CHAPTER 8: CAPACITY - The utilization rate indicates the need for adding extra capacity or eliminating

unneeded capacity.
 After deciding what products or services should be offered and how they should be made. Management must plan the - The greatest difficulty in calculating utilization lies in defining maximum capacity,
system’s capacity. the denominator in the ratio.
 CAPACITY is the maximum rate of output for a facility.
o Two Useful Definitions of Maximum Capacity
o The Facility can be a workstation or an entire organization.
o The Operations Manager must provide the capacity to meet current and future demand; other wise, the 1. Peak Capacity
organization will miss opportunities for growth and profits.  It is the maximum output that a process or facility can
 Capacity Plans are made at Two levels achieve under ideal conditions.
a. Long-term Capacity Plans  Rated Capacity when capacity is measured relative to
- Deal with investments in new facilities and equipment. equipment alone; an engineering assessment of maximum
- It covers at least two years into the future, but construction lead times alone can force much longer time annual output, assuming continuous operations except for
horizons. an allowance for normal maintenance and repair downtime.
- Such sizable investments require top-management participation and approval because they are not easily  Peak capacity can be sustained for only a short time,
reversed.
b. Short-term Capacity Plans
such as few hours in a day or a few days in a month.
- Focus on work-force size, overtime budgets, inventories and other types of decisions. o a firm reached it by using marginal methods of
production, such as:
CAPACITY PLANNING 1) excessive overtime
- It is central to the long-term success of an organization. Too much capacity can be as agonizing as too 2) extra shifts
little. 3) temporarily reduced maintenance activities
- When choosing a capacity strategy, managers have to consider questions such as the following: 4) overstaffing
o How much cushion is needed to handle variable, uncertain demand? 5) subcontracting
o Should we expand capacity before the demand id there to wait until demand is more certain?
(Note: a systematic approach is needed to answer these and similar questions and to develop a
 although they can help with temporary peaks, these options
capacity strategy appropriate for each situation) can’t be sustained too long. Employees don’t want to work
excessive overtime for extended periods, overtime and
MEASURES OF CAPACITY night-shift premium drive up costs, and quality drops.
 No single capacity measure is applicable to all types of situations. 2. Effective Capacity
o Hospitals measure capacity as the number of patients that can be treated per day  It is the maximum output that a process or firm can
o Retailer measures capacity as annual sales dollars generated per square foot economically sustain under normal conditions.
o Airline measures capacity as available seats-miles (ASMs) per month  In some organization it implies a one-shift operation; in
o Theatre measures capacity as the number of seats
other it implies a three-shift operation.
o Job shop measures capacity as number of machine hours.
 In general, capacity can be expressed in one of two ways: Output Measures or Input Measures
 Census Bureau surveys define CAPACITY as the greatest
 OUTPUT MEASURES are the usual choice for Line Flow Processes: level of output the frim can reasonably sustain by using
o Nissan Motor Company states capacity at its Tennessee plant to be 450,000 vehicles per year. That plant realistic employee work schedules and the equipment
produces only one type of vehicle, making capacity easy to measure. currently in place.
o As the amount of customization and variety in the product mix becomes excessive, output-based - When operating close to peak capacity, a firm can make minimal profits or even lose
capacity measures becomes less useful. money despite of high sales level.
o Output measures are best utilized when the firm provides a relatively small number of standardized
products and services. Increasing Maximum Capacity
 INPUT MEASURES are the usual choice for Flexible Flow Processes.
 Most facilities have multiple operations, and often their effective capacities aren’t identical.
o Example: in a photocopy shop capacity can be measured in machine hours or number of machines.
o Just as product mix can complicate output capacity measures, so too can demand complicate input  A bottleneck is an operation that has the lowest effective capacity of any operation in the facility and
measures. Demand, which invariably is expressed as an output rate, must be converted to an input thus limits the systems output.
measures. o When there is bottleneck in the process it creates slow operation, to prevent this, operation
 Only after making the conversion can a manager compare demand requirements and capacity should be balance by making every operation a bottleneck. True expansion of a facility’s
on an equivalent basis. capacity occurs only when bottleneck capacity is increased.
