Strategic Capacity

Planning for
Products and
Services
Capacity Planning
• Capacity
The upper limit or ceiling on the
load that an operating unit can
handle
Capacity needs include
Equipment
Space
Employee skills

5-2
Strategic Capacity Planning
• Goal
To achieve a match between the
long-term supply capabilities of an
organization and the predicted
level of long-term demand
Overcapacity operating costs that
are too high
Undercapacity strained resources
and possible loss of customers 5-3
 Capacity Planning Questions
• Key Questions:
What kind of capacity is needed?
How much is needed to match demand?
When is it needed?
• Related Questions:
How much will it cost?
What are the potential benefits and risks?
Are there sustainability issues?
Should capacity be changed all at once, or through several smaller
changes
Can the supply chain handle the necessary changes?
5-4
 Capacity Decisions Are Strategic
• Capacity decisions
1. impact the ability of the organization to meet future demands
2. affect operating costs
3. are a major determinant of initial cost
4. often involve long-term commitment of resources
5. can affect competitiveness
6. affect the ease of management
7. have become more important and complex due to globalization
8. need to be planned for in advance due to their consumption of
financial and other resources
5-5
Capacity
Design capacity
• Maximum output rate or service capacity an operation,
process, or facility is designed for
Effective capacity
• Design capacity minus allowances such as personal
time, maintenance, and scrap
Actual output
• Rate of output actually achieved--cannot
exceed effective capacity.
5-6
Defining and Measuring Capacity
• Measure capacity in units that do not require
updating
Why is measuring capacity in dollars problematic?
• Two useful definitions of capacity
• Design capacity
• The maximum output rate or service capacity an
operation, process, or facility is designed for
• Effective capacity
• Design capacity minus allowances such as personal
time and maintenance
5-7
 Measuring System Effectiveness
• Actual output
• The rate of output actually achieved
• It cannot exceed effective capacity
• Efficiency
actual output
Efficiency 
effective capacity
• Utilization
actual output
Utilizatio n 
design capacity
Measured as percentages
5-8
Example– Efficiency and Utilization
• Design Capacity = 50 trucks per day
• Effective Capacity = 40 trucks per day
• Actual Output = 36 trucks per day

actual output 36
Efficiency    90%
effective capacity 40

actual output 36
Utilizatio n    72%
design capacity 50

5-9
Determinants of Effective Capacity
• Facilities
• Product and service factors
• Process factors
• Human factors
• Policy factors
• Operational factors
• Supply chain factors
• External factors
5-10
Strategy Formulation
• Strategies are typically based
on assumptions and
predictions about:
Long-term demand patterns
Technological change
Competitor behavior

5-11
Capacity strategies
• Leading – build capacity in anticipation of
future demand increases
• Following-build capacity when demand
exceeds current capacity
• Tracking- similar to the strategy, but adds
capacity in relatively small increments to
keep pace with increasing demand
Capacity Cushion
• Capacity Cushion
 Extra capacity used to offset demand uncertainty
 Capacity cushion = 100% - Utilization
 Capacity cushion strategy
Organizations that have greater demand
uncertainty typically have greater capacity
cushion
Organizations that have standard products and
services generally have greater capacity cushion
5-13
Steps in Capacity Planning
1. Estimate future capacity requirements
2. Evaluate existing capacity and facilities; identify gaps
3. Identify alternatives for meeting requirements
4. Conduct financial analyses
5. Assess key qualitative issues
6. Select the best alternative for the long term
7. Implement alternative chosen
8. Monitor results

