Ch6 Capacity

Introduction to Operations and Supply
Chain Management
Fifth Edition
Chapter 6
Managing Capacity
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Chapter Objectives
Be able to:
• Explain what capacity is, how firms measure capacity, and
the difference between theoretical and rated capacity.
• Describe the pros and cons associated with three different
capacity strategies: lead, lag, and match.
• Apply a wide variety of analytical tools for choosing between
capacity alternatives, including expected value and break-
even analysis, decision trees, and learning curves.
• Understand and apply the Theory of Constraints.
Introduction (1 of 2)
• Strategic decisions that managers face about capacity:
– How much capacity do we need?
– When do we need it?
– What form should the capacity take?
• Important points about capacity:
– Capacity can take many different forms, and capacity
planning is an important activity in both service and
manufacturing organizations.
Capacity (1 of 4)
• Capacity – The capability of a worker, a machine, a
workcenter, a plant, or an organization to produce output in
a time period.
© 2016 APICS Dictionary
• Capacity decisions that managers face:

– How capacity is measured?
– Which factors affect capacity?
– The impact of the supply chain on the organization’s
effective capacity.
Capacity (2 of 4)
• Measures of Capacity
– Theoretical capacity – The maximum output capability,
allowing for no adjustments for preventive
maintenance, unplanned downtime, or the like.
– Rated capacity – The long-term, expected output
capability of a resource or system.
© 2016 APICS Dictionary
Capacity (3 of 4)
Table 6.1 Examples of Capacity in Different Organizations
Organization Capacity Measure Factors Affecting Capacity

Law firm Billable hours available Number of lawyers and paralegals;
each Month education and skill levels; supporting
software
Textile-spinning Spinning hours per shift; Number of machines running; quality
plant number of spindles of raw materials; maintenance
produced per week
Automatic car wash Cars per hour Availability of water and chemicals;
reliability of the car wash (Is it
frequently down for repairs?)
Airline (Seats) × (miles flown) Number of jets, pilots, and terminals
Capacity (4 of 4)
• Factors that Affect Capacity
– Many factors affect capacity and many assumptions
must be made:
 Number of lines used
 Number of shifts operating
 Number of temporary workers used
 Number of public storage facilities used
 Product variations
 Conformance quality
 Quality improvement
Three Common Capacity Strategies (1 of 2)
• Lead capacity strategy – A capacity strategy in which
capacity is added in anticipation of demand.
• Lag capacity strategy – A capacity strategy in which
capacity is added only after demand has materialized.
• Match capacity strategy – A capacity strategy that strikes a
balance between the lead and lag capacity strategies by
avoiding periods of high under or overutilization.
Three Common Capacity Strategies (2 of 2)
Figure 6.1 When to Add Capacity: Lead, Lag, and Match Strategies
Methods of Evaluating Capacity Alternatives (1 of
7)
• Cost
• Demand Considerations
• Expected Value
• Decision Trees
• Break-Even Analysis
• Learning Curves
7)
• Cost
– Fixed costs – The expenses an organization incurs
regardless of the level of business activity.
– Variable costs – Expenses directly tied to the level of
business activity.
TC = FC +VC* X
TC = total cost
FC = fixed cost
VC = variable cost per unit of business activity
X = amount of business activity
14
Activity 6.2 – Evaluation of Costs

• Answer Problem #1 on pp 170 of the course text……….
TC = FC + VC * X
TC = Total Cost
FC = Fixed Cost
VC = Variable cost per unit of business activity
X = amount of business activity
15

• (*) The Shelly Group has leased a new copier that costs $700 per
month plus $0.10 for each copy. What is the total cost if Shelly
makes 5,000 copies a month? If it makes 10,000 copies a month?
What is the per-copy cost at 5,000 copies? At 10,000 copies?
Fixed Cost: $700

Variable Cost: $0.10 Per Copy
Number of Per Copy

Copies Total Cost Cost
5000 $1,200 $0.24
10000 $1,700 $0.17
16

• Answer Problem #2a and b only on pp 170 of the course
text……….
a. (*) What would the cost be for each option if the demand level
is 25,000 units per year? If it is 75,000 units per year?
b. (**) In general, which option do you think would be better as
volume levels increase? As they decrease? Why?
17