 Example: the manager of a copy center must convert its annual demand for copies from o If the process has flexible flows, such as at a job shop, it doesn’t enjoy the simple line flows.
different clients to the number of machines required.  Its operations may process many different items and the demands on any one
 UTILIZATION or the degree to which equipment, space, or labor is currently being used, is expressed as percentage
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑂𝑢𝑡𝑝𝑢𝑡 𝑅𝑎𝑡𝑒 operation could vary considerably from one day to the next.
Utilization = x 100%  Bottlenecks can still be identified by computing the average utilization of each
𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝐶𝑎𝑝𝑎𝑐𝑖𝑡𝑦
- Capacity planning requires knowledge of current capacity and its utilization. operation. However, the variability in workload also created floating bottlenecks.
- The average output and the capacity must be measured in the same terms- that is,
time, customers, units, or dollars.
  This type of variability increases the complexity of day-to-day scheduling.
In this situation, management prefers lower utilization rates, which
allow greater slack to absorb unexpected surges in demand.
Economies of Scale
 It states that the average unit cost of a good or service can be reduced by increasing its output rate.
 4 Principal reason why Economies of Scale can drive cost down when output increases:
a. Fixed Costs are Spread over more units (Spreading Fixed Costs)
- in the short-term, certain costs don’t vary with changes in the output rate.
- These fixed costs include heating costs, debt service, and management salaries.
o Depreciation of plant and equipment already owned is also a fixed costs
in the accounting sense.
- When the output rate – and therefore the facility’s utilization rate – increases, the
average unit cost drops because fixed costs are spread over more units.
- As increments of capacity often are rather large, a firm initially might have to buy
more capacity than it needs. However, demand increases in subsequent years can
then be absorbed without additional fixed costs.
b. Construction costs are reduced (Reducing Construction Costs)
- Certain activities and expenses are requires in building small and large facilities
alike: building permits, architect’s fees, rental of building equipment and the like.
- Doubling the size of the facility usually doesn’t double construction costs.
- The construction cost of equipment or a facility often increases relative to its surface
area, whereas its capacity increases in proportion to its cubic volume.
o Example: the cost of steel to build an oil tanker increased more slowly
than the tanker’s capacity increases.
o Industries such as breweries and oil refineries benefit from strong
economic of scale because of this phenomenon.
c. Costs of purchased materials are cut (Cutting Costs of Purchased Materials)
- Higher volumes can reduce the costs of purchased materials and services. They give
the purchases a better bargaining position and the opportunity to take advantage of
quantity discounts.
- Example:
o Retailers such as Wal-Mart Stores and Toys “R” Us reap significant
economies of scale because their national and international stores sell huge
volumes of each item.
o Personal computer business: large firms can negotiate volume discounts
on the component that determine up to 80% of PCs costs. Thus Compaq
can sell its based model for just $100 more than it costs a smaller firm,
making only 200 to 500 units a month, for material alone.
- Producers who rely on a vast network of suppliers and food processors also can buy
inputs for less because of the quantity they order.
d. Process advantages are found (Finding Process Advantages)
- High volume production provides many opportunities for cost reduction.
- At a higher output rate, the process shifts toward a line flow strategy, with
resources dedicated to individual prudes.
o Firms may be able to justify the expense for more efficient technology or
more specialized equipment.
o Benefits from dedicating resources to individual products or services:
 Speeding up the learning effect
 Lowering inventory
 Improving process and job designs
 Reducing the numbers of changeovers
- Example:
o Higher volumes allow James River Corporation, a paper manufacturer, to
achieve greater efficiency than manufacturers producing a wide variety of
products in small volumes, because the mill can set up machines for one
long run of a certain grade of paper and not have to make as many
adjustments for different grades.
