12.

Scale and Capacity Planning

(Inclusive of ‘Service Capacity Planning’,
with emphasis on the ‘long term’ capacity planning)
By Prof. N. Narayanan
In
“OPERATIONS MANAGEMENT – I”
(WMP, Term I: July – Sep, 2012)

Reference:
Sup 6: Capacity Planning (pp 247 – 273),

In: J. Heizer, B. Render and J. Rajashekhar, Operations

Management, 9th Edition, Pearson Education, 2009
 Sessions Plan – Part B

Sn. Text
Date Topic Core Agenda for Session
Nos. Reading
12 17 Scale and Sup. 6: 1. Case: Too Little Capacity at Dalrymple Bay (pp
Aug Capacity Capacity 252);
2012 Planning Planning 2. Case: Too Much Capacity at GM and Ford (pp 253)
(Fri) (pp 247 – 3. BE Analysis: Single Product Case (pp 258)
273)
4. BE Analysis: Multiproduct Case (pp 258 – 260)
5. Capacity Planning at Arnold Palmer Hospital (pp
272)
• Problem No. 6.28 (pp 271) – Holtz Furniture –
Capacity Planning by Decision Tree Analysis
• Problem No. S6.22: A & Z Lettuce Products (pp
270) – Breakeven analysis for single product
• Problem No. S6.23: Carter Manufacturing (pp 270)
– Breakeven analysis for single product
• Problem No. S6.24: Red Rose Club (pp 271) –
Breakeven analysis for multiple products
• HBSP Case: 9-687-045: Chaparral Steel (Abridged),
19pp. [Assignment – 1]
 Global Co. Profile: Hard
Rock Café’s Concert Hall
— Planning for Capacity (pp 248)
The concern is that both:
1. Forecasted capacity requirements (and hence
the operating operation level), i.e., the market
demand for
1. Operas,
2. Symphony, and
3. Other special events,
2. ‘The Expected Output’ of the facility
should be adequate for the operation of the
concert hall, well above its breakeven point.
 Example:
Hard Rock Café’s Concert Hall
— Planning for Capacity1 (Continued)
• Ensuring by strategic planning that Hard Rock
Cafe’s Concert Hall will be able to operate well
above the ‘break-even point’ is not merely a
matter of the ‘long term capacity planning’ alone.
• All the basic long term decisions of ‘product
design’, ‘process design’, ‘business design’ and a
corresponding the ‘long term capacity planning’
need to be considered together to ensure at the
strategic level that the operation will be above its
break-even point.
 Overview
1. What is Capacity?
a. Design and Effective Capacity
b. Capacity and Strategy
c. Additional Capacity Considerations
d. Medium/Short Term Capacity Planning – OMIT
2. Long Term Capacity Planning
3. Break Even Analysis (in Resolving the
Process Choice/ Capacity Options)
a. Single-Product Case (in terms of ‘units’ , or dollar value of
the product)
b. Multi-Product Case (in terms of dollar value for all the
products)
4. Applying Decision Trees to Capacity Decisions (based
on both break-even points and market conditions being favorable/ unfavorable)
[Continued]
 Overview (Continued)

5. Applying Investment Analysis to Strategy-Driven

Investments – OMIT
a. Investment, Variable Cost, and Cash Flow
b. Net Present Value
6. Overall Methodology in Making Right Process and
Capacity Choice – OMIT
7. Caselet: Capacity Planning at Arnold Palmer
Hospital (pp 272)
1. What is Capacity?
 What is ‘Capacity’?
 The throughput1, or the number of units a
facility can hold, receive, store, or produce in
a period of time.
 Determines fixed costs, to cover investments
in equipment, etc.
 Determines if the market demands can be
fully satisfied.
 Generally involves three time horizons, of
which the long term horizons cover
equipment investments.
1 throughput – output in relation to input;
– the amount passing through a system from input to output
 Capacity Planning Over a Time Horizon

Modify capacity Use capacity

Long-range Add facilities

planning Add long lead time eqpt. *

Intermediate Subcontract Add personnel

-range Add equipment Build or use inventory
planning Add shifts

Schedule jobs
Short-range * Schedule personnel
planning Allocate machinery

* Limited options exist The focus of this session

1a. ‘Design’ and ‘Effective’
Capacity
 ‘Design’ and ‘Effective’ Capacity
 Design capacity is the maximum theoretical
output of a system
 Normally expressed as a rate
 Effective capacity is the capacity a firm expects
to achieve given current operating constraints
(e.g., high product variety in a jobbing environment, requiring
giving high allowances for the non-value-adding ‘changeover’
task elements)
 Often lower than ‘design capacity’, but can be
higher too.
 Expected Output (also often referred to as the
‘rated capacity’—as used for production planning,
etc.) given current performance efficiency.
 Often lower than ‘effective capacity’
 ‘Utilization’ and ‘Efficiency’
Utilization is the percent of design capacity
achieved

Utilization = Actual Output/Design Capacity

Efficiency is the percent of effective capacity

achieved

Efficiency = Actual Output/Effective Capacity

Expected output = (Effective capacity)∙(Efficiency)