FIXED COST VARIABLE COST
(PER YEAR) (PER UNIT)
Option 1 $500,000 $2
Option 2 $100,000 $10
a.)
Demand Scenario: 25,000
Total Cost Cost Per Unit
Option 1 $550,000 $22
Option 2 $350,000 $14
Demand Scenario: 75,000

Total Cost Cost Per Unit
Option 1 $650,000 $9
Option 2 $850,000 $11
18

• The Point of Indifference….
…..the output level at which two capacity alternatives generate equal
cost……
…..ie, we are indifferent at this point in our selection of option
(because the costs are the same).
19

…..the relationship between the two options………
…..determined by: FC1 + VC1 = FC2 + VC2
• Resolve to X………
X = (FC1 – FC2)/(VC2 – VC1)……….so,
20
FIXED COST (PER VARIABLE COST (PER

YEAR) UNIT): (X)
Option 1 $500,000 $2
Option 2 $100,000 $10
Solve for ‘X’………
FC1 + VC1 = FC2 + VC2
$500,000 + $2X = $100,000 + $10X……..therefore,
X = (FC1 – FC2)/(VC2 – VC1)
21
FIXED COST (PER VARIABLE COST (PER

YEAR) UNIT): (X)
Option 1 $500,000 $2
Option 2 $100,000 $10
Solve for ‘X’………
FC1 + VC1 = FC2 + VC2
$500,000 + $2X = $100,000 + $10X……..therefore,
X = (FC1 – FC2)/(VC2 – VC1)……….so,
X = (500,000 – 100,000)/(10 – 2) = 50,000 Units
6-23
Expected Value
A calculation that summarizes the expected costs, revenues,
or profits of a capacity alternative, based on several demand
levels, each of which has a different probability.
Copyright © 2016 Pearson Education, Inc.

24
Activity 6.3 – Expected Value

26

EV = FC + VC x Probability
• EV = ($700 + ($0.1 X 5000)) X 50% = $600
• EV = ($700 + ($0.1 X 10000)) X 50% = $850
Fixed Cost: $700

Variable Cost: $0.10 Per Copy
Number of Per Copy Expected

Copies Total Cost Cost Probability Cost
5000 $1,200 $0.24 50% $600
10000 $1,700 $0.17 50% $850
Total: $1,450
28

• What is the result for the following options……….
EV = FC + VC x Probability
FIXED COST VARIABLE COST
(PER YEAR) (PER UNIT)
Option 1 $500,000 $2
Option 2 $100,000 $10
a.)
Demand Scenario: 25,000 Probability: 30%
Total Cost Cost Per Unit Expected Cost:
Option 1 $550,000 $22 $165,000
Option 2 $350,000 $14 $105,000

Option 1 $620,000 $10 $248,000
Option 2 $700,000 $12 $280,000

Option 1 $700,000 $7 $210,000
Option 2 $1,100,000 $11 $330,000
Total Expected
Cost: Option 1 $623,000
Option
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Pearson $715,000
Education, Inc. All Rights Reserved.
7)
• Decision tree – A visual tool that decision makers use to

evaluate capacity decisions and to enable users to see the
interrelationships between decisions and possible
outcomes.
1. Draw the tree from left to right starting with a decision
point or an outcome point and develop branches from
there.
2. Represent decision points with squares.
3. Represent outcome points with circles.
4. For expected value problems, calculate the financial
results for each of the smaller branches and move
backward by calculating weighted averages for the
branches based on their probabilities
Example 6.3 – Ellison Seafood Company
• Capacity Alternatives:
FC VC
– Common Carrier None $750
– Contract Carrier $5,000 $300
– Lease Truck $21,000 $50
• Three levels of demand: 30, 50, and 80 shipments
• Question - what are the costs for the 3 levels of demand?