Diseconomies of Scale
 At some point a facility can become so large that diseconomies of scale set in; that is, the average cost
per unit increases as the facility’s size increases.
o The reason is that excessive size can bring complexity, loss of focus, and inefficiencies that
raise the average unit sot of a product or service.
 There may be too many layers of employees and bureaucracy, and management
loses touch with employees and customers.
 The organization is less agile and loses the flexibility needed to respond to changing
demand.
o Many large companies become so involved in analysis and planning that they innovate less
and avoid risks. The result is that small companies outperform corporate giants in numerous
industries.
 Figure 8.2. Please refer to Page 307 it shows the transition from economies of scale to diseconomies of
scale
o The 500-bed hospital shows economies of scale because the average unit cost at its best
operating level is less than that of the 250-bed hospital.
o However further expansion to a 750-bed hospital leads to higher average unit cots and
diseconomies of scale.
o One reason the 500-bed hospital enjoys greater economies of scale than 250-bed hospital is
that the cost of building and equipping it is less than twice the costs for a smaller hospital.
 The 750-bed facility would enjoy similar savings. Its higher average costs can be
explained only by diseconomies of scale, which outweigh the savings realized in
construction costs.
o Figure 8.2 doesn’t mean that the optimal size for all hospitals is 500-beds.
 Optimal Size depends on the number of patients per week to be served.
 A hospital serving a small community would have lower costs by
choosing a 250-bed capacity rather than the 500-bed capacity.
 On the other hand, assuming same cost structure, a large community will
be served more efficiently by two 500-bed hospitals than by one 1000-bed
facility.
 Economies of Scale vary by industry, which affects plant size. Thus managers often set policies
regarding the maximum size for any one facility.
o Plan size ceilings of 33 employees are common for industries such as metal working.
 Example: Dana Corporation has a cap of 200 employees at all but a few of its 120
plant.
o When division gets too big, it simply gets split in half.
 For industries such as transportation equipment or electronics, where economies of
scale are particularly strong, the limits are as large as 6000 employees.
 The real challenge in setting such limits is predicting how costs and
revenues will change for different output rates and facility sizes.
Capacity Strategies
 3 Dimensions of Capacity Strategy that managers must examine:
a. Sizing Capacity Cushion
- Average utilization rate should not get too close to 100%. When they do, that
usually is a signal to increase capacity or decrease order acceptance so as to avoid
declining productivity.
- Capacity Cushion is the amount of reserve capacity that a firm maintains to handle
sudden increases in demand or temporary losses of production capcity; it measures
the amount by which the average utilization (in terms of effective capacity) falls
below 100%.
Capacity Cushion = 100% - Utilization Rate (%)
- The appropriate size of cushion varies by industry.
o In the capital-intensive paper industry, where machines can cost hundreds
of millions of dollars each, cushion well under 10% are preferred.
o Electric utilities are capital intensive but consider cushions of 15% - 20%
in electric generating capacity to be optimal to avoid brownouts and loss
of service to customers.
- Businesses find large cushions appropriate when demand varies.
o In certain service industries, demand on some days of the week is
predictably higher than on other days, and there are even hou-to-hour
patterns.
 Long customer waiting times are np acceptable because
customers grow impatient if they have to wait in a supermarket
checkout line for more than a few minutes.
 Prompt customer service requires supermarket to maintain a
capacity cushion large enough to handle peak demand.
- Large cushions also are necessary when future demand is uncertain, particularly if
resource flexibility is low.
o Waiting line analysis and simulation can help managers anticipate better
relationship between capacity cushion and customer service.
- Another type of demand uncertainty occurs with a changing product mix. Though
total demand might remain stable, the load can shift unpredictably from one work
center to another as the mix changes.
o High customization also leads to uncertainty.
o Example: Municipal Court System, where the capacity in courtroom
hours varies with the nature of the trials and whether a jury is needed. The
mix varies from week to week and month to month.