Performance Measures
– Sara James Bakery Example
(p 249, 250)
 Bakery Example S1: Sara James Bakery (pp 249)
Actual production last week = 148,000 rolls
Effective capacity = 175,000 rolls per week
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 per week

Utilization1 = 148,000/201,600 = 73.4%

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

1 Utilization rates can be high in product-focused facilities, but tend to be
low in process-focused facilities, because of low effective capacities.
But in some ‘Lean’ factories, utilizations of more than 1.00 have also
been realized!
 Bakery Example S2: Sara James Bakery (pp 250)
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% (because the

crew will be new hires

Expected Output = (Effective Capacity)∙(Efficiency)

= (175,000)(.75) = 131,250 rolls
 Design and Effective Capacity (Continued)
 Increasing ‘design capacity’ requires investments in
fixed assets which can be expensive, and also
subject to its inherent characteristic of being risk-
prone.
 Need for increases in design capacity can be
reduced in two ways:
1. By enhancing ‘Effective capacity’.
2. By enhancing ‘Efficiency’
 ‘Efficiency’ can be enhanced by better management
of the operations, in the short term
 However, enhancing ‘Effective capacity’ can be
attempted only in the long term through approaches
such as TQM, Lean Manufacturing, etc.
 Case:
Too Little Capacity at Dalrymple Bay
(p 252)
– The issue of expansion in port’s capacity
 Case:
Too Little Capacity at Dalrymple Bay (p 252)
1. Ships anchored at Coral Sea, waiting to be loaded with
coal for Asian steel mills, because the port at Dalrymple
Bay isn’t big enough to meet the demand.
2. Even the current plan to invest $610 million to expand
capacity is insufficient, so that even after expansion the
coal companies may find access to shipping rationed.
3. There are uncertainties in the supply chain to be handled,
though, for the port managers to invest in expansion of
the port capacity (to assure adequate ROI):
a. There needs to be certainty of long term demand.
b. The mines need to be large enough to ensure long term supply
 Case:
Too Much Capacity at GM and Ford
(p 253)
(The issue of ‘excess’ in capacity, arising from
falling demand—arising from low productivity—
and exacerbated later, by rising productivity!)
 Case:
Too Much Capacity at GM and Ford (p 253)
(as of case date 2006)
1. As world’s greatest automobile companies, GM and Ford
continually expanded capacity for decades, building
product-focused plants with low flexibility for range.
2. GM alone produced over half of cars sold in U.S.
3. But now, GM is producing less than one-fourth of cars
sold in U.S., as Toyota, VW, BMW, Mercedes and other
are stealing their car sales, with
1. Imports, and
2. Domestic production.
4. Toyota’s plants at U.S. were operating at 111% of
‘expected output1’, with 87% for GM and 79% for Ford.
1 – ‘Expected output’ = (Effective capacity) x (efficiency)
 Too Much Capacity at GM and Ford (p 253)
(Continued)
5. In attempt to drive down costs, both GM and Ford are
increasing their productivity and flexibility.
6. In the past 6 years, total labor hours per vehicle for
stamping, assembly and engine production have dropped
by 26%, from 46.5 hours to 34.3 hours.
7. Number of stamping machines needed to make fenders,
hoods, doors, etc., have dropped from 330 to 241.
8. The net effect of both lower sales and increasing
productivity means ‘too much capacity at GM and Ford’!
9. Expected productivity rise at GM and Ford will mean
drop of about 50,000 people by 2010. Such capacity
adjustments can be painful.
1b. Capacity and Strategy
 Capacity and Strategy (for the long term)

 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
1c. Additional Capacity
Considerations
 Additional Considerations for
Good Capacity Decisions
1. Forecast demand accurately
2. Understanding the technology and
capacity increments
3. Find the optimal operating level (volume),
based on ‘Economies and Diseconomies
of Scale’ principle. This has implications
for optimal size of capacity increments.
4. Build for change.
 Economies and Diseconomies of Scale
These curves show ‘costs of capacity under- or over- utilizations’, of operating
(dollars per room per night) a specific motel at above or below its designed/effective capacity
(Relevant when considering the effective plant capacity, in the ‘medium term’
and the ‘short term’)
25 - Room
Average unit cost

75 - Room
Roadside Motel Roadside Motel
50 - Room
Roadside Motel

Economies of scale Diseconomies

(arising from high fixed costs of scale1
but very low variable costs),

25 50 (Optimum size of facility) 75

Scale: Number of Rooms (in the Motel)
This curve shows the expected cost per unit with 100% utilization (i.e. at full design capacity),
as resulting from the combined ‘cost savings from economy of scale’, and the
‘costs of complexity’ which too tend to typically arise when the scale gets too big.
(Relevant when considering the creation of plant capacity, in the ‘long term’)
1 ‘Diseconomies of Scale’ may begin to overshadow the ‘economies of scale’ as a result of
forced complexities in processes as the process scale gets bigger, and a result of often trying
to fully utilize large capacities with increased variety in products.
 1d. Medium/ Short Term
Capacity Planning
– OMIT

