Copperbelt University

School of Business

BS 343-Production and
Operations Management
Capacity Planning
 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

Schedule jobs
Short-range
planning
* Schedule personnel
Allocate machinery

Modify capacity Use capacity

* Limited options exist
Figure S7.1
 CAPACITY
• Capacity is defined as the maximum output of a
system in a given period under ideal conditions.
• In a process-focused facility, capacity is often
determined by some measure of size such as the
number of beds in a hospital or seating capacity in
a restaurant.
• In a repetitive process, the number of units
assembled each shift, such as number of
refrigerators, may be the criterion for capacity.
• And in a product-focused facility, such as in a steel
plant, tons of steel processed per shift may be the
measure of capacity.
 effective capacity or utilization
• Many organizations operate their facilities at a
rate less than capacity.
• Instead, they operate at perhaps 92% of
capacity. This concept is called effective
capacity or utilization.
• Effective capacity or utilization is simply the
percentage capacity expected.
• Effective capacity, or utilization
= Expected capacity/Capacity
 efficiency
• Depending on how facilities are used and
managed, it may be difficult or impossible to
reach 100% efficiency.
• Typically, efficiency is expressed as a percentage
of the effective capacity. Efficiency is a measure
of actual output over effective capacity:
• Efficiency = Actual output/Effective capacity
 Rated Capacity
• The rated capacity is a measure of the maximum
usable capacity of a particular facility.
• Rated capacity will always be less than or equal to
the capacity.
• The equation used to compute rated capacity is:
• Rated capacity = (capacity) (utilization) (efficiency)
 Example 1
• The Mafioso Bakery has a plant for processing
breakfast rolls. The facility has an efficiency of
90%, and the utilization is 80%. Three process
lines are used to produce the rolls. The lines
operate 7 days a week and three 8-hour shifts
per day. Each line was designed to process 120
standard (that is, plain) rolls per hour. What is
the rated capacity?
• In order to compute the rated capacity, we multiply
the capacity (which is equal to the number of lines
times the number of hours times the number of rolls
per hour) times the utilization times the efficiency.
• Each facility is used 7 days a week, three shifts a day.
• Therefore, each process line is utilized for 168 hours
per week (168 = 7 days x 3 shifts per day x 8 hours
per shift).
• Rated capacity = (capacity) (utilization)
(efficiency)
• = [(120) (3) (168)] (.8) (.9) = 43, 546 rolls/week
 Example
• Yamy Barkery has a plant for processing Breakfast
rolls and wants to better understand its capacity.
Determine the design capacity, utilisation, efficiency
and expected output for this plant.
• Last week the plant produced 148,000 rolls. The
effective capacity is 175,000 rolls. The production line
operates 7 days per week, with three-8 hours shift
per day. The line was designed to produce rolls at a
rate of 1,200/hour.
 Bakery Example
Actual production last week = 148,000 rolls
Effective capacity = 175,000 rolls
Design capacity Rate= 1,200 rolls per hour
Bakery operates 7 days/week, Three 8 hour shifts

Design capacity = (7 x 3 x 8) x (1,200) = 201,600 rolls

 Bakery Example
Actual production last week = 148,000 rolls
Effective capacity = 175,000 rolls
Design capacity Rate= 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

 Bakery Example
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

Design capacity = (7 x 3 x 8) x (1,200) = 201,600 rolls

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

 Bakery Example
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

Design capacity = (7 x 3 x 8) x (1,200) = 201,600 rolls

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

 Bakery Example
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

Design capacity = (7 x 3 x 8) x (1,200) = 201,600 rolls

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

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

 Bakery Example
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

Design capacity = (7 x 3 x 8) x (1,200) = 201,600 rolls

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

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

 Bakery Example
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%

Expected Output = (Effective Capacity)(Efficiency)

= (175,000)(.75) = 131,250 rolls

 Bakery Example
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%

Expected Output = (Effective Capacity)(Efficiency)