5-14
How would you select between alternatives?
Example: Getting a line of credit
• Interest rate on the revolver (including monitoring fees,
etc.)
• Up Front fees (commitment fees, closing fees, audit fee,
etc.)
• Size of the line offered
• Expected Covenant Restrictions
• Advance Rate on Inventory and AR
• Unused line fee
• Default Rate
• Perceived “friendliness” of lender
Rank the decision criteria as to importance to the
situation at hand
Decision Factor Weight (1-10)
Interest Rate on Revolver 8
Up Front Fees 3
Size of Line 7
Covenant Restrictions 7
Advance Rate 5
Unused Line Fee 3
Default Rate 5
Friendliness of Lender 7
 Rank each lender as to how they compare in each
category.
Weight
Decision Factor (1-10) Lender 1 Lender 2 Lender 3 Lender 4
Interest Rate on Revolver 8 1 3 2 4
Up Front Fees 3 2 1 3 4
Size of Line 7 3 2 1 4
Covenant Restrictions 7 4 3 2 1
Advance Rate 5 1 2 2 1
Unused Line Fee 3 2 1 1 2
Default Rate 5 2 1 2 1
Friendliness of Lender 7 1 2 3 4
 Lender 1 Lender 2 Lender 3 Lender 4
Decision Factor Weight Rank Score Rank Score Rank Score Rank Score
Interest Rate
on Revolver 8 4 32 2 16 3 24 1 8
Up Front Fees 3 2 6 4 12 3 9 1 3
Size of Line 7 1 7 3 21 4 28 1 7
Covenant
Restrictions 7 1 7 2 14 3 21 4 28
Advance Rate 5 4 20 3 15 3 15 4 20
Unused Line
Fee 3 3 9 4 12 4 12 3 9
Default Rate 5 2 10 2 10 3 15 4 20
Friendliness of
Lender 7 4 28 3 21 2 14 1 7
Total
Score   119   121   138   102
Criterion Weight Alternative A Alternative B Alternative C

ROI 15% 2 4 10
Financial Payback 10% 3 5 10
NPV 15% 2 4 10
Alignment with
strategic objectives 10% 3 5 8
Organizational
Likelihood of achieving
project’s MOV 10% 2 6 9

Availability of skilled
team members 5% 5 5 4

Project Maintainability 5% 4 6 7
Time to develop 5% 5 7 6
Risk 5% 3 5 5
Customer satisfaction 10% 2 4 9
External
Increased market share 10% 2 5 8

Total Score 100% 2.65 4.85 8.50

Notes: Risk scores have a reverse scale – i.e., higher scores for risk imply lower levels of risk
 Competitive Profile Matrix
Company One Company Two Company Three
Critical Success Factors Weight Rating Score Rating Score Rating Score

Advertising 0.20 1 0.20 4 0.80 3 0.60

Product Quality 0.10 4 0.40 3 0.30 2 0.20
Price Competitiveness 0.10 3 0.30 2 0.20 4 0.40

Management 0.10 4 0.40 3 0.30 3 0.30

Financial Position 0.15 4 0.60 2 0.30 3 0.45
Customer Loyalty 0.10 4 0.40 3 0.30 2 0.20

Global Expansion 0.20 4 0.80 1 0.20 2 0.40

Market Share 0.05 1 0.05 4 0.20 3 0.15
Total 1.00 3.15 2.60 2.70
Forecasting Capacity Requirements
• Long-term considerations relate to overall level
of capacity requirements
• Require forecasting demand over a time horizon and
converting those needs into capacity requirements
• Short-term considerations relate to probable
variations in capacity requirements
• Less concerned with cycles and trends than with
seasonal variations and other variations from
average

5-25
Calculating Processing Requirements
• Calculating processing requirements requires
reasonably accurate demand forecasts, standard
processing times, and available work time
k

pD i i
NR  i 1
T
where
N R  number of required machines
pi  standard processing time for product i
Di  demand for product i during the planning horizon
T  processing time available during the planning horizon
5-26
Service Capacity Planning
• Service capacity planning can present a
number of challenges related to:
• The need to be near customers
• Convenience
• The inability to store services
• Cannot store services for consumption later
• The degree of demand volatility
• Volume and timing of demand
• Time required to service individual customers

5-27
Demand Management Strategies
• Strategies used to offset capacity limitations
and that are intended to achieve a closer
match between supply and demand
• Pricing
• Promotions
• Discounts
• Other tactics to shift demand from peak
periods into slow periods

5-28
In-House or Outsource?
• Once capacity requirements are determined, the
organization must decide whether to produce a
good or service itself or outsource
• Factors to consider:
• Available capacity
• Expertise
• Quality considerations
• The nature of demand
• Cost
• Risks
5-29
Developing Capacity Alternatives
• Things that can be done to enhance capacity
management:
• Design flexibility into systems
• Take stage of life cycle into account
• Take a “big-picture” approach to capacity changes
• Prepare to deal with capacity “chunks”
• Attempt to smooth capacity requirements
• Identify the optimal operating level
• Choose a strategy if expansion is involved

5-30
Capacity Strategies
• Leading
• Build capacity in anticipation of future demand
increases
• Following
• Build capacity when demand exceeds current
capacity
• Tracking
• Similar to the following strategy, but adds capacity in
relatively small increments to keep pace with
increasing demand
5-31
Bottleneck Operation

