5: Capacity Planning

Charles E. Oyibo

Capacity refers to the upper limit or ceiling on the load that an operating unit (a plant, department, machine, store, or worker) can handle.

The basic questions in capacity planning are the following:

What kind of capacity is needed?
How much is needed?
When is it needed?

Importance of Capacity Decisions

Capacity decisions are among the most fundamental of all the design decisions that managers must make:

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.
Capacity decisions affect operating costs. Because actual demand often differs from expected (or forecasted) demand, decisions have to be made to balance the costs of over- and undercapacity.
Capacity is usually a major determinant of initial cost.
Capacity decisions often involve long-term commitment of resources. Furthermore, once they are implemented, it may be difficult or impossible to modify those decisions without incurring major costs.
Capacity decisions can affect competitiveness. A firm that can quickly add capacity will be more competitive than others who cannot.
Capacity affects the ease of management. Having appropriate capacity makes management easier than when capacity if mismatched.

Defining and Measuring Capacity

Capacity is related to productivity in that capacity if the upper limit on productivity. That is, capacity imposes an upper limit on the rate of output. At this junction, it might be instructive to expound on our definition of "capacity" with regard to two useful definitions:

Design capacity: the maximum output that can be possibly attained
Efficiency capacity: the maximum possible output given a product mix, scheduling difficultings, machine maintenance, quality factors, and so on.

Effective capacity is usually less than design capacity (it cannot exceed design capacity) owing to realities of changing product mix, the need for periodic maintenance of equipment, problems in scheduling and balancing operations, lunch and coffee breaks, and similar circumstances.

Actual outpus cannot exceed effective capacity and is often less because of machine breakdowns, absenteesm, shortage of materials, and quality problems, as well as factors that are outside the control of the operations managers.

Hence Design Capacity > Effective Capacity > Actual Capacity

These different measure 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.

Because effective capacity acts as a lid on actual output, the real key to improving capacity utilization is to increase effective capacity by correcting quality problems, maintaining equipment in good operating condition, fully training employees, and fully utilizing bottleneck equipment.

Determinants of Effective Capacity

The benefits of high utilization are realized only in instances where there is demand for the output. When demand is not there, focusing exclusively on utilization can be counterproductive, because the excess output not only results in additional variable costs; it also generates the cost of having to carry the output as inventory. Another advantage of high utilization is that operating costs may increase because of increasing waiting time due to bottleneck operations.

Facilities Factors. How much consideration has gone into the design of facilities, including size and provision for expansion; locational factors, such as transportation costs, distance to market, labor supply, energy sources, and room for expansion; layout of work area; external factors such as heating, lighting and ventilation?
Product/Service Factors. How similar are the products? How diverse is the product/service mix?
Process Factors. What is the level of product/service quality? How much need is there for inspection and rework activities?
Human Factors. What tasks make up the employees' tasks, and what is the variety involved? How much training, skills, and experience is required to perform given tasks? How motivated are employees? What is the level of absenteesm and labor turnover?
Operational Factors. What differences are there in equipment capacity among alternative pieces of equipment or in job requirements? How much consideration has been given to inventory, late deliveries, acceptability of purchased materials and parts, quality inspection and control procedures.
External Factors. How much consideration has been given to product standards, especially minimum quality and performance standards, government regulations, union contract limitations, safety regulations, pollution control standards, etc.

Determining Capacity Requirements

Long-term considerations relate to overall levels of capacity, such as facility size. We determine long-term capacity by forecasting demand over a time horizon and then converting those forecasts into capacity requirements. Examples of basic patterns of that might be identified by a forecast include growth, decline, cyclical, and stable. It is also possible to have more complex patterns such as a combination of cycles and growth trends.

When trends are identified, the questions to be asked are:

How long might the trend persist?
What is the slope of the trend?

If cycles are identified, we ask:

What is the approximate lenght of the cycles?
What is the amplitude of the cycle (i.e. the deviation from average)?

Short-term considerations relate to probable variations in capacity requirements created by such things as seasonal, random, and irregular fluctuations in demand. Short-term capacity needs are more concerned with seasonal variations and other variations from average. These deviations are particularly important because they can place a severe strain on a system's ability to satisfy demand at some times and yet result in idle capacity at other time.

Developing Capacity Alternatives

Design flexibility into systems. Provision for furture expansion into the original design of a structure can often be obtained at a small price compared to what it would cost to remodel an exisiting structure that did not have such a provision.
Differentiate between new and mature products or services. Mature products and services tend to be more predictable in terms of capacity requirements. The predictable demand pattern translate to less risk in choosing an incorrect capacity.
Take a "big-picture" approach to capacity changes. When developing capacity alternatives, it is important to consider how the parts of the system interrelate. For instance, when considering expanding a motel, one should take into account probable increased demand for parking, entertainment and food, and housekeeping.
Prepare to deal with capacity "chunks." Capacity increases are often acquired in fairly large chunks rather than smooth increments, making it difficult to achieve a match between desired capacity and feasible capacity.
Attempt to smooth out capacity requirements. Variability in demand, and consequently, uneveness in capacity requirements can pose problems for managers. One possible approach to this problem is to identify products and services that have complementary demand patterns, that is, patterns that tend to offset each other. For instance, demand for snow skis (high in fall and winter months) and demand for water skis (high in spring and summer months) tend to complement each other. The same might apply to heating and air-conditioning equipment. The ideal case is one in which products and services with complementary demand patterns involve the use of the same resources but at different times, so that overall capacity requirements remain fairly stable.

