5 Strategic Capacity Planning

Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 1

 Outline
Capacity Planning
 Defining capacity

 Reasons of capacity planning

 Defining and Measuring Capacity

 Determinants of Effective Capacity

 Developing Capacity Alternatives

 Evaluating Alternatives

Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 2

 Defining capacity
 Capacity refers to an upper limit or the maximum
load (rate of output) that an operating unit can
handle, to achieve a match between supply
capabilities and the predicted level of demand.
 The load might be in terms of the number of
physical units produced (e.g. bicycles assembled
per hour) or the number of services performed (e.g.
computers upgraded per hour, customer being
served).
 The operating unit might be a factory, department,
machine, store or worker.

Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 3

 Reasons of capacity planning
Impacts ability
to meet future
demands of
product/service
It enables Affects
managers to operating
quantify
production costs
capability in (Capacity and
terms of inputs Capacity demand are
matched)
or outputs
Planning

Impacts long
term Affects
commitments competitiveness
of resources

Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 4

 Defining and Measuring
Capacity
No single measure of capacity will be appropriate in
every situation.
Rather, the measure of capacity must be tailored to
the situation.
The following Table provides some examples of
commonly used measures of capacity.

Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 5

Examples of Capacity Measures

Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 6

 Capacity Planning
 Up to this point, we have been using a working definition of
capacity. Although it is functional, it can be developed into
two useful definitions of capacity:
 Design capacity (Max. Capacity)
 The maximum output that can possibly be attained
 Effective capacity (Best Operating Level) = DC – Planned stops
 The maximum possible output given a product mix, with
scheduling problems, machine maintenance, quality factors,
and so on.
 Actual output (Capacity Used) = DC – Planned stops – Unplanned stops
 It is subject to random distractions: sudden break down,
absenteeism, material shortages.
Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 7
 Capacity Planning

Actual output (Capacity Used)

Effective capacity (Best Operating Level)
Efficiency Available output
Capability of doing something well
without wasting time or energy

Actual output (Capacity Used)

Design capacity (Max. Capacity)

Utilization Real output

Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 8

 Measuring system
effectiveness
actual output
Efficiency  x100
effective capacity
The ratio of actual output to effective capacity

actual output
Utilizatio n  x100
design capacity
The ratio of actual output to design capacity

Both measures expressed as percentages

Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 9
 Example (1)
 Given the following information, compute the efficiency
and the utilization of the truck repair department:
 Design capacity = 50 trucks per day
 Effective capacity = 40 trucks per day
 Actual Output = 36 trucks per day

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

actual output 36
Utilizatio n    72% Real output
design capacity 50
Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 10
 Capacity Strategy formulation

Leading Following
capacity (Lag) capacity
strategy strategy

Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 11

 Capacity Strategy formulation
 A leading capacity strategy: capacity is added in

advance to meet any increase in future demand.

Advantages Disadvantages
Organization has adequate Very risky especially when
capacity to meet all demand demand is unpredictable or
even during periods of high when technology is evolving
growth. rapidly.

Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 12

 Capacity Strategy formulation
 Following (Lag) capacity strategy: companies

wait for demand increases before expanding.

Advantages Disadvantages
Greater productivity due to The reduced availability of
higher utilization levels (no extra products during periods of
capacity). high demand.

Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 13

 Do it in-house or Outsource
 Once capacity requirements is determined; organizations
must decide whether to produce a good or service itself
or to outsource from another organization.
In sourcing
Advantages Disadvantages
 Ability to oversee the entire process.  Require high investment.
 High degree of control.  Potential suppliers may offer superior
products/services.

Outsourcing
Advantages Disadvantages
 Low investment risk.  Possibility of choosing wrong
 Improved cash flow. suppliers.
 Access to state of the art of products  Loss of control.
/services  Hollowing out the corporation.
 Increased risk of supply chain
disturbance. 14
 How capacity management
can be enhanced?

Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 15

Developing Capacity Alternatives
Things that can be done to enhance capacity
management:

Design flexibility into systems

For example, future expansion of a restaurant.
Take a “big-picture” approach to capacity
changes
For example, when making a decision to increase
the number of rooms in a hotel, one should also take
into account probable increased demands for
parking, entertainment, food, and housekeeping.
Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 16
Developing Capacity Alternatives
 Attempt to smooth capacity requirements
Unevenness in capacity requirements can create
certain problems.
At certain times the system will tend to be overloaded,
while at other times it will tend to be under loaded.
One possible approach to this problem is to identify
products or services that have complementary
demand patterns; patterns that tend to balance each
other (involve the use of the same resources but at
different times, so that overall capacity requirements
remain fairly stable).
For instance, demand for snow skis and demand for water
skis might complement each other; cinema and playing area. 17
Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT
Developing Capacity Alternatives
 Identify the optimal operating level (economies of scale)
 If the output rate is less than the optimal level; so
increasing the output rate will result in decreasing
average unit costs (do we use the full capacity or not?).