Strategic Management of Capacity for the

long term
↕
Tactical Management of Capacity and
Demand for the medium and short term
 Tactics in ‘Managing Demand’
When:
 Demand exceeds capacity:
 Curtail demand by raising prices, scheduling longer lead
time (stretching the lead time thus increases WIP, and is
undesirable)
 Long term solution is to increase capacity

 Capacity exceeds demand:

 Stimulate market
 Product changes

 Adjusting to seasonal demands:

 Produce products with complimentary demand patterns
Tactics in Matching Capacity to Demand

1. Making staffing changes

2. Adjusting equipment and processes
 Purchasing additional machinery
 Selling or leasing out existing
equipment
3. Improving methods to increase
throughput
4. Redesigning the product to facilitate
more throughput
 Complementary Demand Patterns
By combining both, the variation in the aggregate demand is
reduced
4,000 –
Sales in units

3,000 – Snowmobile
sales
2,000 –

1,000 – Jet ski

sales

JFMAMJJASONDJFMAMJJASONDJ
Time (months)

Combining products with contra-cyclical demand patterns

into a company’s product profile
can help realize better capacity utilization.
2. Long Term Capacity
Planning
 Three Approaches to Capacity Strategy

• Policy A: Try not to run short. Here capacity

must lead demand, so on average there will be
excess capacity.
• Policy B: Maximize capacity utilization.
Capacity additions lag demand, so that average
demand is never met.
• Policy C: Build to forecast. Capacity additions
should be timed so that the firm has excess
capacity half the time and is short half the
time.
Approaches to Capacity Expansion

Expected Demand
New Capacity
Demand

Policy A
(Proactive mode)

Time in Years

Capacity leads demand with incremental expansion

Approaches to Capacity Expansion
(Continued)

Expected Demand
New Capacity
Demand

Policy B
(Reactive mode)

Time in Years
Capacity lags demand with incremental expansion
 Approaches to Capacity Expansion
(Continued)
Expected Demand
New Capacity
Demand

Policy C
(Typically
adopted mode)

Time in Years
Capacity partially leading and partially lagging demand
with incremental expansion,
with average capacity close to demand
 Approaches to Capacity Expansion (Continued)
Expected Demand Policy D
New Capacity • Only when incremental
expansion is not
Demand

possible, or when
pursuit of ‘economy of
scale is particularly
important.
• Optimum sizes for such
expansions may be
determined.
Time in Years
• Capacity will generally lead demand with such one-step expansions,
employed infrequently.
• Since the strategy involves both ‘capacity leading demand’ and ‘step
capacity expansions’, the risks involved are extremely high, but so
are the rewards. What are the possible rewards of such a strategy?
Approaches to Capacity Expansion (Continued)
(Policy A) Leading demand with (Policy B) Capacity lags demand
incremental expansion with incremental expansion
New New
capacity capacity
Expected
Demand

Expected

Demand
demand demand

(Policy C) Attempts to have an (Policy D) Leading demand

average capacity with with one-step expansion
incremental expansion
New
New capacity
Demand

capacity Expected Expected

Demand

demand demand
 Simultaneous Maximization of ‘Scale Benefits’ and
Minimization of ‘Risks’, in
Capacity Expansion Strategies
The best way to combine, for synergy, the bold but
risky strategies of
Step capacity expansion
as well as of
Capacity leading demand
may be to adopt the combination strategy of
Capacity ‘leading demand’ in a big step,
but with a significant starting ‘lagging demand’
[where the period of ‘capacity expansion lagging demand’
can be used to assess the proposal
for the investment for capacity expansion.]
 Determinants of Capacity Strategy
• Highly competitive industries (commodities, large
number of suppliers, limited functional difference in
products, time sensitive customers) – here shortages
are very costly. Use Type A Policy.
• Monopolistic environment where manufacturer has
power over the industry: Use Type C Policy.
• (Intel, Lockheed/Martin).
• Products that become obsolete quickly, such as
computer products. Want type C policy, but in
competitive industry, such as computers, you will be
gone if you cannot meet customer demand. Need best
of both worlds: Dell Computer. (tend toward A with B
in mind!)
 Example of Capacity Strategy: Dell Computers
• Often the need may be to make a combination of the four
policies, rather than adopt just one the policies alone.
• For example, for products which become obsolete
quickly, such as computer products, type C policy (with
solutions like those for the classical ‘Newsboy problem’)
can be suitable, but in competitive industry, such as
computers, you will be gone if you cannot meet customer
demands, as and when they arise.
• For a company in such an industry, the need is to have
best of both worlds: Tend toward Policy A, but with
Policy C in mind!
• A good example is ‘Dell Computer’—where such a
capacity strategy is a crucial part of its operations strategy.
 The Basic Dichotomies to be Faced in
‘Capacity Expansion’ Decision Making,
leading to Corporate Growth
The dilemma needing
Macro issue Micro issue managerial attention, on
on-going basis
Adopting specific Adopting general The desirability of ‘minimizing
strategy of strategy of risks in capacity expansions’
occasional, bold, frequent, watchful, by adopting incremental
proactive capacity reactive capacity capacity increases and/or
expansions based expansions based capacity lagging demand’ and, at
on (a) step on (a), incremental the same time, also the
capacity capacity desirability of ‘pursuing
expansions1, expansions2 and/or economy of scale’ by adopting
and/or (b) capacity (b) capacity step capacity expansions and
leading demand. lagging demand. capacity leading demand’.
1 Step capacity expansions based on high capital investments in plant and equipment, etc.
2 Incremental capacity expansions with only minimal capital investments, and based mainly on additional manpower, overtime, subcontracting, etc.
 3. Break Even Analysis
(in Resolving the
Process Choice/ Capacity Options)
 Break-Even Analysis
 Technique for evaluating process and
equipment alternatives.
 Objective is to find the point in dollars and/ or
units at which cost equals revenue (thus
separating the ‘loss’ and ‘profit’ corridors.
 Requires estimation of fixed costs, variable
costs, and revenue.
 Total cost = Fixed cost + Variable Cost
 Can be employed in decision making
situations involving individual events, annual
(recurring) costs, or single life-time decisions.
 Break-Even Analysis (Continued)
 Fixed costs are costs that continue even if
no units are produced
 Rents, taxes, capital related costs in various
forms such as direct investments, debt or
mortgage payments, etc.
 Variable costs are costs that vary with the
volume of units produced
 Labor, materials, portion of utilities that tend to
vary with volumes, etc.
 Contribution is the difference between selling
price and variable cost
 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 accomplish
 There is no time value of money
 Break-Even Analysis
– Profit

