Chapter 2 Lecture 1: Capacity Planning

5.1 Introduction
The most fundamental decision in any organizations related to the products and services it
offers. These decisions are relative to capacity, process, facilities, location and the likes are governed
by product and service choices. Thus, a decision to produce high quality product will necessitate
certain types of processing equipment and certain kinds of labour skills, and it will suggest certain type
of arrangement of facilities. It will influence size and type of building as well as the plant location. In
some instances, capacity choices are made very infrequently; in others, they are made much more
regularly, as part of an ongoing process. Generally, the factors that influence this frequency are the
stability of demand, the rate of technological change in equipment, the rate of change in product
design and competitive factors.
5.2 What is Capacity?
The upper limit or ceiling on the load that an operating unit can handle is called its capacity.
Capacity is the rate of productive capability of a facility. The operating unit might be a plant,
department, machine, store, or worker. The load can be specified in terms of either inputs or outputs.
To understand these, consider the following examples.
• Capacity in respect of capability: Airlines capacity measures their capacity in Available Seat
Miles (ASMs) over a year. Or hospitals may measure its capacity in number of beds available.
However, this measure is incorrect, as it doesn’t consider outpatient treated by the hospital.
• Capacity in respect of inputs: A machine is able to process 120 pounds of raw materials in
every hour it works, so its input capacity is 120- pounds/hour.
• Capacity in respect of outputs: A machine can produce 20 units of finished goods in every
hour it works, so its output capacity is 20 units/hour.

The definition that has been provided earlier is a working definition of capacity; although it is
functional, it can be refined into three useful definitions:

• Design Capacity: The maximum output that can possibly be attained.

• Effective Capacity: The maximum possible output given a product mix, scheduling difficulties,

machine maintenance, quality factors, and so on.

• Actual Output: The rate of output actually achieved. It cannot exceed effective capacity and

often less than effective capacity due to breakdowns, defective outputs, shortage of
materials, and similar factors.
5.3 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 5.1 provides some commonly used
measure of capacity.
Table 5.1 Common measures of capacity

5.4 Measures of System Effectiveness

These different measures (Table 5.1) of capacity are useful in defining two measures of system
effectiveness: Efficiency and Utilization. Where efficiency is the ratio of actual output to effective
capacity i.e., (Actual output / Effective capacity) and the utilization is the ratio of actual output to
design capacity i.e., (Actual output/Design capacity). It is common for managers to focus exclusively
on efficiency, but in many instances, this emphasis can be misleading. This happens when effective
capacity is low compared with design capacity. In those cases, high efficiency would seem to indicate
effective use of resources when it does not. The following example illustrates this point:

Example:
Design capacity = 50 trucks per day
Effective capacity = 40 trucks per day
Actual output = 36 units per day
Efficiency = Actual output / Effective capacity = 36 units per day/ 40 units per day = 90%
Utilization = Actual output / Design capacity = 36 units per day/ 50 units per day = 72%
Thus, compared with the effective capacity of 40 units per day, 36 units per day (90%) looks pretty
good. However, compared with design capacity of 50 units per day, 36 units per day (72%) is much
less impressive although probably more meaningful.

Because effective capacity acts as a lid on actual output, the real key to improving capacity
utilization is to increase effective capacity. Now assume that Ato Tekele wants to travel from his home
at Addis Ababa to his sister’s home at Debre birhan, 25 miles away. He could borrow his son’s bicycle
or his motorbike. Instead of using the bicycle and concerning himself with pedalling as efficiently as
possible, he could make the trip in less time (same output in a shorter time) by using the motorbike.
Hence, increasing utilization depends on being able to increase effective capacity, and this requires
knowledge of what is constraining effective capacity.

5.5 Capacity Planning

Capacity Planning is defined as the process of aggregating all the requirements for fulfilling
capacity requirements for each period in the intermediate horizon and determining the best way to
provide the needed capacity. The objectives of capacity planning are feasibility i.e., the internal needs
must be within the capability of the operations system and optimality i.e., it is desirable to determine
the least costly way to meet the capacity needs.
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 and outputs, and thereby
make other decisions or plans related to those quantities. There the basic questions in capacity
planning of any sort are:
• What kind of capacity is needed?

• How much is needed?

• When is it needed?

The question of what kind of capacity is needed relates to the product and services that
management intends to produce or provide. Hence, in a very real sense, capacity planning is governed
by those choices.
5.5.1 Capacity Planning Activities
Capacity planning is the first step when an organization decides to produce more of a new or
existing product. Once capacity is evaluated and a need for new or expanded facilities is determined,
facility location and process technology activities occur. Too much capacity would require exploring
ways to reduce capacity, such as temporarily closing, selling, or consolidating that might involve
relocation, combining of technologies, or a rearrangement of equipment and processes. Capacity
planning normally involves the following activities:
a) Assessing existing capacity
b) Forecasting capacity needs
c) Identifying alternative ways to modify capacity
d) Evaluating financial, economical, and technological capacity alternatives
e) Selecting a capacity alternative most suited to achieve strategic mission
(a) Assessing existing capacity & requirements: Assessing starts with measurement. There is no
single measurement technique customized for such decisions, rather a blend of different
approaches is utilized when necessary. As noted, there are two systems of measurements of
 system effectiveness: efficiency and utilization. Efficiency is the ratio of actual output to
effective capacity and Utilization is the ratio of actual output to design capacity.
(b) Forecasting capacity needs: Capacity requirements can be evaluated from two extreme
perspectives – short term and long-term capacity needs:
• Short-term Requirements: Managers often use forecasts of product demand to estimate the

