2. ⚫ Capacity
⚫ The upper limit or ceiling on the load that an operating
unit can handle
⚫ Capacity needs include
⚫ Equipment
⚫ Space
⚫ Employee skills
Capacity Planning
5-2
3. ⚫ Goal
⚫ To achieve a match between the long-term supply
capabilities of an organization and the predicted level
of long-term demand
⚫ Overcapacity🡪 operating costs that are too high
⚫ Undercapacity🡪 strained resources and possible loss of
customers
Strategic Capacity Planning
5-3
4. ⚫ Key Questions:
⚫ What kind of capacity is needed?
⚫ How much is needed to match demand?
⚫ When is it needed?
⚫ Related Questions:
⚫ How much will it cost?
⚫ What are the potential benefits and risks?
⚫ Are there sustainability issues?
⚫ Should capacity be changed all at once, or through several
smaller changes
⚫ Can the supply chain handle the necessary changes?
Capacity Planning Questions
5-4
5. ⚫ Capacity decisions
1. impact the ability of the organization to meet future demands
2. affect operating costs
3. are a major determinant of initial cost
4. often involve long-term commitment of resources
5. can affect competitiveness
6. affect the ease of management
7. have become more important and complex due to globalization
8. need to be planned for in advance due to their consumption of
financial and other resources
Capacity Decisions Are Strategic
5-5
6. Capacity
Design capacity
⚫ Maximum output rate or service capacity an operation, process,
or facility is designed for
Effective capacity
⚫ Design capacity minus allowances such as personal time,
maintenance, and scrap
Actual output
⚫ Rate of output actually achieved--cannot
exceed effective capacity.
5-6
7. Defining and Measuring Capacity
⚫ Measure capacity in units that do not require
updating
⚫ Why is measuring capacity in dollars problematic?
⚫ Two useful definitions of capacity
⚫ Design capacity
⚫ The maximum output rate or service capacity an operation,
process, or facility is designed for
⚫ Effective capacity
⚫ Design capacity minus allowances such as personal time and
maintenance
5-7
8. ⚫ Actual output
⚫ The rate of output actually achieved
⚫ It cannot exceed effective capacity
⚫ Efficiency
⚫ Utilization
Measured as percentages
Measuring System Effectiveness
5-8
9. Example– Efficiency and Utilization
⚫ Design Capacity = 50 trucks per day
⚫ Effective Capacity = 40 trucks per day
⚫ Actual Output = 36 trucks per day
5-9
10. Determinants of Effective Capacity
⚫ Facilities
⚫ Product and service factors
⚫ Process factors
⚫ Human factors
⚫ Policy factors
⚫ Operational factors
⚫ Supply chain factors
⚫ External factors
5-10
11. Strategy Formulation
⚫ Strategies are typically based on assumptions
and predictions about:
⚫ Long-term demand patterns
⚫ Technological change
⚫ Competitor behavior
5-11
12. Capacity Cushion
⚫ Capacity Cushion
⚫ Extra capacity used to offset demand uncertainty
⚫ Capacity cushion = 100% - Utilization
⚫ Capacity cushion strategy
⚫ Organizations that have greater demand uncertainty
typically have greater capacity cushion
⚫ Organizations that have standard products and services
generally have greater capacity cushion
5-12
13. Steps in Capacity Planning
1. Estimate future capacity requirements
2. Evaluate existing capacity and facilities; identify gaps
3. Identify alternatives for meeting requirements
4. Conduct financial analyses
5. Assess key qualitative issues
6. Select the best alternative for the long term
7. Implement alternative chosen
8. Monitor results
5-13
14. How would you select between alternatives?
Example: Getting a line of credit
⚫ Interest rate on the revolver (including
monitoring fees, etc.)
⚫ Up Front fees (commitment fees, closing fees,
audit fee, etc.)