= (175,000)(.75) = 131,250 rolls

 Capacity Considerations
• Changing capacity is not as simple as acquiring the right amount of
capacity to exactly match our needs.
• The reason is that capacity is purchased in discrete chunks.
• Also, capacity decisions are long term and strategic in nature.
• Acquiring anticipated capacity ahead of time can save cost and
disruption in the long run. Later, when demand increases, output
can be increased without incurring additional fixed cost.
• Extra capacity can also serve to intimidate and preempt
competitors from entering the market. Important implications of
capacity that a company needs to consider when changing its
capacity are discussed in this section.
 Basic Strategies for Timing Capacity
• CRP provides information to determine the timing of capacity
expansion. The basic strategies in relation to a steady growth in
demand are:
– Capacity Lead Strategy
– Capacity Lag Strategy
– Average Capacity Strategy

• When to increase capacity and how much to increase it

are critical decisions.
 Approaches to Capacity
Expansion
(a) Leading demand with (b) Leading demand with
incremental expansion one-step expansion
New New
capacity capacity
Demand

Demand
Expected
Expected
demand demand

(c) Capacity lags demand with (d) Attempts to have an average

incremental expansion capacity with incremental
New
expansion
capacity New
Demand
Demand

Expected capacity Expected

demand demand

Figure S7.5
 Capacity Lead Strategy
• In anticipation of demand, capacity is increased.
• This is an aggressive strategy and is used to lure customers away from
competitors who are capacity constrained or to gain a foothold in a rapidly
expanding market.
• Acquiring anticipated capacity ahead of time can save cost and disruption in the
long run. Later, when demand increases, output can be increased without
incurring additional fixed cost.
• It allows companies to respond to unexpected surges in demand
• To provide superior levels of service during peak demand periods.
• Extra capacity can also serve to intimidate and preempt competitors from
entering the market.
• How much to increase capacity demands depend upon a number of factors,
including:
– Anticipated demand – volume & certainty
– Strategic objectives
– Costs of expansion and operation
 Approaches to Capacity Expansion

Capacity can be increased incrementally or in one large step as shown in the

Figure. Incremental expansion is less risky but more costly
 Capacity Lag Strategy
• Increase capacity after demand has increased.
• This is a conservative strategy and may result in lose of customers.
• It produces a higher return on investment but may lose customers
in the process.
• It is used in industries with standard products and cost-based or
weak competition.
• It assume lost customers will return after capacity has been met.
 Average Capacity Strategy
• Average expected demand is calculated and capacity is
increased accordingly.
• This is the most moderate strategy.
• Managers certain to sell at least some portion of expanded
output, and endure some periods of unmet demand.
• Approximately half of the time capacity leads demand, and
half of the time capacity lags demand
 Economies of Scale
• Every production facility has a volume of output that results in the lowest average
unit cost. This is called the facility’s best operating level.
• Figure below illustrates how the average unit cost of output is affected by the
volume produced.
• As the number of units produced is increased, the average cost per unit drops.
• The reason is that when a large amount of goods is produced, the costs of
production are spread over that large volume.
• These costs include the fixed costs of buildings and facilities, the costs of
materials, and processing costs.
• The more units are produced, the larger the number of units over which costs can
be spread—that is, the greater the economies of scale.
• Suppose you decide to make cookies in your kitchen. Think about the cost per
cookie if you make only five cookies. There would be a great deal of effort—
getting the ingredients, mixing the dough, shaping the cookies—all for only five
cookies. If you had everything set up, making five additional cookies would not
cost much more. Perhaps making even ten more cookies would cost only slightly
more because you had already set up all the materials. This lower cost is due to
economies of scale.
 Economies and Diseconomies of
Scale
(dollars per room per night)
Average unit cost