- Supply uncertainty also favors large cushions.
o Capacity often comes in large increments, so expanding even the
minimum amount possible may create a large cushion.
o Firms also need to build in excess capacity to allow for employee
absenteeism, vacations, holidays, and any other delays.
o Penalty costs for overtime and subcontracting can create the need for
further increases in capacity cushions.
- The argument in favor of small cushions is simple: Unused capacity costs money.
o For capital intensive firms, minimizing the capacity cushion is vital.
o Studies indicate that businesses with high capital intensity achieve a low
ROI when the capacity cushion is high.
 This strong correlation doesn’t exist for labor-intensive firms,
however, their ROI is about the same because the lower
investments in equipment makes high utilization less critical.
o Advantages of Small Cushions:
 They reveal inefficiencies that may be masked by capacity
excess – problems with absenteeism, or unreliable suppliers.
b. Timing and Sizing Expansion
- The second issue of capacity strategy is when to expand and by how much.
- Figure 8.3 illustrate two extreme strategies (please refer to page 3090
o Expansionist Strategy
 Involves large, infrequent jumps in capacity
 Example:
 Limited, a firm with 7 specialty apparel store division,
opted for expansionist strategy by aggressively
opening new outlets and expanding existing ones.
 American Airlines followed expansionist strategy but
because of several setbacks, they adopted less risky
wait-and-see strategy.
o Wait-and-see Strategy
 Involves smaller, more frequent jumps.
- The timing and sizing of expansion are related; that is, if demand is increasing and
the time between increments increases, the size of the increments must also increase.
o The expansionist strategy, which stays ahead of demand, minimizes the
chance of sales lost to insufficient capacity.
o The wait-and-see strategy lags behind demand, relying on short-term
options such as use of overtime, temporary workers, subcontractors, stock
outs, and postponement of preventive maintenance to meet any shortfalls.
 However these options have their drawback. Nonetheless, some
mix of short-term operations might make the wait-and0see
strategy best in certain situations.
- Several factors favor the expansionist strategy:
o Expansion may result in economies of scale and a faster rate of learning,
thus helping a firm reduce its costs and compete on price.
o This strategy might increase the firm’s market share or act as a form of
preemptive marketing.
 By making a large capacity expansion or announcing that one is
imminent, the firm uses capacity to preempt expansion by other
firms.
 These other firms must sacrifice some of their market share or
risk burdening the industry with overcapacity.
 To be successful, however, the preempting firm must have the
credibility to convince the competition that it will carry out its
plans – and must signal its plans before the completion can act.
- The conservative wait-and-see strategy us to expand in smaller increments, such as
be renovating existing facilities rather than building new ones.
o Because the wait-and-see strategy follows demand, it reduces the risks of
overexpansion based on overly optimistic demand forecasts, obsolete
technology, or inaccurate assumptions regarding the competition.
o This strategy has different risks, such as:
 Being a preempted by a competitor or being unable to respond if
demand is unexpectedly high.
 Wait-and-see strategy has been criticized as a short-term
strategy typical for some US management style.
- an intermediate strategy could be to follow-the-leader, expanding when others do. If
others are right, so are you, and nobody gains a competitive advantage. If they make
 a mistake and over expand, so have you, but everyone shares in the agony of o Supposed that capacity is expressed as the number of available machines
overcapacity. at an operation. When just one product (serv9ce) is being processed, the
c. Linking Capacity and other operating decisions number of machine required, M, is
- Capacity decisions should be closely linked to strategies and operations throughout 𝑃𝑟𝑜𝑐𝑒𝑠𝑠𝑖𝑛𝑔 ℎ𝑜𝑢𝑟𝑠 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑓𝑜𝑟 𝑦𝑒𝑎𝑟 ′ 𝑠𝑑𝑒𝑚𝑎𝑛𝑑
Number of Machines required =
the organization. When managers make decisions about location, resource ℎ𝑜𝑢𝑟𝑠 𝑎𝑣𝑎𝑖𝑎𝑙𝑏𝑙𝑒 𝑓𝑟𝑜𝑚 𝑜𝑛𝑒 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟,𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑑𝑢𝑐𝑡𝑖𝑛𝑔 𝑑𝑒𝑠𝑖𝑟𝑒𝑑 𝑐𝑢𝑠ℎ𝑖𝑜𝑛
flexibility, and inventory, they must consider the impact on capacity cushions.