‘Break-even’ Occurs where

Total Revenue =Total cost
Total Revenue = $ Sales
Total cost = Fixed cost + Total variable cost
Or,
Profit = 0
 Break-Even Analysis (To be used when process
choices exist even within a particular desired volume)
–
Total revenue line (per period)
900 –

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

Total cost (per period) line

600 –

500 –
Variable cost (per period)
400 –

300 –

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

In general, large plants (with high fixed costs) tend to have high economy of
scale but also high break-even points, and small plants (with low fixed
costs) tend to have low economy of scale but also low break-even points.
 Breakeven Chart
Cost Total revenue line
($1000)
Breakeven point: Profit
TC = TR (Profit = 0)
BEP$ Variable cost Total cost line
Loss Fixed cost
BEPX Volume(X) (units/year)
Fixed Cost (annualized cost) = $90000 / year
Annual Revenue = PX = $9X
Variable Cost = $4.50 / unit. So, annual variable cost = $4.5X
At BEP, $90000+$4.5X = $9X, or BEPX = 20,000 per year
 Breakeven analysis
F – Fixed costs of production
v – Variable cost of production of one unit
p – Selling Price of one unit of the product
c – Contribution of one unit of product towards the fixed
costs
S – Sales volume (in terms of number of units)
BEPSales – Sales volume required to achieve breakeven

Contribution Margin (c) = p – v

F
BEPSales =
c
 Breakeven Analysis – An example
A company manufactures a certain component, which it is able to sell at Rs. 15 per
component. The variable cost of the component is Rs. 10 per unit. If the company
has made a total investment in fixed costs to the tune of Rs. 30,000, what is the
breakeven sales for the component?

Solution

F – Fixed costs of production = Rs. 30,000

v – Variable cost of production of one unit = Rs. 10
p – Selling Price of one unit of the product = Rs. 15

Therefore contribution of one unit of product towards the fixed costs, C is

computed as:

c = p – v = 15 – 10 = Rs. 5
F 30,000
BEPSales =   6,000 units
c 5
 Break Even Analysis – Example Revenue
Rs./ TC
year
BEP
●

FC (of owning and operating an

Rs. 1,0,000 equipment = Rs. 1,00,000/- per year)
per year

0 Volume (units per year) 333 C

Let = equipment capacity
Production cost (per unit) = Rs. 100/- = 1000 per year
Selling price (per unit) = Rs. 400/-
Contribution (per unit) = Rs. 300/-
Then,
Break Even Point = FC / Contribution = Rs. 1,00,000per year / Rs. 300 per unit = 333 units/year
At Full Capacity,
Profit = Rs. 4.00.000 – (1,00.000 + 1000x100) = Rs. 2,00,000/-

Prefer processes with as low BEP and as high capacity C as possible. This
is mainly a matter of selecting from the available process technologies.
 Breakeven Analysis
A graphical representation
Fixed cost Variable cost Total cost Revenue

160,000

140,000

120,000
Cost & Revenue

100,000

80,000

60,000

40,000

20,000

-
0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000 11000

Sales (Units)
 Comparison of Process Choices
Use of ‘Crossover Chart’

1. Helps to determine the point at which the total

costs for the different alternative processes
change.

2. The Figure in the next slide shows three different

processes, which have three different costs in
terms of ‘fixed costs’ and ‘variable costs’.