• Capacity Alternatives:
FC VC
– Common Carrier None $750
 30 Shipments: TC = 0 + (750 x 30) = $22,500

 50 Shipments: TC = 0 + (750 x 50) = $37,500
 80 Shipments: TC = 0 + (750 x 30) = $60,000
Figure 6.4 Decision Tree for Transportation Decision
$22,500 @ 25% = $5,625

$37,500 @ 60% = $22,500
$60,000 @ 15% = $9,000
Total = $37,125
7)
• Break-even analysis
– Break-even point – The volume level for a business at
which total revenues cover total costs.
FC
BEP 
R  VC
where:
BEP = break-even point
FC = fixed cost
VC = variable cost per unit of business activity
R = revenue per unit of business activity
34
Activity 6.4 – Break-even Analysis

Answer Problem 7, parts A & B only, on pp171 of the course text…….
36
Revenue Per Unit: $ 25.00 BEP=FC/(R-VC)
Fixed Costs: $ 12,000.00 $12000/$25-$8
Variable Costs: $ 8.00 $12000/$17
Profit: $ 17.00 BEP= 706
37
Revenue Per Unit: $ 25.00 BEP=FC/(R-VC)
Fixed Costs: $ 20,000.00 $12000/$25-$5
Variable Costs: $ 5.00 $20000/$20
Profit: $ 20.00 BEP= 1000
38
Revenue Per Unit: $25
FIXED COST VARIABLE COST Break-Even

(PER YEAR) (PER UNIT) Volume Point
Original $12,000 $8 706
Expanded $20,000 $5 1,000
So, what is the point of indifference?

X = (FC1 – FC2)/(VC2 – VC1)……….so,
X = (12,000 – 20,000)/(5 – 8)……….so,
X = 8,000/3……….so,
X = 2,667
7)
• Learning curve theory – A body of theory based on applied

statistics which suggests that productivity levels can
improve at a predictable rate as people and even systems
“learn” to do tasks more efficiently.
– For every doubling of cumulative output, there is a set
percentage reduction in the amount of inputs required.
Tn T1nb
where:
Tn = resources (usually labor) required for the nth unit
T1 = resources required for the 1st unit
b = ln(Learning percentage)/ln2
Example 6.5 – Service Call Center (1 of 4)
• A video game producer has hired a new service technician
to handle customer calls. The time it takes the new service
technician to help the first, second, fourth, and eighth
callers and the resulting productivity figures are shown
below:
Learning Rate 4/5 = 80% or .80
Call Time for Call Productivity
1 5.00 minutes 0.20 calls per minute
Example 6.5 – Service Call Center (2 of 4)
• Estimate the time it will take her to handle her 25th call:
Hint – you will need to use table 6.4, which is on page 155 of the hard-copy text
Figure 6.6 Eighty Percent Learning Curve for Service Technician
43
Activity 6.5 – Learning Curve
Tn = T1nb …where b = log learning %age/ log 2
T25 = 5(25(log 0.80/log 2))

• Table 6.4………..
• 25 = 0.355, so….
• T25 = 5 X 0.355 = 1.78 minutes
The 25th customer will take 1.78 minutes to serve.
7)
• Other Considerations:
– The strategic importance of an activity to a firm.
– The desired degree of managerial control.
– The need for flexibility.
Understanding and Analyzing Process
Capacity (1 of 9)
• Theory of Constraints – An approach to visualizing and
managing capacity which recognizes that nearly all
products and services are created through a series of
linked processes, and in every case, there is at least one
process step that limits throughput for the entire chain.
Figure 6.7 Throughput of a “Pipeline” is Determined by the Smallest
“Pipe”
Throughput of a “Pipeline” Is Determined by
the Smallest “Pipe”
• The movement of customers or products through a series
of process steps is analogous to the movement of liquid
through a pipeline.
• Each process step has a certain capacity, as represented
by the diameter of the “pipe.” process E has the largest
capacity, while process C has the smallest capacity.
• Because process C is the constraint, it will limit the amount
of throughput for the entire process chain. Increasing the
capacity at any other process step will not increase
throughput for the entire process chain.
Capacity (2 of 9)
Figure 6.8 Throughput is Controlled by the Constraint,
It should be clear from this simple illustration that process 3 limits total
throughput for the chain to 40 units per hour.
Pushing out more than 40 units an hour in processes 1 and 2 will simply
create a glut of inventory in front of process 3.
Furthermore, output from process 3 will limit process 4 to just 40 units