 If I want Transport 100 units and rent car by 1000 L.E

 So to transport 100 units; cost will be 1000L.E/100 unit =10 L.E/unit

 So to transport 1000 units…….cost will be 1 L.E/unit …..
This is economies of scale… cost/unit is minimum
 So to transport 1001 units … can’t do it…need another car
Diseconomy of scale (but better responsiveness)
Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 18
 Evaluating alternatives
 An organization needs to examine alternatives for
future capacity from a number of different
perspectives; mostly, economic perspectives.

 There are a number of techniques that are useful

for evaluating capacity alternatives from an
economic standpoint; Cost Volume Analysis is
among one of the familiar techniques.

Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 19

 Cost-Volume analysis
 It focuses on relationships between Cost,
Revenue, and Volume of output.
 The purpose is to estimate the income of an
organization under different operating conditions.
 Thus, the total cost associated with a given
volume of output is equal to the sum of the fixed
cost (taxes, debt, ….) and the variable cost (labor,
materials,…) per unit times volume:

TC = FC + VC
Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 20
 Cost-Volume Analysis
Total Cost: TC = FC + VC
Fixed Costs (FC)
are costs that continue even if no units are
produced (taxes, debt, ….)

Variable Costs (VC)

 vary directly with volume of output (labor,
materials,…)
VC = Quantity(Q) x variable cost per unit (v)

Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 21

 Cost-Volume Analysis
Profit (P) = Total Revenue - Total Cost
P = revenue per unit (R) x Q - TC
= R x Q – (FC + VC)
= R x Q – (FC + v x Q)
P = Q (R – v) – FC

Price = R = Profit + (FC + v x Q)

Q
Profit + FC
Q= R–v
Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 22
 Break-Even Point (BEP)

A break-even analysis can help you determine fixed

and variable costs, set prices and plan for your
business's financial future.

The break-even point is an important measurement

in understanding the health of a company; because
starting this Q, company will start yield profit.

Total profit at the break-even point is zero.

Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 23

 Break-Even Point (BEP)
BEP is the volume of
output at which
Amount ($)

total cost and

total revenue
are equal
(one alternative)

FC
0 BEP units
QBEP 
Q (volume in units)
Rv
Operations Management
Starting this Q, company will start yield profit. 24
 Example (1)
 The owner of old-fashioned Berry pies, is thinking of
adding a new line of pies, which will require buying new
equipment for a monthly payment of $6000. Variable
costs would be $2 per pie, and pies would sell for $7
each.
a) How many pies must be sold in order to breakeven?
b) What would the profit / loss be, if 1000 pies are made
and sold in a month?
c) How many pies must be sold to realize a profit of
$4000?
d) If 2000 can be sold, and a profit target is $ 5000, what
price should be charged per pie?
Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 25
 FC = $6000, v = $2 per pie, Revenue (R) = $7 per pie
a) FC
QBEP  = $6000 / (7-2) = 1200 pies/month
Rv
b) P = ? For Quantity (Q) = 1000
Profit (P) = Q (R – v) – FC
= 1000 (7- 2) – 6000 = -1000
c) Q = ? To realize profit = 4000 Q = Profit + FC
R–v
Q = (4000 + 6000) / (7- 2)
Q = (4000 + 6000) / 5 = 2000 pies
d) Q = 2000, profit = $5000, Price (R) = ?
R = Profit + (FC + v x Q)
Q
R = 5000 + [6000 + ( 2*2000)] \ 2000 R = $7.5
Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 26
 Example (2)
 A firm’s manager must decide whether to make or buy a
certain item used in the production of vending machines,
making the item would involve annual rent costs of
$150000.
 Cost and volume estimates are as follows:
Make Buy
Annual fixed cost $150000 None
Variable cost/unit $60 $80
Annual volume (units) 12000 12000

a) Should the firm make or buy ?