3. However, at any specific volume of production

desired, only one will have the lowest costs.
 Similar to ‘Crossover Charts’
Variable
costs
Variable Variable
$ costs $ costs $
Fixed costs Fixed costs
Fixed costs
Process A Process B Process C
(May be ‘low volume, (May be ‘Repetitive’) (May be ‘high volume,
high variety’) low variety’)

400,000
300,000
200,000 However,
Fixed cost
Process A
Fixed cost Fixed cost ‘revenues’
Process B Process C
are also
V1 V2 Volume
= (2,857) = (6,666)
considered.
 Similar to ‘Crossover Chart’
Process A (low volume, high variety) TC = $50000 + $7.50X
Process B (Repetitive) TC = $90000 + $4.50X
Process C (High volume, low variety) TC = $120000 + $3.20X

Fixed cost(C)
Fixed cost(B)
Fixed cost(A)
Proc. A Proc. B Proc C Lowest cost process
 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 (after V = Variable costs
all discounts) TC = Total costs = F + Vx

Break-even point occurs when

TR = TC F
or BEPx =
P–V
Px = F + Vx
In general, when considering alternative processes, as F increases, V decreases.
 Break-Even Analysis
BEPx = Break-even point in x = Number of units
units produced
BEP$ = Break-even point in TR = Total revenue = Px
dollars F = Fixed costs
P = Price per unit (after V = Variable costs
all discounts) TC = Total costs = F + Vx

BEP$ = BEPx P
= F P Profit = TR – TC
P–V = Px – (F + Vx)
F
= = Px – F – Vx
(P – V)/P
F = (P – V)x – F
= ,
1 – V/P
where (1 – V/P) is
the contribution per
dollar.
 Breakeven Analysis
BEPX: TR = TC or P•x = F + V•x
F
Or, BEPX =
P–V

BEP$ = (BEPX)•P

F
Or, BEP$ =
1 – V/P

Profit = (P – V)x – F
 Breakeven Analysis:
– Certain Implications for Capacity Planning
In general, when considering alternative processes, as F
increases,
– Scale increases, and so ‘economy of scale’ benefit may increase,
and thus total cost per unit may decrease (arising from reductions
both in per unit fixed costs and the per unit variable cost V),
but
– BEPx also increases, thus leading to reduced volume flexibility
(thus necessitating large demand which may not exist).
Thus,
– Pursuing scale may not be the right way to low per unit cost,
but
– Pursuing low cost per unit (through continuous
improvements) can be the way to the scale benefits.
3a. Break-Even Analysis
– Single Product case
(pp 258)
 Break-Even Example – S3 (pp 258)
(For single product)

Break-Even Point in Dollars:

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)]
 Break-Even Example (For single product)
– S3 (pp 258)
Fixed costs = $10,000 Material = $.75/unit
Direct labor = $1.50/unit Selling price = $4.00 per unit

Break-Even Point in Dollars:

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

$10,000
= .4375 = $22,857.14

Break-Even Point in Units:

F $10,000
BEPx = = = 5,714
P–V 4.00 – (1.50 + .75)
3b. Break-Even Analysis
– Multiple Products case
(pp 258 – 260)
 Break-Even Analysis, for multiple products,
Made in a common facility (pp 258 – 260)
Determining ‘relative ‘weights’ for the different products1:
For ‘annual sales’ Xi of ith product, PiXi = WiT,
Then, Xi = WiT/Pi
where V = variable cost per unit
P = price per unit
F = fixed costs
Wi = percent each product is of total dollar sales
i = each product, and
T = Total annual sales of all products

At BEP, F + ΣVi .Xi = ΣPi Xi

Or, ΣPi Xi – ΣVi .Xi = F
1 Way to determine the weights for the products, as chosen here, based on the
assumption that the pattern of sales mix will be maintained.
[Continued…]
 Break-Even Example
(For multiple products, made in a common facility)
(Continued)

Substituting in the equation in the previous slide,

ΣPi .WiT/Pi – ΣVi . WiT/Pi = F,
or,
F
Total $ Sales ‘T’ at BEP = BEP$ =

∑ 1 – Vi
Pi
x (Wi)

Here, ∑ 1–
Vi
Pi
x (Wi) constitutes the weighted contribution per
dollar, for all the products together.
Multiproduct Example – S4 (pp 258 – 260)
(Multi-product Break-Even Analysis)

Fixed costs = $3,500 per month

Annual Forecasted
Item Price Cost Sales Units
Sandwich $2.95 $1.25 7,000
Soft drink .80 .30 7,000
Baked potato 1.55 .47 5,000
Tea .75 .25 5,000
Salad bar 2.85 1.00 3,000
 Multiproduct Example – S4 (pp 258 – 260)
(Multi-product Break-Even Analysis) – Continued
Multi-Product Break-Even Determining Contribution:

Annual Weighted
Selling Variable ContributionForecasted % of Contribution
Item (i) Price (P) Cost (V) (V/P) 1 - (V/P) Sales $ Sales (col 5 x col 7)
Sandwich $2.95 $1.25 .42 .58 $20,650 .446 0.259
Soft drink .80 .30 .38 .62 5,600 .121 0.075
Baked 1.55 .47 .30 .70 7,750 .167 0.117
potato
Tea .75 .25 .33 .67 3,750 .081 0.054
Salad bar 2.85 1.00 .35 .65 8,550 .185 0.120
$46,300 1.000 0.625