𝐷𝑝
- Capacity cushions buffer the organization against uncertainty, as do resource M= 𝐶
𝑁[1−( )]
flexibility, inventory, and longer customer lead times. 100

- If a system is well balanced and a change is made in some other decision area, then
the capacity cushion may need change to compensate.
- Examples of such links with capacity include the following:
a. Competitive Priorities
 A change in competitive priorities that emphasizes faster deliveries
requires a larger capacity cushion to allow for quick response and
uneven demand, if holding finished goods inventory is infeasible or
uneconomical.
b. Quality Management
 A drive that has obtained higher levels of quality allows for a smaller
capacity cushion because there will be less uncertainty based by yield
losses.
c. Capital Intensity
 An investment in expensive new technologies makes a process more
capital-intensive and increases pressure to have a smaller capacity
cushion to het an acceptable ROI.
d. Resource Flexibility
 A change or less worker flexibility requires a larger capacity cushion
to compensate for the operation overloads that are more likely to
occur with a less flexible work force.
e. Inventory
 A change to less reliance on inventory in order to smooth the output
rate requires a larger capacity cushion to meet increased demands
during peak periods.
f. Scheduling
 A change to a more stable environment allows a smaller cushion
because products or services can be scheduled with more assurance.
Where: D = number of units (customers) forecast per year
p = processing time (in hours per unit or customers)
N = Total number of hours per year during which the process operates
C = desired capacity cushion
- The processing time, p, in the numerator depends on the process and method
selected to do the work.
o Estimates of p come from established work standards.
- The denominator is the total number of hours, N, available for the year, multiplied
by a proportion that accounts for the desired capacity cushion.
o The proportion is simply 1.0 – C, where C is converted from a percentage
to a proportion by dividing by 100.
- If multiple products or services are involved, extra time is needed to change over
from one product or service to the next.
- Setup Time is the time required to change a machine from making one product or
service to making another.
o it is derived from process decisions, as is processing time.
o The total setup time is found by dividing the number of units forecast per
year, D, by the number of units made in each lot, which gives the number
of setups per year, and then multiplying by the time per setup.
o Accounting for both processing and setup time when there are multiple
products (services) we get:
𝑃𝑟𝑜𝑐𝑒𝑠𝑠𝑖𝑛𝑔 ℎ𝑜𝑢𝑟𝑠 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑓𝑜𝑟 𝑦𝑒𝑎𝑟 ′ 𝑠𝑑𝑒𝑚𝑎𝑛𝑑
Number of Machines required =
ℎ𝑜𝑢𝑟𝑠 𝑎𝑣𝑎𝑖𝑎𝑙𝑏𝑙𝑒 𝑓𝑟𝑜𝑚 𝑜𝑛𝑒 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟,𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑑𝑢𝑐𝑡𝑖𝑛𝑔 𝑑𝑒𝑠𝑖𝑟𝑒𝑑 𝑐𝑢𝑠ℎ𝑖𝑜𝑛
𝐷 𝐷
[𝐷𝑝+( )𝑠]𝑝𝑟𝑜𝑑𝑢𝑐𝑡 1+𝑝𝑟𝑜𝑑𝑢𝑐𝑡 2+⋯.[𝐷𝑝+( )𝑠]𝑝𝑟𝑜𝑑𝑢𝑐𝑡 𝑛
M= 𝑄
𝐶
𝑄
𝑁[1−( )]
100

- Another crucial linkage is between capacity and location decisions.
o A firm that is expanding eventually must add new facilities and find
suitable locations for them, whereas a multisite firm that is downsizing
often must identify which locations to eliminate.
