Management Science – 2

ABI-301
Prelim Period Lecture Note#3
Introduction
Capacity issues are important for all organizations, and at all levels of an
organization. Capacity refers to an upper limit or ceiling on the load that an
operating unit can handle. The operating unit might be a plant, department,
machine, store, or worker. The capacity of an operating unit is an important piece
of information for planning purposes: It enables managers to quantify production
capability in terms of inputs or outputs, and thereby make other decisions or
plans related to those quantities. The basic questions in capacity planning are
the following:
1. What kind of capacity is needed?
2. How much is needed?
3. When is it needed?

Importance of Capacity Decisions

For a number of reasons, capacity decisions are among the most fundamental of
all the
design decisions that managers must make.

1) Capacity decisions have a real impact on the ability of the organization to

meet future demands for products and services; capacity essentially limits
the rate of output possible.
2) Capacity decisions affect operating costs. Ideally, capacity and demand
requirements will be matched, which will tend to minimize operating costs.
3) Capacity is usually a major determinant of initial cost. Typically, the
greater the capacity of a productive unit, the greater its cost.
4) Capacity decisions often involve long-term commitment of resources and
the fact that, once they are implemented, it may be difficult or impossible
to modify those decisions without incurring major costs.
5) Capacity decisions can affect competitiveness.
6) Capacity affects the ease of management.

Defining and Measuring Capacity

Capacity often refers to an upper limit on the rate of output. Even though this
seems simple enough, there are subtle difficulties in actually measuring capacity
in certain cases. These difficulties arise because of different interpretations of the
term capacity and problems with identifying suitable measures for a specific
situation. Up to this point, we have been using a working definition of capacity.
Although it is functional, it can be refined into two useful definitions of capacity:
1) Design capacity: the maximum output that can possibly be attained.
2) Effective capacity: the maximum possible output given a product mix,
scheduling difficulties, machine maintenance, quality factors, and so on.
3) Actual Capacity: The actual production at specific time.

These different measures of capacity are useful in defining two measures of

system effectiveness: efficiency and utilization. Efficiency is the ratio of actual
output to effective capacity. Utilization is the ratio of actual output to design
capacity.

Determinants of Effective Capacity

Many decisions about system design have an impact on capacity. The same is true for many operating
decisions. This section briefly describes some of these factors, which are then elaborated on elsewhere
in the book. The main factors relate to the following:
1. Facilities 2. Products or services
3. Processes 4. Human considerations
5. Operations 6. External forces

Developing Capacity Alternatives

Aside from the general considerations about the development of alternatives (i.e., conduct a
reasonable search for possible alternatives, consider doing nothing, take care not to overlook non-
quantitative factors), there are other things that can be done to enhance capacity management:
1) Design flexibility into systems. The long-term nature of many capacity decisions and the
risks inherent in long-term forecasts suggest potential benefits from designing flexible
systems. (For example provision for future expansion).
2) Differentiate between new and mature products or services. Mature products or services
tend to be more predictable in terms of capacity requirements, and they may have limited life
span.
3) Take a “big picture” approach to capacity changes. When developing capacity
alternatives, it is important to consider how parts of the system interrelate. (for example
increase capacity without enough car park).
4) Prepare to deal with capacity “chunks.” Capacity increases are often acquired in fairly
large chunks rather than smooth increments.
5) Attempt to smooth out capacity requirements. Unevenness in capacity requirements also
can create certain problems.
6) Identify the optimal operating level. Production units typically have an ideal or optimal
level of operation in terms of unit cost of output. Production units have an optimal rate of output
for minimum cost Minimum cost and optimal operating rate are functions of size of a
production unit
COST–VOLUME ANALYSIS
Cost–volume analysis focuses on relationships between cost, revenue, and
volume of output. The purpose of cost–volume analysis is to estimate the income
of an organization under different operating conditions. It is particularly useful as
a tool for comparing capacity alternatives. One of the famous mathematical
modeling using to identify capacity is break-even point (BEP) the volume of output
at which total cost and total revenue are equal.

COST–VOLUME (BEP) ASSUMPTIONS

Cost–volume analysis can be a valuable tool for comparing capacity alternatives if certain
assumptions are satisfied:
1) One product is involved.
2) Everything produced can be sold.
3) The variable cost per unit is the same regardless of the volume.
4) Fixed costs do not change with volume changes, or they are step changes.
5) The revenue per unit is the same regardless of volume.
6) Revenue per unit exceeds variable cost per unit.

Cost–volume symbols
The owner of Old-Fashioned Berry Pies, S. Simon, is contemplating adding a new
line of pies, which will require leasing new equipment for a monthly payment of
$6,000. Variable costs would be $2.00 per pie, and pies would retail for $7.00
each.
a. How many pies must be sold in order to break even?
b. What would the profit (loss) be if 1,000 pies are made and sold in a
month?
c. How many pies must be sold to realize a profit of $4,000?

1. The efficiency of a productive unit is 60%. The unit produces an average of 20

forklift trucks per day. Determine the effective capacity of the unit.

2. The utilization of a machine is 50%. The machine has a design capacity of 70 units
per hour and an effective capacity of 60 units per hour. Find the efficiency of the
machine.

3. A producer of pottery is considering the addition of a new plant to absorb the

backlog of demand that now exists. The primary location being considered will
have fixed costs of $9,200 per month and variable costs of 70 cents per unit
produced. Each item is sold to retailers at a price that averages 90 cents.
a. What volume per month is required in order to break even?
b. What profit would be realized on a monthly volume of 61,000 units?
87,000 units?
c. What volume is needed to obtain a profit of $16,000 per month?
d. What volume is needed to provide revenue of $23,000 per month?

4. A small firm intends to increase the capacity of a bottleneck operation by adding a

new machine. Two alternatives, A and B, have been identified, and the associated
costs and revenues have been estimated. Annual fixed costs would be $40,000 for
A and $30,000 for B; variable costs per unit would be $10 for A and $12 for B; and
revenue per unit would be $15 for A and $16 for B.
a. Determine each alternative’s break-even point in units.
b. At what volume of output would the two alternatives yield the same
profit?
c. If expected annual demand is 12,000 units, which alternative would
yield the higher profit?

5. A producer of felt-tip pens has received a forecast of demand of 30,000 pens for
the coming month from its marketing department. Fixed costs of $25,000 per
month are allocated to the felt-tip operation, and variable costs are 37 cents per
pen.
a. Find the break-even quantity if pens sell for $1 each.
b. At what price must pens be sold to obtain a monthly profit of $15,000,
assuming that estimated demand materializes?

6. A firm plans to begin production of a new small appliance. The manager must
decide whether to purchase the motors for the appliance from a vendor at $7 each
or to produce them in-house. Either of two processes could be used for in-house
production; one would have an annual fixed cost of $160,000 and a variable cost
 of $5 per unit, and the other would have an annual fixed cost of $190,000 and a
variable cost of $4 per unit. Determine the range of annual volume for which each
of the alternatives would be best.

7. Giving the Following Table solve the questions bellow :-

a) What is the break-even quantity?

b) What are total revenues at the break-even quantity?
c) What are total costs at the break-even quantity?
d) What quantity would be required for a profit of $2,000?
e) What profit (loss) would there be for a quantity of 27,000?
f) What is the anticipated utilization?
g) What is the anticipated efficiency?