Determining weights: For instance, revenue for sandwiches is $20,650 (2.95x

7,000), which is 44.6% of the total revenue of $46,300, Therefore, the contribution
for sandwiches is “weighted” by 0.446. The weighted contribution is 0.446x0.58 =
0.259. In this manner, its relative contribution is properly reflected.
 Multiproduct Example – S4 (pp 258 – 260)
(Multi-product Break-Even Analysis) – Continued
Multi-Product Break-Even Determining Contribution:
F
BEP$ =

Selling Variable
Annual
∑1-
Forecasted
Vi
x (WWeighted
i)
%i of Contribution
P
Item (i) Price (P) Cost (V) (V/P) 1 - (V/P) Sales $ Sales (col 5 x col 7)
Sandwich $2.95 $1.25 .42 .58 $20,650
$3,500 x.446
12 0.259
Soft drink .80 .30 .38 .62 = 5,600 = $67,200
.625 .121 0.075
Baked 1.55 .47 .30 .70 7,750 .167 0.117
potato
Tea .75 .25 .33 $67,200
.67Daily 3,750 .081 = $215.38
0.054
=
Salad bar 2.85 1.00 .35 .65sales 8,550
312 days
.185 0.120
$46,300 1.000 0.625
BEPx = 0.446 x $215.38 = 32.6  33
(as stated
Determining weights: For instance, revenue
$2.95 sandwiches
for sandwiches is $20,650 (2.95x
in terms of
7,000), which is 44.6% of the total revenuetheofmain per day
$46,300, Therefore, the contribution
for sandwiches is “weighted” by 0.446. Theproduct)
weighted contribution is 0.446x58 =
0.259. In this manner, its relative contribution is properly reflected.
 See also:
Solved Problem S6.3 (p 267)
 4. Applying Decision Trees to
Capacity Decisions
Based on:
a) Market conditions being favorable/
unfavorable—common to all players in a
specific industry.
b) Alternatives developed before hand,

– Helps to determine the ‘desirable

capacity’ for a particular operation.
 Capacity Decisions & Decision Trees (based on both
market conditions and break-even points)
Example S6: Southern Hospital Supplies (pp 266 – 267)
• Capacity expansion proposal by a manufacturer of
hospital gowns.
• The alternatives are:
a. Do nothing.
b. Build a small plant.
c. Build a medium plant
d. Build a large plant.
• The possible expected market conditions considered
are:
a. Favorable market
b. Unfavorable market
• Analyses have been made for all above possibilities,
and corresponding expected profits are known.
 Use of ‘Break-Even Analysis’ for Process Choice
• Useful when choices of processes (with similar levels of profitability)
exist even when the decision is confined to a desired volume.
Choice of process will be
dependent on how the ‘desired
Revenue volume’ may change in the
future.
3
2 • If the ‘desired volume’ may fall
1
BEP - 1 ● (Unfavourable market), opt for
● process with low BEP, and
● generally also with
BEP - 2
correspondingly lower
●
BEP - 3 equipment capacity.
• If the ‘desired volume’ may rise
‘Desired
(Favourable market), opt for
Volume’
process with high BEP , and
generally also with
Volume correspondingly higher
equipment capacity.
 Capacity Decisions & Decision Trees (based on both
market conditions and break-even points) (Continued) (pp 266 – 67)
-$14,000 Market Favorable (0.4)
Large Plant $100,000
Market Unfavorable (0.6)
$18,000 -$90,000
Market Favorable (0.4)
Medium Plant $60,000
Market Unfavorable (0.6)
-$10,000
$13,000 Market Favorable (0.4)
Small Plant $40,000
Market Unfavorable (0.6)
-$5,000
Do Nothing
$0
Large plants (with high fixed costs and generally high break-even points) would be
favored when the markets are favorable, and small plants (with low fixed cost and
generally low break-even points) would be favored when markets are unfavorable.
Capacity Decisions & Decision Trees (based on both market
conditions and break-even points)
Example S6: Southern Hospital Supplies (pp 266 – 67) (Continued)

Question to think over:

1. Are the ‘four alternatives’ and the ‘two expected
market conditions’ considered by ‘decision tree
analysis’ are each different in ‘kind’ or in
‘degrees’?
2. Decision tree analysis has considered them as
different in kinds. Discuss what would be the
impact of your answer to the previous question
on how exactly a manager can actually use the
technique for decision making.
5. Applying Investment Analysis
to Strategy-Driven Investments
– OMIT
 Strategy-Driven Investment

 Operations may be responsible for

return-on-investment (ROI)
 Analyzing capacity alternatives
should include capital investment,
variable cost, cash flows, and net
present value
 Net Present Value
Consider: Investment = $100,000
Cost of capital: 12% per year

Year Return P (@12%)

1 $30,000 $26,786
2 $50,000 $39,860
3 $30,000
SV $10,000 $28,741
$95,387 P
- $100,000 Inv .
- $4,613 NPV
 Net Present Value