b) If the volume changed, at what volume would the
manager be indifferent between making and buying?
Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 27
 Solution - 2
(a) Total cost = TC = FC + VC = FC + Q*v
•in case of make = $150000 + (12000*60) = $870000
•in case of buy = 0 + (12000*80) = $960000
Tcost (make) < Tcost (buy)
So the solution is “Make” Make Buy
Annual fixed $150000 None
(b) Tcost (make) = Tcost (buy) cost
$150000 + Q*60 = 0 + Q*80 FC
Variable $60 $80
$150000 = Q*80 - Q*60 cost/unit
$150000 = Q*20 V
Q = $150000 / 20 Annual volume 12000 12000
(units)
Q = 7500 unit Q
28
Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT
 Example (3)
 Thomas Manufacturing intends to increase capacity by
overcoming a bottleneck operation through the addition
of new equipment. The revenue for each product is $20.
Two vendors have presented proposals as follows:
Proposal Fixed Costs Variable Costs
A $ 50,000 $12
B $ 70,000 $10
a) What is the breakeven quantity for each proposal?
b) Which alternative will produce the highest profits for
an annual output of 20,000 units?
c) Which alternative would require the lowest volume of
output to generate an annual profit of $70,000?
Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 29
 Solution (3)
a) QBEP = FC/R - v
$ 50,000
Proposal A QBEP = = 6250
$20 - 12
Proposal B $ 70,000
QBEP = = 7000
$20 - 10
b) Profit = ?? For Q = 20,000
P for proposal A = Q (R – v) – FC
= 20,000 (20 – 12) – 50,000 = 110,000
P for proposal B = Q (R – v) – FC
= 20,000 (20 – 10) – 70,000 = 130,000

Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 30

 Solution (3)
c) Which alternative would require the lowest volume of
output to generate an annual profit of $70,000?

Profit = $70,000 For lowest volume (Q) = ??

Profit + FC
Q=
R–v
Q for proposal A = 70000 + 50000 / (20 -12)
= 15,000

Q for proposal B = 70000 + 70000 / (20 – 10)

= 14,000

Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 31

 Solve
 Company XYZ has production line with a max. capacity
230,000 /ton.
 During 2017 and 2018, the capacity of the factory barely
covered the market demand. Thus, it seems critical to
rethink their capacity for 2019.
 During the meeting, the operations manager proposed
two capacity alternatives to increase their capacity.
The first alternative is to buy a new production line. The
second alternative is to produce with a third party
(outsource).

Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 32

 Solve
The following table indicates the fixed and
variable cost of each alternative:

Buy a new line To Produce

Fixed cost $ 100000 None

Variable cost $ 150/ton $ 900/ton

1. You are required to assess the two proposals,

regarding the to produce/buy alternative.
2. If the volume changed, at what volume would the
manager be indifferent between buying and to
produce? 33
 Buy a new To Produce
line
Solution Fixed
cost
$ 100000 None

Variable $ 150/ton $ 900/ton

cost

1. TFC + TVC = TFC + (v*Q)

TC of Buy= TFC + TVC
= 100,000 + ( 150*230,000)
= $ 34,600,000
TC of To Produce = TFC + TVC
= 0 + ( 900*230,000 )
= $ 207,000,000
Based on the given data, it is recommended to choose
the Buy option, since the TC is less than the TC of To
Produce that will save the company $172,400,000.
34
Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT
 Solution

The volume that would be indifferent

between buying and to produce is called the
point of indifference, at which they are equal:
TC of Buy = TC To Produce
100,000 + ( 150*Q ) = 900*Q
100,000 = 900Q - 150Q
100,000 = 750Q
133.33 units = Q

Approximately Q =133 units

Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT 35
 Solve
 Later, company XYZ is considering two capacity
alternatives as follows:
A B
FC 100,000 120,000
VC/ unit $ 22 $ 20

 Revenue is expected to be $50 per unit.

1. Which alternative has the lowest total cost?
2. Which alternative has the lowest break-even quantity?
3. Which alternative will produce the highest profits for an annual
output of 10,000 units?
4. Which alternative would require the lowest volume of output to
generate an annual profit of $50,000?
36
Production Operations Management – Dr. Nevien Farouk Khourshed - AASTMT
 A B
Total Cost TC = FC + (V*Q) TC = FC + (V*Q)
=100,00+($22*230,000) =120,000+($20*230,0000)
=$ 5,160,000 =$ 4,720,000
Alternative B has the lowest TC.

Break-Even quantity Q BEP= FC/R-V Q BEP= FC/R-V

(Quantity at which TC= Q BEP= 100,000 Q BEP= 120,000
Total Revenue) 50-22 50-20
= 3,571.4 = 4000 units
= 3,571 units

Highest Profit if P = [Q*( R-V)] - FC P = [Q*( R-V)] – FC

output = 10,000 = [10,000*( 50-22)] – 100,000 = [10,000*( 50-20)] –120,000
units = $ 180,000 = $ 180,000
Alternative A&B will produce the highest Profit for the
output of 10,000 units.

Lowest Volume (Q) Q = Profit + FC Q = Profit + FC

of output to reach R-V R-V
annual profit of = 50,000 + 100,000 = 50,000 + 120,000
50-22 50-20
$ 50,000 = 5,357.14 = 5666.67
= 5,357 units = 5667 units
Alternative A will require the lowest volume of 5357 units to
generate an annual Profit of $ 50,000.
37
O Production perations Management – Dr. Nevien Farouk Khourshed - AASTMT