SYSTEMATIC APPROACH TO CAPACOTY DECISIONS
 Four-step Procedure that helps managers make sound capacity decisions:
o In this, we assume that management has already performed the preliminary step of
determining existing capacity.
1. Estimate Future Capacity Requirements
- The foundation for estimating long-term capacity needs is forecasts of demand,
productivity, competition, and technological changes that extend well into the
future.
o Unfortunately, the farther ahead you look, the more chance you have of
making an inaccurate forecasts.
- The demand forecasts has to be converted to a number that can be compared directly
with the capacity measure being used.
Where: Q = number of units in each lot
s = setup time (in hours) per lot
o Always round up the fractional part unless it is cost efficient to use short-
term options such as overtime or stockouts to cover any shortfalls.
2. Identify Gaps by Comparing Requirements with available capacity
- Capacity Gap is any difference (positive or negative) between projected demand
and current capacity.
o Identifying the gaps requires use of the correct capacity measure.
o Complications arise when multiple operations and several resource inputs
are involved.
- Expanding the capacity of some operations may increase overall capacity. However,
it one operation is a bottleneck, capacity can be expanded only if the capacity of the
bottlenecks is expanded.
3. Develop alternative plans for filling the gaps
- Base Case is one alternative, is to do nothing and simply lose orders form any
demand that exceeds current capacity.
 - Other alternatives are various timing and sizing options for adding new capacity, - It can be particularly valuable for evaluating different capacity expansion
including the expansionist and wait-and-see strategy. alternatives when demand is uncertain and sequential decisions are involved.
4. Evaluate each alternative, both qualitatively and quantitatively, and make a final
choice.
- Qualitative Concerns: Qualitatively, the manager has to look at how each
alternative first the overall capacity strategy and other aspects of the business not
covered by the financial analysis.
o Of particular concern might be uncertainties about demand, competitive
reaction, technological change, and cost estimates.
 Some of these factors cannot be quantified, and the manager can
analyzes each alternative by using different assumptions about
the future.
 One set of assumptions could represent a worst case, where
demand is less, competition is greater, and construction costs are
higher than expected.
 Another set of assumptions could represent the most optimistic
view of the future. This type of “what if” analysis allows the
manager to get an idea of each alternative’s complications
before making a final choice.
- Quantitative Concerns: quantitatively, the manager estimates the change in cash
flows for each alternative over the forecast time horizon, compared to the base case.
o Cash Flow is the difference between the flows of funds into and out od an
organization over a period of time, including revenues, costs, and changes
in assets and liabilities.
o The manager is concerned here only with calculating the cash flows
attributable to the project.

Tools for Capacity Planning

 Long-term capacity planning requires demand forecasts for an extended period of time.
o Unfortunately, forecasts accuracy declines as the forecasting horizon lengthens.
 Anticipating what competitors will do increases the uncertainty of demand forecasts.
 Finally, demand during any period of time isn’t evenly distributed; peaks and valleys of demand may
occur within the time period.
o These realities necessitate the use of capacity cushions.
 2 Tools that deal more formally with demand uncertainty and variability:
1. Waiting Line Models
- It account for the random, independent behavior of many customers, in terms of
both their time of arrival and their processing needs.
- Often are useful in capacity planning. It tends to develop in front of a work center,
such as an airport counter, a machine center, or a central computer.
o The reason is that the arrival time between jobs or customers varies and
the processing time may vary from one customer to the next.
- It uses probability distributions to provide estimates of average customer delay time,
average length of waiting lines, and utilization of the work center.
o Managers can use this information to choose the most cost-effective
capacity, balancing customer service and the cost of adding capacity.
- It supplements provides a fuller treatment of waiting lines. It introduces formulas for
estimating important characteristics of waiting line, such as average customer
waiting time and average facility utilization, for different facility deisgns.
2. Decision Trees
- Allow anticipation of events such as competitor’s actions.