Simply adding capacity by increasing the size of the operation (e.g. increasing the size of the facility, the workforce, or the amount of processing equipment) is not always the best approach, because that reduces flexibility and adds to fixed costs. Managers often choose to respond to higher than normal demand in other ways. One is through the use of overtime work. Another is to subcontract some of the work. A third approach is to draw down finished goods inventory during period of high demand and replenish them during period of slow demand. These issues are discussed more expansively under the topic Aggregate Planning.
Identify the optimal operating level. At the ideal level of production, cost per unit is the lowest for that production unit; larger or smaller levels of output will result in a higher unit cost. Recall that at lower levels of output, the cost per unit of output is high because there are few units to share the fixed costs. As output increases, there are more units to absorb the fixed cost. However after a certain point, other factors now become important: worker fatigue, equipment breakdowns, loss of flexibility, which leaves less of a margin for error, and, generally, greater difficulty in coordinating operations.

Planning Service Capacity

There are three important factors in planning service capacity:

The need to be in close (physical) proximity to the customer (location),
The inability to store (or inventory) services (timing), and
The degree of volatility of demand. Because service planners cannot turn to inventory to smoothen demand requirements on the system, they must devise other methods of coping with demand volatility. They might, for example, consider hiring extra workers, outsourcing some or all of a service, or using pricing and promotion to shift some demand to slower periods. This is the subject matter of Demand Mangement.

Evaluating Alternatives

A number of technoques are useful for evaluating capacity alternatives from an economic standpoint. Some of the more common are cost-volume analysis, financial analysis, decision theory, and waiting-line analysis. We discuss some methods below:

Calculating Processing Requirements

To calculate the capacity requirements of products that will be processed with a given alternative, one must have reasoably accurate demand forecasts for each product on each alternative machine, the number of workdays per year, and the number of shifts that it will be used.

Cost-Volume Analysis

Cost-volume analysis focuses on the relationship between cost, revenue, and volume of output as a way to estimate the income of an organization under different operating conditions. It is particularly useful as a tool for comparing capacity alternatives.

Cost-volume analysis can be a valuable tool for comparing capacity alternatives if certain assumptions are satisfied:

One product is involved
Everything produced can be sold
The variable cost per unit is the same regardless of the volume
Fixed costs do not change with volume changes, or they are step changes
The revenue per unit is the same regardless of volume
Revenue per unit exceeds variable cost per unit

If a proposal looks attractive using cost-volume analysis,, the next step would be to develop cash flow models to see how well it fares with the addition of time and more flexible cost functions.

Financial Analysis

Two important term in financial analysis are cash flows and present value.

Cash flow refers to the difference between the cash received from sales (of goods and services) and other sources (e.g. sale of old equipment) and the cash outflow for labor, materials, overhead, and taxes.

Present value expressed in current value the sum of all future cash flows of an investment proposal.

The three most commonly used methods of financial analysis are payback, present value, and internal rate of return.

Payback is a crude but widely used method that focuses on the lenght of time it will take for an investment to return to its original cost. For example, an investment with an original cost of $6000 and a monthly net cash flow of $1000 has a payback period of six months. Payback ignores the time value of money. Its use is easier to rationalize for short-term than for long-term projects.

The present value (PV) method summarizes the initial cost of the investment, its estimated annual cash flows, and any expected salvage value in a single value called the equivalent current value, taking into account the time value of money (i.e. interest rates)

The internal rate of return (IRR) summarizes the initial cost, expected annual cash flows, and estimated future salvage value of an investment proposal in an equivalent interest rate. In other words, this method identifies the rate of return that equates the estimated future returns and the initial cost.

Using PV and IRR are appropriate when there is a high degree of certainty associated with estimates of future cash flows. In many instances however, operations managers must deal with situations better described as risky or uncertain. When conditions of risk or uncertainty are present, decision theory is often applied.

Decision Theory

Decision Theory is a helpful tool for financial comparison of alternatives under conditions of risk and uncertainty. It is suited to capacity decisions and to a wide range of other decisions managers must make.

Waiting Line Analysis

Analysis of lines is often useful for designing service systems. Waiting lines have a tendency to form in a wide vareity of service systems (banks, airports, technical support telephone lines). The lines are symptoms of bottleneck operations. Analysis is useful in helping managers choose a capacity level that will be cost-effective through balancing the costs of having customers wait with the cost of providing additional capacity. It can aid in the determination of expected costs for various levels of service capacity.

Top of page

Contact Information

Page Last Updated: Thursday September 30, 2004 9:03 PM