1

OM – II
Capacity Planning
Meaning: Capacity is the limiting capability of a
productive unit to produce within a stated time period,
normally expressed in terms of output (units) per unit
time.
Output may be expressed as a common unit, e.g. rupee
sales, tons, cubic meters, etc. for heterogeneous products.
2
OM – II
Capacity Planning
Capacity depends on a number of factors:
 Intensity of use – Working hours per unit time,
equipment availability (considering downtime),
worker availability (considering absence).
 Product mix – The proportion of different products
having different output rates being produced.
 Bottleneck operation – The capacity of the weakest
link in the sequential sub-processes.
 Availability of required inputs – Quantities and
qualities of raw materials and other purchased
items.
 Outsourcing – of productive activities.
3
OM – II
Capacity Planning
In some cases, especially processing industries,
capacity is further qualified as –
 Licensed capacity – as licensed by statutory bodies.
 Installed capacity – as provided when installing
plant.
 Rated capacity – based on highest production rate
established by actual trials.

4
OM – II
Capacity Planning
Service capacity: It is the greatest level of service output
that can be provided with a given level of resources
under sustainable operating conditions.
Measures can be many:
 For homogeneous service – No. of services/unit
time, e.g. Kwh of power supplied per day by a
power station.
 For heterogeneous service – Availability of the
limiting resource, e.g., man-hours per week, no. of
beds/month (hospital), seat-kilometers per day
(airlines) etc.
Capacity utilization: It relates output measures to inputs
availability, e.g. if 8,500 man-hrs are used in April
against availability of 10,000 man-hours, cap. utilization
is 85%

5
OM – II
Capacity Planning
Objectives: Creation of capacity requires investments, quite
large in case of manufacturing units. Hence, this strategic
decision should satisfactorily answer –
 What are the expectations regarding industry growth,
and the firm’s market share?
 How accurately can the market trends be predicted?
 What is the firm’s attitude towards risk taking?
 If capacity should be created at a few locations with
large capacities, or a no. of locations with small units?
 What is the firm’s policy about making up temporary
shortfall in capacity, about overtime and outsourcing?
 What is the firm’s policy about deliberately not meeting
some of the market demand, at least for some period?
6
OM – II
Capacity Planning
Steps in capacity planning
 Assess the situation and environment to predict long
range future demands.
 Determine the capacity of the existing facilities.
 Translate the forecasts into physical capacity needs.
 Identify sources of capacity, and develop alternative
capacity plans to meet future capacity needs.
 Analyze the economics of the alternative plans.
 Analyze the risks and other strategic consequences of the
alternative plans.
 Select the alternative that satisfies the objectives in the
best possible manner.
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OM – II
Capacity Planning
Forecasting capacity demand
 Implementation of capacity decision may take 5-10 yrs.
 The facility should have an economic life of 5-20 yrs.
 So, forecasting demand for products/services that would
be met from such facility should cover 10-30 yrs.
 Such long term forecasts are difficult to make and prone
to large errors, due to demographic shifts, political or
military events, technological breakthroughs, etc.
 Effect of product life cycle, emerging technologies,
competitor action, etc have to be considered.
 Mature outputs, e.g. steel, have less demand volatility.
 Multiple outputs provide a hedge against changes in
environment, give better forecasts than single output.
 Forecast for each output has to be made separately.
8
OM – II
Capacity Planning
Capacity of the existing facilities
We have to consider the capacity of each facility in the
industry, including upcoming ones and idle capacities.
Assessing physical capacity needs
Production capacity to be provided may not match expected
demand due to several factors e.g., resource constraints,
uncertainty of forecasts, operations strategy.
Capacity cushion – It is the additional capacity added on to
the expected demand to allow:
 Extra capacity in case demand is more than forecast.
 Ability to satisfy peak seasonal demands.
 Product and volume flexibility for prompt response to
customers’ varying needs.
 Improved quality (Stretching limited capacity affects quality
of the products/services adversely).
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OM – II
Capacity Planning
Ways of changing capacity
Expanding capacities:
 Subcontracting
 Acquiring other companies, facilities, or resources.
 Green field projects to add new facilities.
 Expand, update, or modify existing facilities.
 Reactivate facilities on standby status.
Reducing capacities:
 Sell off existing facilities, inventories, layoff/transfer
employees.
 Mothball facilities and place on standby status, sell
inventories, layoff/transfer employees.
 Develop & phase in new products as others decline.
(The preferred way to maintain high capacity utilization
despite declining demand of the existing outputs).
10
OM – II
Capacity Planning
Effect of time phasing products on capacity utilization
120
20
40
60
80
100
1995 1996 1997 1998 1999 2000 2001 2002 2003
Aggregate Capacity Utilization
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Time (Years)
11
OM – II
Capacity Planning
Economies & Diseconomies of Scale
For a given production facility, there is an annual volume of
outputs that results in least average unit cost. This is called
the facility’s best operating level (BOL).
As the annual output increases, fixed costs of the facility per
unit output decreases.
Operating costs also go down due to fewer set up changes,
proportionately less scrap, & other economies.
12
OM – II
Capacity Planning
Economies & Diseconomies of Scale (contd.)
Past BOL, additional volume results in reduced efficiency
of operation due to:
 Increased materials and workers congestion.
 Difficulty in scheduling.
 Damaged goods.
 Reduced morale.
 Increased use of OT.
 Other diseconomies.

