CAPACITY PLANNING

Capacity refers to an upper limit or ceiling on the load that an operating unit can handle.
The load might be in terms of the number of products or services. The operating unit
might be a plant, department, machine, store, or worker.

Organizations become involved in capacity planning for various reasons such as;
 Changes in demand
 Changes in technology
 Product/Service Design
 Changes in the environment
 Competitive forces

The frequency of making capacity decision also depends on changes in above

factors. The goal of strategic capacity planning is to achieve a match between the
long-term supply capabilities of an organization and the predicted level of long-
term demand.

The key questions in capacity planning are the following:

1. What kind of capacity is needed?
2. How much is needed to match demand?
3. When is it needed?

The question of “what kind of capacity is needed” depends on the products and
services that management intends to produce. For example, the kind of capacity
needed to produce steel will be different from the kind of capacity needed by a
hospital.

For the other two questions, Forecasts are key inputs used to answer these
questions of how much capacity is needed and when is it needed.

Because of uncertainty in demand, some organizations delay the decision to

increase the capacity till the demand materializes. But such strategies hinder growth
because it takes time to increase capacity and to produce increased number of good
to fulfill increased demand but customers do not wait. On the other hand, those
organizations which respond quickly to forecasted demand and increase their
capacity realize that the new capacity actually attracts growth.

IMPORTANCE OF STRATEGIC CAPACITY DECISIONS

Capacity decisions are among the most fundamental of all the design decisions that
managers must make for the following reasons.
1. Because capacity decisions often involve substantial financial and other
resources, it is necessary to plan for them far in advance and for longer term.
This (long term) is the reason capacity decisions are said to be strategic.
2. Capacity decisions have a real impact on the ability of the organization to
meet future demands for products and services; capacity essentially limits
the rate of output possible.
3. Capacity decisions affect operating costs. Ideally, capacity and demand
requirements should be matched, which tends to minimize operating costs.
 4. Capacity is usually a major determinant of initial cost. Typically, the greater
the capacity of a productive unit, the greater its cost
5. Capacity decisions often involve long-term commitment of resources and the
fact that, once they are implemented, those decisions may be difficult or
impossible to modify without incurring major costs.
6. Capacity decisions can affect competitiveness. If a firm has excess capacity,
or can quickly add capacity, that fact may serve as a barrier to entry by other
firms.

HOW TO MEASURE CAPACITY

In selecting a measure of capacity, it is important to choose one that does not
require updating. For example, dollar amounts are often a poor measure of capacity
(e.g., capacity of $30 million a year) because price changes, and exchange rates
require updating of that measure.

Single product: Where only one product or service is involved, the capacity of the
productive unit may be expressed by stating the maximum number of that product
that can be produced.

Multiple Products or Services: For multiple products or services using a simple

measure of capacity can be misleading. One the other hand, it is also impractical to
add up all the capacities of all the products separately. Therefore, a preferred
measure used in that case is availability of inputs. Thus, a hospital has a certain
number of beds, a factory has a certain number of machine hours available, and a
bus has a certain number of seats. Etc.

Up to this point, we have been using a general definition of capacity. Although it is

functional, but capacity can be refined into two useful definitions of capacity:

1. Design capacity: The maximum output that a process can achieve under ideal
conditions.

2. Effective capacity:
The maximum output that a process can achieve under Real conditions.
Conditioned by the realities of machine breakdowns, the need for periodic
maintenance of equipment, lunch breaks, coffee breaks etc, the Actual Capacity can
not exceed effective capacity. (Breakhorsepower Example.)

These different measures of capacity are useful in defining two measures of system
effectiveness: efficiency and utilization. Efficiency is the ratio of actual output to
effective capacity. Capacity utilization is the ratio of actual output to design capacity.

ActualOutput
Efficiency= × 100
Effective Capacity

Actual Output
Utilization= × 100
Design Capacity
 DETERMINANTS OF EFFECTIVE CAPACITY
Many factors have an impact on capacity planning decisions. Some of these are only
briefly described here, you will learn more details about them later in the course.

Facilities.
The design of facilities, including size and provision for expansion, is key.
Locational factors, such as transportation costs, distance to market, labor supply,
energy sources, and room for expansion, are also important.

Product and Service Factors.

Product or service design can have a tremendous influence on capacity. For
example, the more uniform the output, the more opportunities there are for
standardization of methods and materials, which leads to greater capacity. Thus, a
restaurant that offers a limited menu can usually prepare and serve meals at a faster
rate than a restaurant with an extensive menu.

Process Factors.
The quantity capability of a process is an obvious determinant of capacity. For
instance, Quality. If quality of output does not meet standards, the rate of output
will be slowed by the need for inspection and rework activities. Therefore capacity
will reduce.

Human Factors.
The tasks that make up a job, the variety of activities involved, and the training,
skill, and experience, all have an impact on the potential and actual output. In
addition, employee motivation also has a very basic relationship to capacity.

Policy Factors.
Management policy can affect capacity by allowing or not allowing capacity options
such as overtime or second or third shifts.

Operational Factors.
Scheduling problems, Inventory stocking decisions, late deliveries, quality
inspection and control procedures also affect capacity decisions.

External Factors.
Product standards, minimum acceptable quality limits, regulations by government
or labor unions which may keep employees busy in other activities also affect the
capacity of production.

CAPACITY STRATEGY FORMULATION

The three primary strategies are leading, following, and tracking.

Leading Strategy: A leading capacity strategy builds capacity in anticipation of

future demand increases. If capacity increases involve a long lead time, this strategy
may be the best option.

