5.7 Capacity decisions

	Manufacturing and service capacity investment decisions can be very complex.
	Consider some of the following difficult questions that need to be addressed:

		How long will it take to bring new capacity on stream?
		How does this match with the time that it takes to develop a new product?
		What will be the impact of not having sufficient capacity for a promising product?
		Should the firm use third-part contract manufacturers?
		How much of a premium will the contract manufacturer change for providing flexibility in manufacturing volume?

In this section, we look at these tough capacity decisions. We begin by discussing the nature of capacity from an operations management perspective.

Capacity management in operations

	Capacity is most frequently viewed as the amount of output that a system is capable of achieving over a specific of time.
	In a service setting, this might be the number of customers that can handle between noon and 1:00pm.

5.7 Capacity decisions

	In manufacturing, this might be the automobiles that can be produced in a single shift.
	When looking at capacity, operations managers need to look at resource inputs and product outputs.
	The reason is that, for planning purposes, real (or effective) capacity depends on what is to be produced.
	For example, a firm that makes multiple products inevitably can produce more of one kind of another with a given level of resource inputs.
	Thus, while the managers of an automobile may state that their facility has 10,000 labor hours available per year, they are also thinking that these labor can be used to make either 50,000 two-door models or 40,000 four-door models (or some mix of the two-and four-door models).
	This reflects their knowledge of what their current technology and labor can produce and the product mix is to be demanded from these resources.
	Operations management views also emphasize the time dimension of capacity.
	That is, capacity must also be stated relative to some period of time.
	This is evidenced in the common distinction drawn between long-range, intermediate-range, and short-range capacity planning.

5.7 Capacity decisions

	Finally, capacity planning itself has different meaning in individuals at different levels within the operation management hierarchy.
	The vice president of manufacturing is concerned with aggregate capacity of all factories within the firm.
	The vice president's concern relates mainly to the financial resources required to support these factories.
	You will study this process when you cover capital budgeting during your finance course.
	The plant manager (PM) is concerned with the capacity of the individual plant.
	The PM must decide how to use this capacity to meet anticipated demand for products.
	Because short-term demand may greatly exceed short-term capacity during peak demand periods, the PM must determine when and how much inventory to hold to build in anticipation of these peaks.
	Today many firms are using information systems to coordinate the use of plant capacity across multiple sites.
	This results in the optimal use of manufacturing and distribution resources.
	The first-level supervisor is concerned with capacity of the equipment and staff mix in his department.
	The person will work out detailed schedules to accommodate the daily flow of work.
	Although there is no one person with the job title "capacity manager".

5.7 Capacity decisions

	There are several managerial positions charged with the effective use of capacity.
	Capacity is a relative term: in an operation management context, it may be defined as the amount resources inputs available relative to output requirements over a particular period of time.
	Note that this definition makes no distinction between efficient and inefficient use of capacity.
	The objective of strategic capacity planning is to provide an approach for determining the overall capacity level of capital-intensive resources-facilities, equipments, and overall labor force size-that beat support the company's long-range competitive strategy.
	The capacity level selected has a critical impact on the firm's response rate, its cost structure, its inventory policies, and its management and staff support requirements.
	If capacity is inadequate, a company may lose customers through slow service or by allowing competitors to enter the market.
	If capacity is excessive, a company may have to reduce prices to stimulate demand; underutilize its workforce, carry excess inventory; or seek additional, less profitable products to stay in business.

5.7 Capacity decisions

Capacity planning concepts

	The term capacity implies an attainable rate of output, for example, 300 cars per day, but says nothing about how long that rate can be sustained.
	Thus, we do not know if these 300 cars per day is a one-day is a peak or a six-month average.
	To avoid this problem, the concept of best operating level is used.
	This is the level of capacity for which the process was designed and thus is the volume of output at which average unit cost is minimized.
	Determining this minimum is difficult because it involves a complete trade-off between the allocation of fixed overhead costs and the cost of overtime, equipment wear, defect rates, and other costs.
	An important measure is the capacity utilization rate, which reveals how close a firm is to its best operating point (that is, design capacity):
	Capacity utilization rate = (Capacity used)/(Best operating level)
	The capacity utilization rate is expressed as a percentage and requires that the numerator and denominator be measured in the same units and time periods (such as machine hour/day, barrels of oil/day, and dollar of output/day).