13
OM – II
Capacity Planning
Economies & Diseconomies of Scale (contd.)
Best operating level (BOL) A
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Annual volume (Units)
14
OM – II
Capacity Planning
Economies & Diseconomies of Scale (contd.)
 Each facility has its unique BOL. All other things being
equal, facilities with higher BOL require higher
investment.
 Managers must decide between two general approaches:
a) Heavy investment in one large facility with higher
BOL that will satisfy the firm’s long range capacity
needs.
b) Low initial investment in a small facility with lower
BOL to satisfy short range demand followed by
incremental capacity expansions as required.
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OM – II
Capacity Planning
Incremental facility capacity strategy
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Annual volume (Units)
240,000
450,000
640,000
Year Forecasted
annual volume
Least unit
cost facility
1 200,000 A
2 250,000 A
3 320,000 B
4 360,000 B
5 400,000 B
6 450,000 B
7 520,000 C
8 560,000 C
9 600,000 C
10 640,000 C
The strategy tends to keep average unit cost lowest. It is less risky
too. But total investments would be more than that for one time
investment in large plant, more interruptions too.
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OM – II
Capacity Planning
Economies & Diseconomies of Scale (contd.)
 Choosing between the two options:
 For mature products with stable, predictable demand,
firms tend to build ultimate capacity in one go.
 For new products with risky future demand, firms
lean toward an incremental expansion strategy.
 The choice will also depend on nature of product,
funds availability, firm’s attitude toward risk taking
etc.
17
OM – II
Capacity Planning
Evaluating capacity planning decisions
 Facility planning decisions can be analyzed using:
• Break-even analysis to compare costs of alternatives.
• Present value analysis to obtain NPV of all cash
outflows & inflows over project lives for the options.
• Computer simulation to get best set of parameters,
given random variations in product demand, etc.
• Decision tree analysis to see what decisions must be
made at each stage in multiphase decision making.
 Break-even analysis and net present value method are
suitable for mature outputs.
 Computer simulation, decision tree & other stochastic
methods are necessary in case of risky demand.
18
OM – II
Capacity Planning
Risk analysis of alternate plans
 A firm would go for over capacity if:
• There are some minimum economic capacity sizes.
• Cost involved in creating capacity is relatively low.
• Subcontracting is impossible or very difficult.
• Lead time required to install new capacity is too
long.
• Demand growth is more likely to be nearer optimistic
than pessimistic prediction.
• Lost sales are perceived more negatively by trade
than proportionate drop in market share.
19
OM – II
Capacity Planning
Risk analysis of alternate plans (contd.)
 A firm would go for small incremental capacity if:
• Alternate sources of capacity are easily available.
• Cost involved in incremental capacity build up is
low.
• Lead time needed to install new capacity is short.
• The customers are expected to wait/lost sales have no
long term consequences.

20
OM – II
Capacity Planning
Capacity Requirement Planning (CRP)
 CRP is a part of resource requirement planning that
tests capacity feasibility of master production schedule
(MPS).
 It results in a plan that assigns orders to work centers
(WC), uses OT, subcontracting, etc. to meet the MPS.
 Planned order releases (MRP schedules) is the basis of
CRP, assigns orders to WCs based on routing plans.
 Lots of materials are then converted to capacity load
data by using labor and machine standards.
 Next, weekly load schedules are prepared for each WC
that includes all orders.
21
OM – II
Capacity Planning
Capacity Requirement Planning (contd.)
 If WCs have enough capacity, MPS is firmed up.
 If not, economical options (OT, subcontracting, etc)
are explored to augment capacity and firm up the MPS.
 If it is not feasible, routing/assignment of orders to
WCs is juggled to improve capacity, or MPS is
changed.