted
Stockout cost $5.00 per unit per month
Subcontracting cost $125.00 per unit
Demand and
Hiring and training cost $200.00 per worker Workdays for
Layoff cost $250.00 per worker
C&A Company
Labor hours required per unit 5.0 per unit
Straight-time cost (first eight hours each day) $4.00 per hour
Overtime cost (time and a half) $6.00 per hour

Initial state
Initial inventory 400 units
Number of workers currently employed 30
Example: Evaluate Alternative Plans
1. Produce to meet (exact) monthly production requirements by varying workforce size

2. Produce to meet expected average demand by maintaining a constant workforce

3. Produce to meet the minimum expected demand using a constant workforce and subcontract to
meet additional requirements

4. Produce to meet expected demand for all but the first two months using a constant workforce
and use overtime to meet additional output requirements
First Alternative: Pure Chase Strategy
It is often useful to convert demand forecasts into production requirements.
January February March April May June Total
Demand forecast 2,250 1,450 1,100 900 1,100 1,600 8,400
Working days (per month) 22 19 21 21 22 20 125

Aggregate Plan
Beginning inventory 400 16 25 0 7 33
Production requirements 1,850 1,434 1,075 900 1,093 1,567
Workers Required 53 48 32 27 32 49
- New Workers Hired 23 0 0 0 5 17
- Workers Laid Off 0 5 16 5 0 0
Units produced 1,866 1,459 1,075 907 1,126 1,568 8,001
Ending inventory 16 25 0 7 33 1
Costs
Material cost 186,600 145,900 107,500 90,700 112,600 156,800 $800,100
Hiring cost 4,600 0 0 0 1,000 3,400 $9,000
Layoff cost 0 1,250 4,000 1,250 0 0 $6,500
Straight time cost 37,312 29,184 21,504 18,144 22,528 31,360 $160,032
Inventory carrying cost 24.0 37.5 0.0 10.5 49.5 1.5 $123
Total Cost $975,755

Assume: Once scheduled, all workers will produce at their full potential.
Second Alternative: Pure Level Strategy
January February March April May June Total
Demand forecast 2,250 1,450 1,100 900 1,100 1,600 8,400
Working days (per month) 22 19 21 21 22 20 125
Initial inventory 400
Production requirements 1,850 1,450 1,100 900 1,100 1,600 8,000
Aggregate Plan
Workers Required 40 40 40 40 40 40
- New Workers Hired 10 0 0 0 0 0
- Workers Laid Off 0 0 0 0 0 0
Units produced 1,408 1,216 1,344 1,344 1,408 1,280 8,000
Monthly inventory -442 -234 244 444 308 -320
Cumulative inventory -442 -676 -432 12 320 0
Costs
Material costs 140,800 121,600 134,400 134,400 140,800 128,000 $800,000
Hiring cost 2,000 0 0 0 0 0 $2,000
Layoff cost 0 0 0 0 0 0 $0
Straight Time Cost 28,160 24,320 26,880 26,880 28,160 25,600 $160,000
Inventory carrying cost 0.0 0.0 0.0 18.0 480.0 0.0 $498
Stockout cost 2210.0 3380.0 2160.0 0.0 0.0 0.0 $7,750
Total Cost $970,248
Third Alternative: Minimum Workforce with Subcontracting
• Hire just enough workers to meet the minimum monthly demand

January February March April May June Total

Demand forecast 2,250 1,450 1,100 900 1,100 1,600 8,400
Working days (per month) 22 19 21 21 22 20 125
Aggregate Plan
Beginning inventory 400 0 0 0 7 0
Production requirements 1,850 1,450 1,100 900 1,093 1,600
Workers Required 27 27 27 27 27 27
- New Workers Hired 0 0 0 0 0 0
- Workers Laid Off 3 0 0 0 0 0
Units produced 950 821 907 907 950 864 5,399
Units subcontracted 900 629 193 0 143 736 2,601
Ending inventory 0 0 0 7 0 0
Costs
Material cost 95,000 82,100 90,700 90,700 95,000 86,400 $539,900
Hiring cost 0 0 0 0 0 0 $0
Layoff cost 750 0 0 0 0 0 $750
Straight time cost 19,008 16,416 18,144 18,144 19,008 17,280 $108,000
Inventory carrying cost 0.0 0.0 0.0 10.5 0.0 0.0 $10.5
Subcontracting Cost 112500.0 78625.0 24125.0 0.0 17875.0 92000.0 $325,125
Total Cost $973,786
Fourth Alternative: Constant Workforce with Overtime and Inventory
• Meet the demand for March-June using a constant workforce on regular time
January February March April May June Total
Demand forecast 2,250 1,450 1,100 900 1,100 1,600 8,400
Working days (per month) 22 19 21 21 22 20 125
Initial inventory 400
Production requirements 1,850 1,450 1,100 900 1,100 1,600 8,000
Aggregate Plan
Workers Required 35 35 35 35 35 35
- New Workers Hired 5 0 0 0 0 0
- Workers Laid Off 0 0 0 0 0 0
Units produced - regular 1,232 1,064 1,176 1,176 1,232 1,120 7,000
Units produced - overtime 618 386 0 0 0 0 1,004
Monthly inventory 0 0 76 276 132 -480
Cumulative inventory 0 0 76 352 484 4
Costs
Material costs 185,000 145,000 117,600 117,600 123,200 112,000 $800,400
Hiring cost 1,000 0 0 0 0 0 $1,000
Layoff cost 0 0 0 0 0 0 $0
Straight Time Cost 24,640 21,280 23,520 23,520 24,640 22,400 $140,000
Overtime Cost 18,540 11,580 0 0 0 0 $30,120
Inventory carrying cost 0.0 0.0 114.0 528.0 726.0 6.0 $1,374
Total Cost $972,894
Summary of Costs for Aggregate Plans

Alternative Full Costs

Pure Chase $975,755

Pure Level $970,248

Minimum workforce with subcontracting $973,786

Constant workforce with overtime $972,894