⚫ Size of the line offered
⚫ Expected Covenant Restrictions
⚫ Advance Rate on Inventory and AR
⚫ Unused line fee
⚫ Default Rate
⚫ Perceived “friendliness” of lender
15. Rank the decision criteria as to importance to the
situation at hand
Decision
Factor
Weight
(1-10)
Interest Rate
on Revolver 8
Up Front Fees 3
Size of Line 7
Covenant
Restrictions 7
Advance Rate 5
Unused Line
Fee 3
Default Rate 5
Friendliness of
Lender 7
16. Rank each lender as to how they compare in each category.
Decision Factor
Weight
(1-10) Lender 1 Lender 2 Lender 3 Lender 4
Interest Rate on
Revolver 8 1 3 2 4
Up Front Fees 3 2 1 3 4
Size of Line 7 3 2 1 4
Covenant Restrictions 7 4 3 2 1
Advance Rate 5 1 2 2 1
Unused Line Fee 3 2 1 1 2
Default Rate 5 2 1 2 1
Friendliness of Lender 7 1 2 3 4
24. Forecasting Capacity Requirements
⚫ Long-term considerations relate to overall level of
capacity requirements
⚫ Require forecasting demand over a time horizon and
converting those needs into capacity requirements
⚫ Short-term considerations relate to probable
variations in capacity requirements
⚫ Less concerned with cycles and trends than with
seasonal variations and other variations from average
5-24
25. ⚫ Calculating processing requirements requires
reasonably accurate demand forecasts, standard
processing times, and available work time
Calculating Processing Requirements
5-25
26. Service Capacity Planning
⚫ Service capacity planning can present a number of
challenges related to:
⚫ The need to be near customers
⚫ Convenience
⚫ The inability to store services
⚫ Cannot store services for consumption later
⚫ The degree of demand volatility
⚫ Volume and timing of demand
⚫ Time required to service individual customers
5-26
27. Demand Management Strategies
⚫ Strategies used to offset capacity limitations and
that are intended to achieve a closer match
between supply and demand
⚫ Pricing
⚫ Promotions
⚫ Discounts
⚫ Other tactics to shift demand from peak periods into
slow periods
5-27
28. In-House or Outsource?
⚫ Once capacity requirements are determined, the organization
must decide whether to produce a good or service itself or
outsource
⚫ Factors to consider:
⚫ Available capacity
⚫ Expertise
⚫ Quality considerations
⚫ The nature of demand
⚫ Cost
⚫ Risks
5-28
29. Developing Capacity Alternatives
⚫ Things that can be done to enhance capacity
management:
⚫ Design flexibility into systems
⚫ Take stage of life cycle into account
⚫ Take a “big-picture” approach to capacity changes
⚫ Prepare to deal with capacity “chunks”
⚫ Attempt to smooth capacity requirements
⚫ Identify the optimal operating level
⚫ Choose a strategy if expansion is involved
5-29
30. Capacity Strategies
⚫ Leading
⚫ Build capacity in anticipation of future demand increases
⚫ Following
⚫ Build capacity when demand exceeds current capacity
⚫ Tracking
⚫ Similar to the following strategy, but adds capacity in relatively
small increments to keep pace with increasing demand
5-30
31. Bottleneck Operation
⚫ An operation in a
sequence of operations
whose capacity is lower
than that of the other
operations
5-31
33. Economies and Diseconomies of Scale
⚫ Economies of Scale
⚫ If output rate is less than the optimal level, increasing
the output rate results in decreasing average per unit
costs
⚫ Diseconomies of Scale
⚫ If the output rate is more than the optimal level,
increasing the output rate results in increasing average
per unit costs
5-33
34. Economies of Scale
⚫ Economies of Scale
⚫ If output rate is less than the optimal level, increasing
the output rate results in decreasing average per unit
costs
⚫ Reasons for economies of scale:
⚫ Fixed costs are spread over a larger number of units
⚫ Construction costs increase at a decreasing rate as facility
size increases
⚫ Processing costs decrease due to standardization
5-34
35. Diseconomies of Scale
⚫ Diseconomies of Scale
⚫ If the output rate is more than the optimal level, increasing the
output rate results in increasing average per unit costs
⚫ Reasons for diseconomies of scale
⚫ Distribution costs increase due to traffic congestion and
shipping from a centralized facility rather than multiple
smaller facilities
⚫ Complexity increases costs
⚫ Inflexibility can be an issue
⚫ Additional levels of bureaucracy
5-35
36. Facility Size and Optimal Operating Level
Minimum cost & optimal operating rate are
functions of size of production unit.
