OPERATIONS MANAGEMENT

MBA – (MIS, PSM, ITM & GENERAL)

Lecture 4: Facility Capacity decisions

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 Introduction
 After the selection of a production process,
managers need to determine capacity.
 Capacity decisions often determine capital
requirements and therefore a large portion of
fixed cost.
 Capacity also determines whether demand
will be satisfied or whether facilities will be
idle.
 2
 Introduction cont…

 Capacity is the “throughput,” or the number of

units a facility can hold, receive, store, or produce
in a given time.
 If a facility is too large, portions of it will sit
unused and add cost to existing production. If a
facility is too small, customers and perhaps entire
markets will be lost.
 Determining facility size, with an objective of
achieving high levels of utilization and a high
return on investment, is critical.
 Capacity Planning
 Capacity Planning is a long-term strategic decision that
establishes a firm’s overall level of resources.
 Capacity planning is a key strategic component in
designing the system. It encompasses many basic
decisions with long-term consequences for the
organization.
 The integral objective of capacity planning is to achieve
a match between the long-term supply capabilities of
an organization and the predicted level of long-run
demand.
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 Capacity Planning Questions
Key Questions:
 What kind of capacity is needed?
 How much capacity 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
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 Can the supply chain handle the necessary changes?
 Capacity planning Horizons
 Capacity planning can be viewed in three-time horizons.
 In long-range capacity (generally greater than 3 years) is a
function of adding facilities and equipment that have a long lead
time.
 In the intermediate range (usually 3 to 36 months), we can
add equipment, personnel, and shifts; we can subcontract; and we
can build or use inventory. This is the “aggregate planning” task.
 In the short run (usually up to 3 months), we are primarily
concerned with scheduling jobs and people, as well as allocating
machinery. Modifying capacity in the short run is difficult, as we
are usually constrained by existing capacity.
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Planning Over a Time Horizon

Long-range Add facilities

planning Add long lead time equipment

Intermediate- Subcontract Add personnel

range Add equipment Build or use inventory
planning Add shifts

Short-range Schedule jobs

Schedule personnel
planning Allocate machinery

Modify capacity Use capacity

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Why Capacity Decisions are strategic?
 impact the ability of the organization to meet future
demands
 affect operating costs
 establishes a firm’s overall level of resources.
 are a major determinant of initial cost
 often involve long-term commitment of resources
 can affect competitiveness
 affect the ease of management
 need to be planned for in advance due to their
consumption of financial and other resources
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 Capacity and Strategy
 Sustained profits come from building competitive advantage,
not just from a good financial return on a specific process.
 Capacity decisions must be integrated into the organization’s
mission and strategy. Investments are not to be made as
isolated expenditures, but as part of a coordinated plan that
will place the firm in an advantageous position.
 The questions to be asked are, “Will these investments
eventually win profitable customers?” and “What
competitive advantage (such as process flexibility,
speed of delivery, quality, and so on) do

we obtain?”
 Capacity and Strategy……
 All OM decisions as well as other organizational
elements such as marketing and finance, are
affected by changes in capacity.
 For example; Change in capacity will have
sales and cash flow implications, just as
capacity changes have quality, supply
chain, human resource, and maintenance
implications.
 All must be considered.
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 Capacity Considerations
In addition to tight integration of strategy and investments,
there are four special considerations for a good capacity
decision:
a. Forecast demand accurately: Product additions and
deletions, competition actions, product life cycle, and
unknown sales volumes all add challenge to accurate
forecasting.
b. Match technology increments and sales volume:
Capacity options are often constrained by technology.

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Capacity Considerations…..
c. Find the optimum operating size
(volume): Economies and diseconomies of
scale often dictate an optimal size for a facility
d. Build for change: Managers build flexibility
into facilities and equipment; changes will occur
in processes, as well as products, product
volume, and product mix.

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 Demand and Capacity match
Next, we note that rather than strategically manage
capacity, managers may tactically manage demand.
 Even with good forecasting and facilities built to
accommodate that forecast, there may be a poor match
between the actual demand that occurs and available
capacity.
 A poor match may mean demand exceeds capacity or
capacity exceeds demand.
 However, in both cases, firms have options.

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 1. Demand exceeds Capacity
 When demand exceeds capacity, the firm may
be able to curtail demand simply by raising prices,
scheduling long lead times (which may be
inevitable), and discouraging marginally profitable
business.
 However, because inadequate facilities reduce
revenue below what is possible, the long-term
solution is usually to increase capacity.

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 2. Capacity exceeds Demand
 When capacity exceeds demand, the firm may
want to stimulate demand through price
reductions or aggressive marketing, or it may
accommodate the market through product
changes.
 When decreasing customer demand is combined
with old and inflexible processes, layoffs and
plant closings may be necessary to bring capacity
in line with demand.

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3. Adjusting to Seasonal Demands
 A seasonal or cyclical pattern of demand is
another capacity challenge. In such cases,
management may find it helpful to offer
products with complementary
patterns; demand that is,
products
demand is high for low
for one when which
for the
the other.
 With appropriate complementing of products,
perhaps the utilization of facility, equipment, and
personnel can be smoothed

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 Demand and Capacity Management
in Services
 In the service sector, scheduling customers is
demand management, and scheduling the
workforce is capacity management.
 Demand When demand and
Management: fairl well matched,
capacity
management are y can demand often be
handled
appointments, reservations, with first-served
or a first-come,
rule. In some businesses, such as doctors’ and lawyers’
offices, an appointment system is the scheduled and is
adequate.
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Demand and Capacity Management
in Services…..
 Capacity Management: When managing demand is
not feasible, then managing capacity through changes in
full-time, temporary, or part-time staff may be an option.
This is the approach in many services.