25 - room 75 - room
roadside motel 50 - room roadside motel
roadside motel

Economies Diseconomies
of scale of scale

25 50 75
Number of Rooms Figure S7.2
 Diseconomies of Scale
• Diseconomies of scale occur at a point beyond the best operating level, when the
cost of each additional unit made increases.
• Diseconomies of scale are also illustrated in Figure below.
• What if you continued to increase the number of cookies you chose to produce?
• For a while, making a few more cookies would not require much additional effort.
• However, after a certain point there would be so much material that the kitchen
would become congested.
• You might have to get someone to help because there was more work than one
person could handle.
• You might have to make cookies longer than expected, and the cleanup job might
be much more difficult. You would be experiencing diseconomies of scale.
• Operating a facility close to its best operating level is clearly important because of
the impact on costs. However, we have to keep in mind that different facility sizes
have different best operating levels. See figure below
cookies comfortably produced by one person in a small kitchen would be much lower than the
number produced by three friends in a large kitchen.
•Figure above shows how best operating level varies between facilities of different sizes.
•Each facility experiences both economies and diseconomies of scale. However, their best
operating levels are different.
•This is a very important consideration when changing capacity levels.
•The capacity of a business can be changed by either expanding or reducing the amount of
capacity.
•Although both decisions are important, expansion is typically a costlier and more critical event.
•When expanding capacity, management has to choose between one of the following two
alternatives: Alternative 1: Purchase one large facility, requiring one large initial investment.
Alternative 2: Add capacity incrementally in smaller chunks as needed.
•The first alternative means that the firm would have a large amount of excess capacity in the
beginning and that our initial costs would be high.
•The firm would also run the risk that demand might not materialize and would be left with
unused overcapacity.
•This alternative also allows the firm to be prepared for higher demand in the future.
•The firm’s best operating level is much higher with this alternative, enabling it to operate more
efficiently when meeting higher demand.
•However, its costs would be lower in the long run, since one large construction project typically
costs more than many smaller construction projects due to startup costs. Thus, alternative 1
provides greater rewards but is more risky.
•Alternative 2 is less risky but does not offer the same opportunities and flexibility. It is up to
management to weigh the risks versus the rewards in selecting an alternative.
 Decision Trees Applied to Capacity
Decisions
• Decision trees require specifying alternatives
and various states of nature.
• For capacity planning situations, the state of
nature usually is future demand or market
favourability.
• By assigning probability values to the various
states of nature, it is possible to make
decisions that maximize the expected value of
the alternatives.
• Decision Alternatives
These are uncertain future events also called chance
events
States of nature
These are possible outcomes for a chance event
Payoff
A measure of the consequence of a decision such as profit,
cost or time
Influence diagram
A graphical device that shows the relationship among
decisions, chance events and consequences for a
decision problem
 Node
An intersection or junction point of an influence
diagram or a decision tree
• Decision nodes
– Nodes indicating points where a decision is made
• Chance node
– Nodes indicating points where an uncertain event
will occur
 Expected Value Approach
An approach to choosing a decision alternative that is
based on the expected value of each decision
alternative. The recommended decision alternative is
that which provides the best expected value.
Expected value
For a chance node it is the weighted average of the
payoffs. The weights are the states of nature
probabilities
• Expected value of perfect information (EVPI)
– The expected value of information that will tell the
decision maker exactly which state of nature is going
to occur ( perfect information)
• ACB Chemicals, a company that makes hospital gowns is
considering capacity expansion. Its major alternatives are; to
do nothing, build a small plant, build a medium plant or build
a large plant.
• The new facility would produce a new type of gown and
currently the potential or marketability for this product is
unknown. If a large plant is built and a favourable market
exists, a profit of $100,000 could be realized. An
unfavourable market would yield a $90,000 loss. However, a
medium plant would earn a $60,000 profit with a favourable
market. A $10,000 loss would result from an unfavourable
market. A small plant, on the other hand, would return $40,
000 with favourable market conditions and lose only $5,000
in an unfavourable market. Of course, there is always the
option of doing nothing.
• Recent market research indicates that there is a 0.4
probability of a favourable market, which means that there is
also 0.6 probability of an unfavourable market.
 -$14,000 Market favourable (.4)
$100, 000

Market unfavourable (.6)

-$90, 000

Large plant +$18,000

Market favourable (.4)

$60,000
Medium plant
Market unfavourable (.6) -$10,000
Small plant
+$13,000
Market favourable (.4) $40,000
Do nothing
Market unfavourable (.6)
-$5,000

$0
With this information, the alternative that will result in the highest expected monetary
value (EMV) can be selected:

EMV (large plant) = (0.4)($100,000) + (0.6)(-$90,000) = -$14,000

EMV (medium plant) = (0.4)($60, 000) + (0.6)(-$10,000) = +$18,000
EMV (small plant) = 0(.4)($40,000) + (0.6)(-$5,000) = +$13,000
EMV (do nothing) = $0

• Based on EMV criteria, Kamwe should build a

medium plant.