• An operation in a
sequence of operations
whose capacity is
lower than that of the
other operations
5-32
Optimal Operating Level

Average cost per unit

Minimum
cost

Optimal
Output
Rate Rate of output

5-33
Economies and Diseconomies of Scale
• Economies of Scale
• If output rate is less than the optimal
level, increasing the output rate results in
decreasing average per unit costs
• Diseconomies of Scale
• If the output rate is more than the optimal
level, increasing the output rate results in
increasing average per unit costs

5-34
Economies of Scale
• Economies of Scale
• If output rate is less than the optimal level, increasing the
output rate results in decreasing average per unit costs
• Reasons for economies of scale:
• Fixed costs are spread over a larger number of units
• Construction costs increase at a decreasing rate as
facility size increases
• Processing costs decrease due to standardization

5-35
Diseconomies of Scale
• Diseconomies of Scale
• If the output rate is more than the optimal level, increasing
the output rate results in increasing average per unit costs
• Reasons for diseconomies of scale
• Distribution costs increase due to traffic congestion and
shipping from a centralized facility rather than multiple
smaller facilities
• Complexity increases costs
• Inflexibility can be an issue
• Additional levels of bureaucracy

5-36
Facility Size and Optimal Operating Level
Minimum cost & optimal operating rate are
functions of size of production unit.
Average cost per unit

Small
plant
Medium
plant
Large
plant

Output rate 5-37

Constraint Management
• Constraint
• Something that limits the performance of a process or
system in achieving its goals
• Categories
• Market
• Resource
• Material
• Financial
• Knowledge or competency
• Policy

5-38
Resolving Constraint Issues
1. Identify the most pressing constraint
2. Change the operation to achieve maximum benefit,
given the constraint
3. Make sure other portions of the process are supportive
of the constraint
4. Explore and evaluate ways to overcome the constraint
5. Repeat the process until the constraint levels are at
acceptable levels

5-39
Evaluating Alternatives
Alternatives should be evaluated from varying
perspectives
Economic
Is it economically feasible?
How much will it cost?
How soon can we have it?
What will operating and maintenance costs be?
What will its useful life be?
Will it be compatible with present personnel and present operations?
Non-economic
Public opinion

5-40
Evaluating Alternatives
• Techniques for Evaluating Alternatives
• Cost-volume analysis
• Financial analysis
• Decision theory
• Waiting-line analysis
• Simulation

5-41
Cost-Volume Analysis
• Cost-volume analysis
• Focuses on the relationship between cost, revenue, and
volume of output
• Fixed Costs (FC)
• tend to remain constant regardless of output volume
• Variable Costs (VC)
• vary directly with volume of output
• VC = Quantity(Q) x variable cost per unit (v)
• Total Cost
• TC = FC + VC
• Total Revenue (TR)
• TR = revenue per unit (R) x Q

5-42
Break-Even Point (BEP)
• BEP
• The volume of output at which total cost
and total revenue are equal
• Profit (P) = TR – TC = R x Q – (FC +v x
Q)
= Q(R – v) – FC
FC
QBEP 
Rv
5-43
Cost-Volume Relationships

5-44
Cost-Volume Relationships

• Capacity alternatives may involve step costs,

which are costs that increase stepwise as
potential volume increases.
• The implication of such a situation is the
possible occurrence of multiple break-even
quantities. 5-45
Cost-Volume Analysis Assumptions
• Cost-volume analysis is a viable tool for comparing
capacity alternatives if certain assumptions are
satisfied
• One product is involved
• Everything produced can be sold
• The variable cost per unit is the same regardless of
volume
• Fixed costs do not change with volume changes, or
they are step changes
• The revenue per unit is the same regardless of
volume
5-46
• Revenue per unit exceeds variable cost per unit
Financial Analysis
• Cash flow
• The difference between cash received from sales and
other sources, and cash outflow for labor, material,
overhead, and taxes
• Present value
• The sum, in current value, of all future cash flow of an
investment proposal

5-47
Operations Strategy
• Capacity planning impacts all areas of the organization
• It determines the conditions under which operations will have to function
• Flexibility allows an organization to be agile
• It reduces the organization’s dependence on forecast accuracy and reliability
• Many organizations utilize capacity cushions to achieve flexibility
• Bottleneck management is one way by which organizations can enhance their
effective capacities
• Capacity expansion strategies are important organizational considerations
• Expand-early strategy
• Wait-and-see strategy
• Capacity contraction is sometimes necessary
• Capacity disposal strategies become important under these
conditions