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 Measures of facility capacity
 No single measure of capacity will be appropriate in
every situation. Rather, the measure of capacity must be
tailored to the situation.
 Example, 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, active members (a
church), etc.
 However, two measures of capacity have been commonly
used; Designed capacity and Effective capacity

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Design capacity
 Design capacity is the maximum theoretical
output of a system in a given period under ideal
conditions.
 It is a maximum output rate or service capacity
an operation, process, or facility is designed for.
 It is normally expressed as a rate, such as the
number of tons of steel that can be produced per
week, per month, or per year.

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 Effective capacity
 Effective capacity is the capacity a firm expects to
achieve given the current operating constraints.
 Effective capacity is often lower than design capacity
because the facility may have been designed for an earlier
version of the product or a different product mix than is
currently being produced.
 Effective capacity = Design capacity minus
allowances such as personal time, maintenance, and
scrap

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 Measures of system performance
 Two measures of system performance are particularly useful:
utilization and efficiency.
 Utilization is simply the percent of design
capacity
actually achieved.
 Efficiency is the percent of effective capacity actually
achieved.
 Depending on how facilities are used and managed, it may be
difficult or impossible to reach 100% efficiency. Operations
managers tend to be evaluated on efficiency. The key to
improving efficiency is often found in correcting quality
problems andmaintenance.
training, and in effective scheduling,
 Utilization and Efficiency

actual output
Utilization 
design capacity

actual output
Efficiency
effectivecapacit
y
Actual output
•The rate of output actually achieved
•It cannot exceed effective capacity
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 Example 1
 Sara James Bakery has a plant for processing Deluxe
breakfast rolls and wants to better understand its
capability. Last week the facility produced 148,000
rolls. The effective capacity is 175,000 rolls. The
production line operates 7 days per week, with three 8-
hour shifts per day. The line was designed to process
the nut-filled, cinnamon- flavored Deluxe roll at a rate
of 1,200 per hour. Determine the design capacity,
utilization, and efficiency for this plant when
producing this Deluxe roll.
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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

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Evaluating Capacity Alternatives
 Alternatives should be evaluated from varying
perspectives
 Economic
 Cost-volume analysis
 Decision theory
 Financial analysis
 Waiting-line analysis
 Simulation
 Non-economic
 Public opinion

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1. 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 = (Q x v) + FC
 Total Revenue (TR)
TR = revenue per unit (P) x Q

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Cost-Volume Relationships

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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
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Break-Even Point (BEP)
 The volume of output at which total cost and total
revenue are equal
 Profit (Pf) = TR – TC = P x Q – (FC +v x Q)

 At BEP, profit =0

 0 = Q(P – V) – FC

F C
Q B E P 
P  V

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Break-Even Analysis
–
Total revenue line
900 –

800 –
Break-even point Total Total cost line
700 – cost = Total revenue

600 –
Cost in dollars

500 –

400 – Variable cost

300 –

200 –

100 – Fixed cost

– | | | | | | | | |
| |
0 100 200 300 400 500 600 700 800 900 1000 1100 31
S u m un i, C I AA
Volume ( u n it s pe r period)
Break-Even Analysis
BEPQ= Break-even point in units Q = Number of units produced
BEP$ = Break-even point in
dollars TR = Total revenue = PQ
P = Price per unit (after all F = Fixed costs
discounts) V = Variable costs
TC = Total costs = F + VQ
BEP$ = BEPQ P
= F *P Profit = TR - TC
P-V
= PQ - (F + VQ)
= F
= PQ - F - VQ
(P = (P - V)Q – F
F
BEP$ = -1V)/P
- V/P
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BEP ……..

BEP (in units) = Total fixed cost

Price – Variable cost

BEP (in dollars) = Total fixed cost

1- Variable cost
Selling price

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 Example 3

IAA cafeteria has fixed cost of $10,000 this period.

Direct labour cost is $1.50 per unit, and material is $
0.75 per unit. The selling price is 4.00 per unit.
Compute the BEP
a) In units
b) In dollars

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Break-Even (Graphical presentation)

50,000 –

Revenue
40,000 –
Break-even
point Total
30,000 –
costs
Dollars

20,000 –

Fixed costs
10,000 –

| | | | |
–
0| 2,000 4,000 6,000 8,000 10,000
Units
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BEP- Multiproduct Case

F
BEP$ =

∑ 1-
Vi
Pi
x (W i)

where V = variable cost per unit

P = price per unit
F = fixed costs
W = percent each product is of total dollar sales
i = each product

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Multiproduct Example
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

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 Example 4 - Multiproduct
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 Annual 5,000 Weighted
Tea Selling Variable .75 .25 Forecasted Pro.of Contribution
5,000 (col 5 x col 7)
Item (i) Price (P) Cost (V) (V/P) 1 - (V/P) Sales $ Sales
Salad bar 2.85 1.00 3,000
Sandwich $2.95 $1.25 .42 .58 $20,650 .446 .259
Soft drink .80 .30 .38 .62 5,600 .121 .075
Baked 1.55 .47 .30 .70 7,750 .167 .117
potato
Tea .75 .25 .33 .67 3,750 .081 .054
Salad bar 2.85 1.00 .35 .65 8,550 .185 .120
$46,300 1.000 .625
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Multiproduct Example
F
BEP$ =
∑ 1-
V
x i
i
(W )
Pi
$3,500 x 12
= .625 = $67,200

Daily $67,200 = $215.38

sales = 312 days

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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

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Break-Even Analysis Example
 Ex-1: For a make or buy decision, the
following details are given;
Particular Make Buy
Annual Fixed Cost $150,000 ---
Variable Cost/Unit $60 $80
Annual Volume 12000 12000

a. Whether the item should be made or purchased?

b. If volume changes, at what volume the manager would
be indifferent between making and buying?

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THANK YOU