Future value: F = PV(1+I)n

Present value: P = FV / (1+I)n

Net Present value:

NPV = S P – Investment
Net Present Value (NPV)

F
P=
(1 + i)N

where F = future value

P = present value
i = interest rate
N = number of years
 NPV Using Factors
F
P= N = FX
(1 + i)
where X = a factor from Table S7.1 defined as =
1/(1 + i)N and F = future value

Year 5% 6% 7% … 10%
Portion of
1 .952 .943 .935 .909
Table S7.1 2 .907 .890 .873 .826
3 .864 .840 .816 .751
4 .823 .792 .763 .683
5 .784 .747 .713 .621
 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
 Present Value of an Annuity
Portion of Table S7.2

Year 5% 6% 7% … 10%
1 .952 .943 .935 .909
2 1.859 1.833 1.808 1.736
3 2.723 2.676 2.624 2.487
4 4.329 3.465 3.387 3.170
5 5.076 4.212 4.100 3.791
 The Overall Methodology
(Step-by-Step)
in the Use of Tools and Techniques,
to Make Right Choices
of Processes and Capacities

(Not covered in Book)

May be skipped
The Overall Methodology (Step-by-Step) in the Use of Tools and
Techniques, to Make Right Choices of Processes and Capacities

1. Consider, from operational point of view, objectives/

purposes to be pursued in long range process strategy
and capacity planning:
1. High economy of scale (to make full use of any available
business potentials for high volume)
2. Low breakeven point (to provide volume flexibility,
especially in the context of ‘Lean Manufacturing’)
(Business objectives such as high annual profits, ROI, etc., can
happen as a result of first pursuing these process and capacity
planning objectives.)
There may be contradictions, amongst the available alternative
processes and capacity plans, in pursuing both these objectives.
The Overall Methodology (Step-by-Step) in the Use of Tools and
Techniques, to Make Right Choices of Processes and Capacities
(Continued)

2. Consider criteria for decision making:

1. What is the desired volume?
2. What is the outlook for future in the market ?
3. Is the ‘Desired Capacity’ really desirable?
1. Use the ‘Economy/Diseconomy of Scale’ principles, and
‘Capacity Expansion/ contraction strategies, to determine
the right process capacity/ size desired.
4. Use the ‘Cross-over Chart’ to determine the right
process for the desired volume.
The Overall Methodology (Step-by-Step) in the Use of Tools and
Techniques, to Make Right Choices of Processes and Capacities
(Continued)
5. If multiple process choices are available for the desired
volume, look for the ‘Break-Even Points’ for the
processes—whether low or high.
Prefer process with low BEP, as well as one with maximal
capacity (more than the current target capacity).
6. Use ‘Decision Tree Analysis’, to make the final choice
for the right combination of the Break Even Point (that
is, the ‘Volume Flexibility’) and the ‘Economy of Scale
to be pursued.
7. Finally Use ‘NPV’, ‘IRR’ calculations, etc., to verify
that the selected alternative is justifiable from the points
of view of return on investment.
 Case-let:
7. Capacity Planning in a Service
Organization,
at
Arnold Palmer Hospital (pp 272)
 Caselet:
Capacity Planning at Arnold Palmer Hospital
(p 272)
1. APH has experienced continuous growth in demand for
its services from the opening day in 1989. – mainly as a
result of the quality of services provided.
2. Originally built with 281 beds, and a capacity for 6,500
births per year.
Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Births 6,144 6,200 6,432 6,950 7,377 8,655 9,536 9,825 10,253 10,555 12,315 13,070 13,600

3. Births surpassed 6,500 in 1998, and 10,000 in 2003.

4. Director Katty Swanson considering a capacity
expansion plan, with a new 11-storey hospital building
across the street from the existing facility.
 Caselet:
Capacity Planning at Arnold Palmer Hospital
(Continued)

5. The Capacity Planning Process at APH: 35 Planning

Teams were established to study such issues as:
1) Demand forecasts,
2) Services that would transfer to the new facility,
3) Services that would remain in the existing facility,
4) Staffing needs,
5) Capital equipment,
6) Pro forma accounting data, and
7) Regulatory requirements
 Caselet:
Capacity Planning at Arnold Palmer Hospital
(Continued)
6. Ultimately APH was ready to move ahead with a
budget of $100 million and a commitment to an
additional 273 beds.
7. Given the growth of the central Florida region,
Swanson decided to expand the hospital in stages: the
top two floors of the hospital would be empty interiors
(“shell”) to be completed at a later date, and the fourth
floor operating room could be doubled in size when
needed.
8. “With the new facility in place (case date: 2006). we
are now able to handle up to 13,500 births per year,”
says Swanson.
 Caselet:
Capacity Planning at Arnold Palmer Hospital
(Continued)
Case Analysis:
1. What is the right measure for capacity at APH?
− Number of beds? – Cannot be, since it is only one of the resources
needed, even though it is related to the hospital’s building design, and
cannot be changed much in the short or medium term.
− Number of childbirths per year? – Chosen as the main measure,
considering it as the main mission of the hospital.
− Number of patients attended to per year (inclusive of patients of other
women’s diseases, and outpatients)? – Not the hospital’s main mission.
2. A review of the births data reveals not a linear trend over the
years, but a combination of periods of high and low growth
rates. So forecast of demand through ‘regression methods’ may
be preferable.
 Caselet:
Capacity Planning at Arnold Palmer Hospital
(Continued)
Case Analysis:
3. Arnold Palmer Hospital’s capacity first lagged demand, and
now is leading demand with incremental expansion.
4. The new building (ready in 2006) will provide sufficient
capacity for several years. The top two floors (left unfinished
for additional beds) and operating rooms (on the 4th floor,
available for horizontal expansion) will be built out when
needed.
5. Presently APH have capacity to handle up to 13,500 births per
year. The expansion of capacity by building the additional
two floors can be taken up when the expected birth per year is
likely to substantially exceed this figure (based on a strategy
of capacity partially lagging and partially leading demand).
 Caselet:
Capacity Planning at Arnold Palmer Hospital
(Continued)