5-48
 Supplem
ent 5

Decision Theory

McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Decision Theory
• A general approach to decision making that is
suitable to a wide range of operations management
decisions
• Capacity planning
• Product and service design
• Equipment selection
• Location planning

5S-50
Characteristics of Suitable Problems
• Characteristics of decisions that are suitable for using
decision theory
• A set of possible future conditions that will have a bearing
on the results of the decision
• A list of alternatives from which to choose
• A known payoff for each alternative under each possible
future condition

5S-51
Process for Using Decision Theory
1. Identify the possible future states of nature
2. Develop a list of possible alternatives
3. Estimate the payoff for each alternative for each possible
future state of nature
4. If possible, estimate the likelihood of each possible future
state of nature
5. Evaluate alternatives according to some decision criterion
and select the best alternative

5S-52
Payoff Table
• A table showing the expected payoffs for each
alternative in every possible state of nature
Possible Future Demand
Alternatives Low Moderate High

Small facility $10 $10 $10

Medium facility 7 12 12

Large Facility (4) 2 16

• A decision is being made concerning which size

facility should be constructed
• The present value (in millions) for each alternative
under each state of nature is expressed in the body of
the above payoff table
5S-53
Causes of Poor Decisions
• Decisions occasionally turn out poorly due to
unforeseeable circumstances; however, this is not
the norm.
• More frequently poor decisions are the result of a
combination of
• Mistakes in the decision process
• Bounded rationality
• Suboptimization

5S-54
Decision Process
Steps:
1. Identify the problem
2. Specify objectives and criteria for a solution
3. Develop suitable alternatives
4. Analyze and compare alternatives
5. Select the best alternative
6. Implement the solution
7. Monitor to see that the desired result is achieved
Errors
 Failure to recognize the importance of each step
 Skipping a step
 Failure to complete a step before jumping to the next step
 Failure to admit mistakes
 Inability to make a decision

5S-55
Bounded Rationality & Suboptimization
• Bounded rationality
• The limitations on decision making caused by costs,
human abilities, time, technology, and availability of
information
• Suboptimization
• The results of different departments each attempting to
reach a solution that is optimum for that department

5S-56
Decision Environments
There are three general environment categories:
Certainty
Environment in which relevant parameters have known values
Risk
Environment in which certain future events have probabilistic
outcomes
Uncertainty
Environment in which it is impossible to assess the likelihood of
various possible future events

5S-57
Decision Making Under Uncertainty
Decisions are sometimes made under complete uncertainty: No
information is available on how likely the various states of nature are.
Decision Criteria:
 Maximin
Choose the alternative with the best of the worst possible payoffs
 Maximax
Choose the alternative with the best possible payoff
 Laplace
Choose the alternative with the best average payoff
 Minimax regret
Choose the alternative that has the least of the worst regrets

5S-58
Example – Maximin Criterion
Possible Future Demand
Alternatives Low Moderate High
Small Facility $10 $10 $10
Medium Facility 7 12 12
Large Facility (4) 2 16

•The worst payoff for each alternative is

Small facility: $10 million
Medium facility $7 million
Large facility -$4 million
•Choose to construct a small facility

5S-59
Example – Maximax Criterion
Possible Future Demand
Alternatives Low Moderate High
Small Facility $10 $10 $10
Medium Facility 7 12 12
Large Facility (4) 2 16

•The best payoff for each alternative is

Small facility: $10 million
Medium facility $12 million
Large facility $16 million
•Choose to construct a large facility

5S-60
Example – Laplace Criterion
Possible Future Demand
Alternatives Low Moderate High
Small Facility $10 $10 $10
Medium Facility 7 12 12
Large Facility (4) 2 16

•The average payoff for each alternative is

Small facility: (10+10+10)/3 = $10 million
Medium facility (7+12+12)/3 = $10.33 million
Large facility (-4+2+16)/3 = $4.67 million
•Choose to construct a medium facility

5S-61
Example – Minimax Regret
Possible Future Demand
Alternatives Low Moderate High
Small Facility $10 $10 $10
Medium Facility 7 12 12
Large Facility (4) 2 16

•Construct a regret (or opportunity loss) table

• The difference between a given payoff and the best
payoff for a state of nature
Regrets
Alternatives Low Moderate High
Small Facility $0 $2 $6
Medium Facility 3 0 4
Large Facility 14 10 0
5S-62
Example – Minimax Regret
Regrets
Alternatives Low Moderate High
Small Facility $0 $2 $6
Medium Facility 3 0 4
Large Facility 14 10 0