short-term workload that the facility must handle. By looking ahead up to 12 months,
managers anticipate output requirements for different products or services. Then they
compare requirements with existing capacity and detect when adjustments are necessary.
• Long-term Requirements: Long-term capacity requirements are more difficult to determine

as future demand and technologies are uncertain. Forecasting five or ten years ahead is a risky
and difficult task. Important questions include what products and services will the firm
produce then for today’s product may not even exist in the future. Obviously, longterm
capacity requirements are dependent on marketing plans, product development, and the life
cycle of products. Changes in process technology must also be anticipated. Even if products
remain unchanged methods for generating them may change dramatically. Capacity planning
thus must involve forecasts of technology as well as product demand.
(c) Identifying ways to modify capacity: After existing and future capacity requirements are
assessed, alternative ways of modifying capacity either short-term or long term must be
identified. Short-term responses to capacity modification include in the Table 5.2.
On the other hand, to consider the long-term responses to capacity modification
management of any organizations today should not only consider expansion of their resource
bases but also consider optimum approaches to contracting it. The costs, benefit, and risks of
expansion pose an interesting decision problem. By building the entire addition now, the
company avoids higher building costs, the risks of accelerated inflation (and even higher future
construction costs), and the risk of losing additional future business because of inadequate
capacity. But there may also be disadvantages to this future alternative. First, the organization
may not be able to muster the financial investment. Second, if the organization expands now,
it may find later that its demand forecasts were incorrect; if ultimate demand is lower than
expected, the organization has overbuilt. Finally, even if the forecasted demand is accurate it
may not fully materialize until the end of the five-year planning horizon. If so, the organization
will have invested in an excess-capacity facility on which no return is realized for several years.
Since it could have been invested in other ways, the firm has foregone the opportunity of
earning returns elsewhere on its investment.
 Table 5.5: Temporary Capacity Changes

(d) Evaluating financial, economical, and technological capacity alternatives: For evaluation
purposes of capacity planning activities different modelling alternatives are available. These
are:
• Present Value Analysis, for instance, is helpful whenever the time value of capital
investments, and fund flows are considered.
• Aggregate Planning Models are useful for examining how best to use existing
capacity in the short term.
• Breakeven Analysis can identify the minimum breakeven volumes when comparing
projected costs and revenues.
• In the short–term capacity utilization: linear programming and computer
simulations are very useful.
• Decision Tree Analysis is useful to the long-term capacity problems of facility
expansion.
(e) Selecting a capacity alternative most suited to achieving strategic mission:
As it has been mentioned, the three types of modeling- decision tree analysis, linear
programming, and computer simulation- all needs to be used selectively to determine the most
suited capacity alternatives. The proper choice among them depends on the type of capacity
problem. Other models, too, are sometimes beneficial. Selecting and using models for managing
 capacity requires a good understanding of the environment within which the organization is
operating, including current demands on existing operations, and a vision of future business
conditions.
5.5.2 Importance of Capacity Planning
For a number of reasons, capacity decisions are among the most fundamental of all the design
decisions that managers must make. These include:
• The importance of capacity decisions relates to their potential impact on the ability of the
organization to meet future demand for products and services; capacity essentially limits the rate of
output possible.
• The importance of capacity stems from the relationship between capacity and operating costs.
Ideally, capacity and demand requirements will be matched, which will tend to minimize operating
costs.
• The importance of capacity decisions also lies in the initial cost involved, of which capacity is usually

a major determinant. Typically, the greater the capacity of a productive unit, the greater its costs. This
does not necessarily imply a one-for-one relationship; larger units tend to cost proportionately less
than smaller units.
• The importance of capacity decisions stems from the often-required 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.
Like many other things, managers have to take decisions regarding the capacity of their
operating units and these decisions are very important because:
• In today's competition, any profit-making organization would like to keep its existing customers and

have new ones as well. If capacity decision contains flaws, the sales team may desperately want to
take a particular order, while the operations team may struggle to meet the demand. Hence it is very
easy to lose customers if their demand is not fulfilled. For example, think of a situation when you bring
your car to a car service centre and learn that due to equipment and staff limitations your car will be
serviced in about a week.
• Capacity planning involve different cost considerations. One type of such cost is operating cost. If,
for example, the capacity of ABC footwear factory is 100,000 units per year and demand for their
product is 50,000 units for the same period, then their operating cost will be higher than it would be
if the capacity and demand were the same. Another type of cost is cost of building the operating unit.
Once this cost is decided upon and the unit is built there is no turning back, it becomes fixed cost. So,
if afterwards management finds out that capacity of the unit is lower or higher than required, any
modification is likely to incur major costs.
 It is important to note that the workload required by the Master Production Schedule (MPS),
a summary of planned end product needs for specific future time periods, is within the capacity of the
company and that it makes wise use of the company’s capacity. Since MPS is developed to fit the
production plan, it is advisable to check the amount of capacity required by the production plan in
certain periods while those periods are far enough in the future to change the capacity in some
departments, if necessary. This is particularly true for business that has significant seasonal variations
in demand.