5.7 Capacity decisions

Concept one: Economies and Diseconomies of Scale:

		The basic notion of economies of scale is that as a plant gets larger and volume increases, the average cost per unit of outputs drops.
		This is partially due to operating and capital cost, because a piece of equipment with twice the capacity of another piece typically dose not cost twice as much to purchase or operate.
		Plants also gain efficiencies when they become large enough to fully utilize dedicated resources for tasks such as material handling, computer equipment, and administrative support personnel.
		At some point, the size of a plant becomes too large and diseconomies of scale become a problem.
		These diseconomies may surface in many different ways.
		For example, maintaining the demand required to keep the large facility busy may require significant discounting of the product.
		In many cases, the size of a plant may be influenced by factors other than the internal equipment, labour, and other capital expenditures.
		A major factor may be the cost to transport raw materials and finished product to and from the plant.
		A cement factory, for example, would have a difficult time serving customers more than a few hours its plant.

5.7 Capacity decisions

		Analogously, automobile companies such as Ford, Honda, Nissan, and Toyota have found it advantageous to locate plants within specific international markets.
		The anticipated size of these intended markets will largely dictate the size of the plants.

Concept Two: The Experience Curve:

		A well-known concept is the experience curve.
		As plants produce more, they gain experience in the best production methods, which reduce their costs of production in predictable manner.
		Every time a plant's cumulative production doubles, its production costs decline by a specific percentage depending on the nature of the business.
		Exhibit 5.3 demonstrates the effect of an experience curve on the production costs of a meat sandwich.
		The experience curve percentage varies across industries.
		To apply this concept to the restaurant industry, consider a hypothetical fast-food chain that has produced 5 million sandwiches.
		Given a current variable cost of $0.55 per sandwich, what will the cost per sandwich be when cumulative production reaches 10 million sandwich? If the firm has a 90 percent experience curve, cost will fall to 90 percent of $0.55, or $0.495, when accumulated production reaches 10 million.

5.7 Capacity decisions

		At 1 billion sandwiches, the variable cost drops to less than $0.25.
		Note that sales volume becomes an important issue in achieving cost saving.
		If firm A serves twice as many sandwiches daily as firm B, it will accumulate "experience" twice as fast.

Exhibit 5.3: The experience curve.

5.7 Capacity decisions

Concept Three: Where Economies of Scale Meet the Experience Curve:

		The astute reader will realize that larger plants can have a two-way cost advantage over their competitors.
		Not only does a larger plant gain from economies of scale, but it will also produce more, giving it experience curve advantages as well.
		Companies often use this dual advantage as a competitive strategy by first building a large plant with substantial economies of scale, and then using its lower costs to price aggressively and increase sales volume.
		The increased volume moves them down the experience curve more quickly than their competitors, allowing the company to lower prices further, gaining still more volume.
		However, two criteria must be met for this strategy to succeed:

			The product must fit customers' needs.
			The demand must be sufficiently large to support the volume.

Concept Four: Capacity Focus:

The concept of the focused factory holds that a production facility works best when it focuses on a fairly limited set of production objectives.

5.7 Capacity decisions

		This means, for example, that a firm should not expect to exceed in every aspect of manufacturing performance: cost, quality, flexibility, new product introductions, reliability, short lead times, and low investment.
		Rather, it should select a limited set of tasks that contribute the most to corporate objectives.
		However, given the breakthroughs in manufacturing technology, there is an evolution in factory objectives toward trying to do everything well.
		How do we deal with these apparent contradictions?
		One way is to say that if the firm does not have the technology to master multiple objectives, then a narrow focus is the logical choice.
		Another way is to recognize the practical reality that not all firms are in industries require them to use their full range of capabilities to compete.
		The capacity focus concept can also be operationalized through the mechanism of plants within plants- or PWPs.
		A focused plant may have several PWPs, each of which may have separate suborganizations, equipment and process policies, workforce management policies, production control methods, and so forth for different products-even if they are made under the same roof.

5.7 Capacity decisions

This, in effect, permits fining the best operating level for each department of the organization and thereby carries the focus concept down the operating level.

Concept Five: Capacity Flexibility:

		Capacity flexibility means having the ability to rapidly increase or decrease production levels, or to shift production capacity quickly from one product or service to another.
		Such flexibility is achieved through flexible plants, processes, and workers, as well as through strategies that use the capacity of other organizations.
		Flexible Plants. Perhaps the ultimate in plant flexibility is the zero-changeover-time plant.
		Using movable equipment, knockdown walls, and easily accessible and reroutable utilities, such a plant can quickly adapt to change.
		An analogy to a familiar service business captures the flavour well: a plant with equipment "that is easy to install and easy to tear down and move.
		Flexible Processes.

Flexible processes are epitomized by flexible manufacturing systems on the one hand simple, easily set up equipment on the other.

5.7 Capacity decisions

Both of these technologies permit rapid low-cost switching from one product line to another, enabling what are sometimes referred to as economies of scope. (By definition, economies of scope exist when multiple products can be produced at a lower cost in combination than they can separately.)