Following Strategy: A following strategy builds capacity when demand actually

exceeds current capacity.
Tracking Strategy: A tracking strategy is similar to a following strategy, but it adds
capacity in relatively small increments to keep pace with increasing demand.

In some instances, Capacity Cushion is used which is Extra capacity used to offset
demand uncertainty.

STEPS IN THE CAPACITY PLANNING PROCESS

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

DEVELOPING ALTERNATIVE CAPACITY STRATEGIES

Following are some strategies that are adopted by the organizations to handle any
potential changes in future capacity.

1. Design for Flexibility:

Managers shall consider a provision for expansion in current capacity to deal with
any change in demand in future. For example, a hospital containing 50 beds may
need to expand to 100 beds after 5 years. In that case, the hospital should have a
flexible design that is capable of expansion. Such as water lines, power hookups,
and waste disposal lines can be put in place initially so that when expansion is
done, modification to the existing structure can be minimized.

Expansion of a 9 hole golf course to an 18 hole course may require a pre-acquisition

of land. Similarly, that is the reason most public or governmental building spare
some land around it to deal with possible future expansions. pu example

2. Take Stages of Life Cycle into Account:

Organizations need different levels of capacity depending upon life cycle stage at
which their product is.

At introduction stage, product is new, size and growth of the market is not assured.
Therefore, capacity is kept smaller.

At growth phase, market is experiencing rapid growth, therefore, capacity needs to

be enhanced. Any expansion in capacity depends on the rate of increase in
organization’s market growth, not on overall market growth in the industry.

In the maturity phase the size of market levels off, and organizations tend to have
stable market shares. At this stage, organizations usually are already operating at
the maximum capacity. But sometimes capacity is increased in order to attain a
competitive advantage over competitors or it is increased if doing so reduces cost
per item i. e. Economies of scale.
In the decline phase, when product demand is declining, organizations’ capacity
seems to be more than needed. It faces underutilization of capacity. In such a case,
organizations may eliminate the excess capacity by selling it, or utilize it by
introducing new products or services

3. Take a “Big-Picture” (i.e., systems) Approach to into Account.

When developing capacity alternatives, it is important to consider how parts of the
system interrelate. For example, when making a decision to increase the number of
rooms in a hotel, one should also take into account probable increase in parking
area, increased supply of food and staff etc. This is Big-Picture approach.

The risk in not taking a big-picture approach is that the system will be unbalanced.
One example of unbalanced system is the existence of a bottleneck operation. A
bottleneck operation is an operation in a sequence of operations whose capacity is
lower than the capacities of other operations in the sequence.

4. Be Prepared to deal with Capacity “Chunks”:

Capacity is increased usually in large chunks rather than small increments. For
example, if your existing capacity is 200 products, the next increase may rise to 300
products (an increase of 100 products [large chunk]) instead of increasing to 220
products.

Managers should be prepared to deal with such increases that may not match with
the combined capacities of your machines. For example, if total demand is increased
by 50 products, each of your machines is capable of producing 15 products per day.
Then how can you match it with the capacity? Adding 3 machines would increase
the capacity by 45 products (15x3=45) which is 5 products short of demand. But
adding 4 machines would produce an excess capacity of 10 products.

5. Be Prepared to deal with Unevenness in Capacity Requirements:

Dealing with unevenness in demand patterns is also another challenge for
managers. Demand may vary from time to time. This variation is either seasonal or it
can be random.

Seasonal Variation is easier to handle because managers can predict the demand in
each season. For example, flow of customers to northern areas of Pakistan decreases
in winter because of land sliding and excess of snow, or harsh cold weather. But
increases in summer because of pleasant weather there.
Another example is a local shop that provides blocks of Ice in summer, may not be
able to continue its operations in winter because the demand declines to zero. Same
is the case with our local banquet halls.

One possible approach to this problem is to identify products or services that have
complementary demand patterns, that is, patterns that tend to offset each other as
shown in following figure. In above example of Ice business, the owner may choose
to sell chicken soup in winter because the demand of soup is higher in winter and
low in summer which is opposite (complementary) to the demand of Ice.
 A & B have complementary demand patters.

Random Variation, on the other hand is difficult and more complicated to handle.
Managers can not predict the pattern. Consequently, the system tends to alternate
between underutilization and overutilization. A different product with
complementary demand can not be used.

In times of higher demand, One solution to this problem is to use worker overtime.
Which means that the workers will have to work overtime when demand rises.
Another solution is to outsource the production of extra products.

6. Identify The Optimal Operating Level.

Production units typically have an ideal or optimal level of operation in terms of
per unit cost of outputs. At the optimal level, cost per unit is minimum, production
below or above that will bear more cost. The reason is, when output is low, fixed
cost is absorbed by lesser products, when output is high, other factors such a
workers fatigue or machine breakdowns increase per unit cost.

At the optimal point, where per unit cost is minimum, it is called economies of
scale. However, if output is increased beyond the optimal level, average unit costs
would become increasingly larger. This is known as diseconomies of scale.

7. Choose Strategy if Expansion is Involved:

As it was discussed earlier that capacity increases happen in large chunks. In such a
case where expansions in capacity are expected in future, managers should plan for
it accordingly.

For example, when demand for output is increased, managers have to increase the
plant size to produce more products, this results in decrease in per unit cost of each
product. Therefore, each expansion shifts the optimal production level of plant as it
is shown in the figure below.

EVALUATING CAPACITY ALTERNATIVES

Cost-Volume Analysis
Financial Analysis