Case Analysis:
6. Possible risks:
– Demand may not continue to grow dramatically.
– The population boom in central Florida could abate with rising
housing prices that are discouraging future growth.
– There are always unforeseen disasters in medicine that could
damage the hospital’s sterling reputation (e.g., lawsuits, drop in
quality).
– There is a nursing shortage that could create a staffing bottleneck
if not corrected. Recently, the two major hospital chains in central
Florida got into a bidding war in attempts to recruit each other’s
nurses.
The End: Any Questions?
 Medium to Short Term
Capacity Planning
(Not part of the session on ‘Capacity Planning’)

OMIT
Will be covered in detail under
‘Aggregate Operations Planning’
 Capacity Planning, Aggregate Scheduling, Master Schedule,
and Short-Term Scheduling – A Hierarchy of Issues
Capacity Planning
1. Facility size
2. Equipment procurement Long-term
Aggregate Scheduling
1. Facility utilization
2. Personnel needs Intermediate-term
3. Subcontracting
Covered by Master Scheduling
OPC
1. End Items Short to Intermediate
2. MRP
Short-term Scheduling
1. Work center loading Short-term
2. Job sequencing
3. Scheduling people
At each of the levels above, ‘capacity planning’ and ‘priority planning’ may both be
be done together, or separately in that sequence.
 Hierarchical Planning Process
Capacity Planning
Production Planning (to complement the
Items Resource level
(Priority Planning) priority planning)
Product lines Aggregate Resource
Requirements Plan Plants
or families Production Plan

Master Production Rough Cut Critical work

Individual
Schedule Capacity Plan centers
products

Material Capacity All work

Components Requirements Requirements Plan centers
Plan

Manufacturing Shop Floor Input/Output Individual

operations Schedule Control machines

Hierarchical planning and control process reduces complexity

by having each layer guide the next. The total planning and
control process thus gets done in several steps in sequence.
 Capacity Planning and Priority Control,
in the ‘Integrated PPC Systems
⇅
(Capacity Planning) (Priority Control)
Enough? Which ones?
Volume Sequence
Loading Scheduling

There needs to be a balance,

through an iterative process (⇅),
at every level of the ‘Hierarchical Planning’ process,
between ‘Capacity Planning’ and ‘Priority Control’.
The Capacity Hockey Stick (Showing how manufacturing lead
time tends to increase exponentially with fuller capacity utilization)

As load nears full capacity, and as both have their variances over
time, the lead time (or flow time) tends to increase asymptotically!
Capacity Design issue – Flexibility/Utilization Trade-off
High utilization
Low cost of operation, but
Operational Performance

Poor service
Measures

Low utilization
High cost of operation, but
Good service

0 100%
Utilization (%)
In designing queuing systems, when customer arrival rates are
highly time-varying, companies may need to prioritize between
high capacity utilization and faster customer service.
 Japanese notion of capacity
• Capacity = Work + Waste/Buffer1
(Excess capacity, viewed both
as ‘waste’, and as ‘buffer’.)

1 This
view of ‘excess capacity’ and ‘waste’ helps to
always keep in mind
a. The more immediate purpose of making process
improvements to minimize all other wastes, while
keeping excess capacity as a buffer*,
and thereby work towards attaining, ultimately,
b. The more ultimate ideal of 100% capacity utilization.

* The ‘buffer capacity’ needed to cover process problems can be very

high—refer to the ‘Capacity Hockey Stick ‘ phenomenon.
Japanese notion of capacity (Continued)

The Long Term, Macro view of

excess capacity as ‘waste’
helps to always keep in mind
the more ultimate ideal
of 100% capacity utilization.
⇅
The Short Term, Micro view of
excess capacity’ as ‘buffer’
helps to focus on solving
the various process problems,
which necessitate the buffer
 Nine types of waste according to
Canon production system:
• Waste in Operations
• Waste in Startup
• Waste in Equipment
• Waste in Defects
• Waste in Materials
• Waste in Indirect Labor
• Waste in Human Resources
• Waste in expense
The End: Any Questions?