per hour.
Capacity (3 of 9)
• Theory of Constraints
– Identify the constraint
– Exploit the constraint
– Subordinate everything to the constraint
– Elevate the constraint
– Find the new constraints and repeat the steps
Theory of Constraints
• Identify the constraint.
– The constraint can be anywhere in the chain including
upstream or downstream supply chain partners.
– When the constraint occurs outside the company, it is
often referred to as an external constraint.
– In contrast, if the constraint is within a company’s set of
activities, it is referred to as an internal constraint.
• Exploit the constraint.
– An hour of throughput lost at the constraint is an hour
of throughput lost for the entire chain.
– It is, therefore, imperative that organizations carefully
manage the constraint to ensure an uninterrupted flow
of customers or products through the constraint.
• Subordinate everything to the constraint.
– If conflicts arise between exploiting the constraint and
efforts to “improve” performance elsewhere,
management needs to remember that it is the
constraint that determines throughput and act
accordingly.
• Elevate the constraint.
– If the organization needs to increase throughput, find
ways to increase the capacity of the constraint.
• Find the new constraint and repeat the steps.
– As the effective capacity of the constraint is increased,
it may cease to be a constraint.
– In that case, the emphasis should shift to finding and
exploiting the new constraint.
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Introduction to Operations and Supply

• Capacity decisions that managers face:

Organization Capacity Measure Factors Affecting Capacity

Activity 6.2 – Evaluation of Costs

Activity 6.2 – Evaluation of Costs

Fixed Cost: $700

Number of Per Copy

Activity 6.3 – Evaluation of Costs

Activity 6.3 – Evaluation of Costs

Demand Scenario: 75,000

Activity 6.3 – Evaluation of Costs

Activity 6.3 – Evaluation of Costs

• The Point of Indifference….

Activity 6.3 – Evaluation of Costs

• The Point of Indifference….

FIXED COST (PER VARIABLE COST (PER

Activity 6.3 – Evaluation of Costs

• The Point of Indifference….

FIXED COST (PER VARIABLE COST (PER

Copyright © 2016 Pearson Education, Inc.

Activity 6.3 – Expected Value

Activity 6.3 – Expected Value

• Answer Problem #3 on pp 170 of the course text……….

Fixed Cost: $700

Number of Per Copy Expected

Activity 6.3 – Expected Value

Demand Scenario: 60,000 Probability: 40%

Demand Scenario: 100,000 Probability: 30%

• Decision tree – A visual tool that decision makers use to

– Common Carrier None $750

– Contract Carrier $5,000 $300

– Lease Truck $21,000 $50

• Three levels of demand: 30, 50, and 80 shipments

• Question - what are the costs for the 3 levels of demand?

– Common Carrier None $750

 30 Shipments: TC = 0 + (750 x 30) = $22,500

$22,500 @ 25% = $5,625

Activity 6.4 – Break-even Analysis

Activity 6.4 – Break-even Analysis

Revenue Per Unit: $ 25.00 BEP=FC/(R-VC)

Fixed Costs: $ 12,000.00 $12000/$25-$8

Variable Costs: $ 8.00 $12000/$17

Profit: $ 17.00 BEP= 706

Activity 6.4 – Break-even Analysis

Revenue Per Unit: $ 25.00 BEP=FC/(R-VC)

Fixed Costs: $ 20,000.00 $12000/$25-$5

Variable Costs: $ 5.00 $20000/$20

Profit: $ 20.00 BEP= 1000

Activity 6.4 – Break-even Analysis

Revenue Per Unit: $25

FIXED COST VARIABLE COST Break-Even

So, what is the point of indifference?

• Learning curve theory – A body of theory based on applied

Figure 6.6 Eighty Percent Learning Curve for Service Technician

Activity 6.5 – Learning Curve

Tn = T1nb …where b = log learning %age/ log 2

T25 = 5(25(log 0.80/log 2))

The 25th customer will take 1.78 minutes to serve.

Furthermore, output from process 3 will limit process 4 to just 40 units