5-36
37. Constraint Management
⚫ Constraint
⚫ Something that limits the performance of a process or system in
achieving its goals
⚫ Categories
⚫ Market
⚫ Resource
⚫ Material
⚫ Financial
⚫ Knowledge or competency
⚫ Policy
5-37
38. 1. Identify the most pressing constraint
2. Change the operation to achieve maximum benefit,
given the constraint
3. Make sure other portions of the process are supportive
of the constraint
4. Explore and evaluate ways to overcome the constraint
5. Repeat the process until the constraint levels are at
acceptable levels
Resolving Constraint Issues
5-38
39. Evaluating Alternatives
⚫ Alternatives should be evaluated from varying
perspectives
⚫ Economic
⚫ Is it economically feasible?
⚫ How much will it cost?
⚫ How soon can we have it?
⚫ What will operating and maintenance costs be?
⚫ What will its useful life be?
⚫ Will it be compatible with present personnel and present
operations?
⚫ Non-economic
⚫ Public opinion
5-39
41. ⚫ Cost-volume analysis
⚫ Focuses on the relationship between cost, revenue,
and volume of output
⚫ Fixed Costs (FC)
⚫ tend to remain constant regardless of output volume
⚫ Variable Costs (VC)
⚫ vary directly with volume of output
⚫ VC = Quantity(Q) x variable cost per unit (v)
⚫ Total Cost
⚫ TC = FC + VC
⚫ Total Revenue (TR)
⚫ TR = revenue per unit (R) x Q
Cost-Volume Analysis
5-41
42. ⚫ BEP
⚫ The volume of output at which total cost and total
revenue are equal
⚫ Profit (P) = TR – TC = R x Q – (FC +v x Q)
= Q(R – v) – FC
Break-Even Point (BEP)
5-42
44. Cost-Volume Relationships
⚫ Capacity alternatives may involve step costs,
which are costs that increase stepwise as
potential volume increases.
⚫ The implication of such a situation is the possible
occurrence of multiple break-even quantities.
5-44
45. Cost-Volume Analysis Assumptions
⚫ Cost-volume analysis is a viable 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 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
5-45
46. Financial Analysis
⚫ Cash flow
⚫ The difference between cash received from sales and
other sources, and cash outflow for labor, material,
overhead, and taxes
⚫ Present value
⚫ The sum, in current value, of all future cash flow of an
investment proposal
5-46
47. Operations Strategy
⚫ Capacity planning impacts all areas of the organization
⚫ It determines the conditions under which operations will have to function
⚫ Flexibility allows an organization to be agile
⚫ It reduces the organization’s dependence on forecast accuracy and reliability
⚫ Many organizations utilize capacity cushions to achieve flexibility
⚫ Bottleneck management is one way by which organizations can enhance
their effective capacities
⚫ Capacity expansion strategies are important organizational
considerations
⚫ Expand-early strategy
⚫ Wait-and-see strategy
⚫ Capacity contraction is sometimes necessary
⚫ Capacity disposal strategies become important under these
conditions
5-47
49. Decision Theory
⚫ A general approach to decision making that is
suitable to a wide range of operations management
decisions
⚫ Capacity planning
⚫ Product and service design
⚫ Equipment selection
⚫ Location planning
5S-49
50. Characteristics of Suitable Problems
⚫ Characteristics of decisions that are suitable for
using decision theory
⚫ A set of possible future conditions that will have a
bearing on the results of the decision
⚫ A list of alternatives from which to choose
⚫ A known payoff for each alternative under each
possible future condition
5S-50
51. Process for Using Decision Theory
1. Identify the possible future states of nature
2. Develop a list of possible alternatives
3. Estimate the payoff for each alternative for each
possible future state of nature
4. If possible, estimate the likelihood of each possible
future state of nature
5. Evaluate alternatives according to some decision
criterion and select the best alternative
5S-51
52. Payoff Table
⚫ A table showing the expected payoffs for each
alternative in every possible state of nature
Possible Future Demand
Alternatives Low Moderate High
Small facility $10 $10 $10
Medium facility 7 12 12
Large Facility (4) 2 16
• A decision is being made concerning which size
facility should be constructed
• The present value (in millions) for each alternative
under each state of nature is expressed in the body of
the above payoff table
5S-52
53. Causes of Poor Decisions
⚫ Decisions occasionally turn out poorly due to
unforeseeable circumstances; however, this is not
the norm.