•Identify the worst regret for each alternative

• Small facility $6 million
• Medium facility $4 million
• Large facility $14 million
•Select the alternative with the minimum of the maximum
regrets
• Build a medium facility

5S-63
Decision Making Under Risk
• Decisions made under the condition that the probability of
occurrence for each state of nature can be estimated
• A widely applied criterion is expected monetary value (EMV)
• EMV
• Determine the expected payoff of each alternative, and choose
the alternative that has the best expected payoff
• This approach is most appropriate when the decision maker is neither
risk averse nor risk seeking

5S-64
Example– EMV
Possible Future Demand
Alternatives Low (.30) Moderate (.50) High (.20)
Small Facility $10 $10 $10
Medium Facility 7 12 12
Large Facility (4) 2 16

EMVsmall = .30(10) +.50(10) +.20(10) = 10

EMVmedium = .30(7) + .50(12) + .20(12) = 10.5
EMVlarge = .30(-4) + .50(2) + .20(16) = $3

Build a medium facility

5S-65
Decision Tree
• Decision tree
• A schematic representation of the available alternatives and their
possible consequences
• Useful for analyzing sequential decisions

5S-66
Decision Tree
Composed of
Nodes
Decisions – represented by square nodes
Chance events – represented by circular nodes
Branches
Alternatives– branches leaving a square node
Chance events– branches leaving a circular node
Analyze from right to left
For each decision, choose the alternative that will yield the greatest
return
If chance events follow a decision, choose the alternative that has the
highest expected monetary value (or lowest expected cost)

5S-67
Example– Decision Tree
• A manager must decide on the size of a video arcade to construct. The manager has narrowed the choices
to two: large or small. Information has been collected on payoffs, and a decision tree has been constructed.
Analyze the decision tree and determine which initial alternative (build small or build large) should be
chosen in order to maximize expected monetary value.

.40) $40
e m and (
D
Low ng $40
o thi
N
High Do
l
D
al

eman Overtime
d (.60 2
Sm

) $50
Ex p
il d

an d
Bu

$55
ing
1 Do Noth ($10)
0 ) 2
d (.4
Bu

n
ma Cut
ild

De Pr ices
w $50
La

Lo
r ge

High
D ema
n d (.6
0) $70 5S-68
Example– Decision Tree
.40) $40
e m and (
D
Low ng $40
o thi
N
High Do

l
D

al
eman
d (.60 Overtime
2

Sm
) $50
Ex p
il d an d
Bu
$55
i ng
1 Do Noth ($10)
0 ) 2
d (.4
Bu

n
ma Cut
ild

De P ri c e
w s $50
La

Lo
r ge

High
D ema
n d (.6
0) $70

EVSmall = .40(40) + .60(55) = $49

EVLarge = .40(50) + .60(70) = $62

Build the large facility 5S-69

Expected Value of Perfect Information
• Expected value of perfect information (EVPI)
• The difference between the expected payoff with perfect information and the expected
payoff under risk
• Two methods for calculating EVPI
• EVPI = expected payoff under certainty – expected payoff under risk
• EVPI = minimum expected regret

5S-70
Example – EVPI
Possible Future Demand
Alternatives Low (.30) Moderate (.50) High (.20)
Small Facility $10 $10 $10
Medium Facility 7 12 12
Large Facility (4) 2 16

EVwith perfect information = .30(10) + .50(12) + .20(16) = $12.2

EMV = $10.5
EVPI = EVwith perfect information – EMV
= $12.2 – 10.5
= $1.7
You would be willing to spend up to $1.7 million to
obtain perfect information
5S-71
Example– EVPI
Regrets
Alternatives Low (.30) Moderate (.50) High (.20)
Small Facility $0 $2 $6
Medium Facility 3 0 4
Large Facility 14 10 0

• Expected Opportunity Loss

• EOLSmall = .30(0) + .50(2) + .20(6) = $2.2
• EOLMedium = .30(3) + .50(0) + .20(4) = $1.7
• EOLLarge = .30(14) + .50(10) + .20(0) = $9.2

• The minimum EOL is associated with the building the

medium size facility. This is equal to the EVPI, $1.7
million
5S-72
 Sensitivity Analysis
• Sensitivity analysis
• Determining the range of probability for which an alternative has the best
expected payoff

5S-73