Flexible Workers.

			Flexible workers have multiple skills and the ability to switch easily from one task to another.
			They require broader training than specialized workers and need managers and staff support to facilities in their work assignments.

Capacity planning

First: Considerations in Adding Capacity:

		Many issues must be considered when adding capacity.
		Three important ones are:

			Maintaining system balance.
			Frequency of capacity additions.
			The use of external capacity.

5.7 Capacity decisions

Maintaining System Balance.

			In a perfectly balanced plant, the output of stage 1 provides the exact requirement for stage 2.
			Stage 2's output provides the exact input requirement for stage 3, and so on.
			In practice, however, achieving such a "perfect" design is usually both impossible and undesirable.
			One reason is that the best operations levels for each stage generally differ.
			For instance, department 1 may operate most efficiently over a range of 90 to 110 units per month, whereas department2, the next stage in the process, is most efficient at 75 to 85 units per month, and department 3 works best over a range of 150 to 200 units per month.
			Another reason is that variability in product demand and the processes themselves generally leads to imbalance except in automated production lines, which, in essence, are just one big machine.
			There are various ways of dealing with imbalance.
			One is to add capacity to stages that are bottlenecks.
			This can be done by temporary measures such as scheduling overtime, leasing equipment, or purchasing additional capacity through subcontracting.

5.7 Capacity decisions

			A second way is through the use of buffer inventories in front of the bottleneck stage to ensure that it always has something to work on.
			A third approach involves duplicating the facilities of one department on which another is dependent.

Frequency of Capacity Additions.

			There are two types of costs to consider when adding capacity: the cost of upgrading too frequently and that of upgrading too infrequently.
			Upgrading capacity too frequently is expensive.
			Direct costs include removing and replacing old equipment and training employees on the new equipment.
			In addition, the new equipment must be purchased, often for considerably more than the selling price of the old.
			Finally, there is the opportunity cost of idling the plant or service site during changeover period.
			Conversely, upgrading capacity too infrequently is also expensive.
			Infrequent expansion means that capacity is purchased in larger chunks.

5.7 Capacity decisions

External Sources of Capacity.

			In some cases, it may be cheaper to not add capacity at all, but rather to use some existing external source of capacity.
			Two common strategies used by operations are outsourcing and sharing capacity.
			An example of outsourcing is Japan banks in California subcontracting check-clearing operations.
			An example of sharing capacity is two domestic airlines flying different routes with different seasonal demands exchanging aircraft (suitably repainted) when one's routes heavily used and the other's are not.
			A new twist is airlines sharing-using the same flight number even though the airline company may change through the route.

Second: Determining Capacity Requirements:

		In determining capacity requirements, we must address the demands for individual product lines, individual plant capabilities, and allocation of production throughout the plant network.
		Typically this done according to the following steps:

			Use forecasting techniques to predict sales for individual products within each product line.
			Calculate equipment and labour requirements to meet product line forecasts.

5.7 Capacity decisions

Project labour and equipment availabilities over the planning horizon.

		Often the firm then decides on some capacity cushion that will be maintained between the projected requirements and the actual capacity.
		A capacity cushion is an amount of capacity in excess of expected demand.
		For example, if the expected annual demand on a facility $10 million in products per year and the design is $12 million per year, it is a 20 percent capacity cushion.
		A 20 percent capacity cushion equates to an 83 percent utilization rate (100%/120%).
		When a firm's design capacity is less than the capacity required to meet its demand, it is said to have a negative capacity cushion.
		If, for example, a firm has a demand of $12 million in products per year but can produce only $10 million per year, it has a negative capacity cushion of 16.7 percent.

Third: Using Decision Trees to Evaluate Capacity Alternatives:

		A convenient way to lay out the steps of a capacity problem is through the use of decision trees.
		The tree format helps not only in understanding the problem but also in finding a solution.

5.7 Capacity decisions

		A decision tree is a schematic model of the sequence of steps in a problem and the conditions and consequences of each step.
		In recent years, a few commercial software packages have been developed to assist in the construction and analysis of decision trees.
		These packages make the process quick and easy.
		Decision trees are composed of decision nodes with branches to and from them.
		Usually squares represent decision points a circles represent chance events.
		Branches from decision points show the choices available to the decision maker; branches from chance events show the probabilities for their occurrence.
		In solving decision tree problem, we work, from the end of the tree backward to the start of the tree.
		As we work back, we calculate the expected values at each step.
		In calculating the expected value, the time value of money is important if the planning horizon is long.
		Once the calculations are made, we prune the tree by eliminating from each decision point all branches expect the one with the highest payoff.
		This process continues to the first decision point, and the decision problem is thereby solved. (Applications are available in quantitative methods references).