⚫ More frequently poor decisions are the result of a
combination of
⚫ Mistakes in the decision process
⚫ Bounded rationality
⚫ Suboptimization
5S-53
54. Decision Process
⚫ Steps:
1. Identify the problem
2. Specify objectives and criteria for a solution
3. Develop suitable alternatives
4. Analyze and compare alternatives
5. Select the best alternative
6. Implement the solution
7. Monitor to see that the desired result is achieved
⚫ Errors
⚫ Failure to recognize the importance of each step
⚫ Skipping a step
⚫ Failure to complete a step before jumping to the next step
⚫ Failure to admit mistakes
⚫ Inability to make a decision
5S-54
55. Bounded Rationality & Suboptimization
⚫ Bounded rationality
⚫ The limitations on decision making caused by costs,
human abilities, time, technology, and availability of
information
⚫ Suboptimization
⚫ The results of different departments each attempting
to reach a solution that is optimum for that
department
5S-55
56. Decision Environments
⚫ There are three general environment categories:
⚫ Certainty
⚫ Environment in which relevant parameters have known
values
⚫ Risk
⚫ Environment in which certain future events have
probabilistic outcomes
⚫ Uncertainty
⚫ Environment in which it is impossible to assess the
likelihood of various possible future events
5S-56
57. Decision Making Under Uncertainty
⚫ Decisions are sometimes made under complete
uncertainty: No information is available on how likely the
various states of nature are.
⚫ Decision Criteria:
⚫ Maximin
⚫ Choose the alternative with the best of the worst possible payoffs
⚫ Maximax
⚫ Choose the alternative with the best possible payoff
⚫ Laplace
⚫ Choose the alternative with the best average payoff
⚫ Minimax regret
⚫ Choose the alternative that has the least of the worst regrets
5S-57
58. Possible Future Demand
Alternatives Low Moderate High
Small Facility $10 $10 $10
Medium Facility 7 12 12
Large Facility (4) 2 16
Example – Maximin Criterion
•The worst payoff for each alternative is
Small facility: $10 million
Medium facility $7 million
Large facility -$4 million
•Choose to construct a small facility
5S-58
59. Possible Future Demand
Alternatives Low Moderate High
Small Facility $10 $10 $10
Medium Facility 7 12 12
Large Facility (4) 2 16
Example – Maximax Criterion
•The best payoff for each alternative is
Small facility: $10 million
Medium facility $12 million
Large facility $16 million
•Choose to construct a large facility
5S-59
60. Possible Future Demand
Alternatives Low Moderate High
Small Facility $10 $10 $10
Medium Facility 7 12 12
Large Facility (4) 2 16
Example – Laplace Criterion
•The average payoff for each alternative is
Small facility: (10+10+10)/3 = $10 million
Medium facility (7+12+12)/3 = $10.33 million
Large facility (-4+2+16)/3 = $4.67 million
•Choose to construct a medium facility
5S-60
61. Possible Future Demand
Alternatives Low Moderate High
Small Facility $10 $10 $10
Medium Facility 7 12 12
Large Facility (4) 2 16
Example – Minimax Regret
•Construct a regret (or opportunity loss) table
•The difference between a given payoff and the best
payoff for a state of nature
Regrets
Alternatives Low Moderate High
Small Facility $0 $2 $6
Medium Facility 3 0 4
Large Facility 14 10 0
5S-61
62. Regrets
Alternatives Low Moderate High
Small Facility $0 $2 $6
Medium Facility 3 0 4
Large Facility 14 10 0
Example – Minimax Regret
•Identify the worst regret for each alternative
•Small facility $6 million
•Medium facility $4 million
•Large facility $14 million
•Select the alternative with the minimum of the maximum
regrets
•Build a medium facility
5S-62
63. Decision Making Under Risk
⚫ Decisions made under the condition that the
probability of occurrence for each state of nature
can be estimated
⚫ A widely applied criterion is expected monetary
value (EMV)
⚫ EMV
⚫ Determine the expected payoff of each alternative, and
choose the alternative that has the best expected payoff
⚫ This approach is most appropriate when the decision maker is
neither risk averse nor risk seeking
5S-63
64. Possible Future Demand
Alternatives Low (.30) Moderate (.50) High (.20)
Small Facility $10 $10 $10
Medium Facility 7 12 12
Large Facility (4) 2 16
Example– EMV
EMVsmall
= .30(10) +.50(10) +.20(10) = 10
EMVmedium
= .30(7) + .50(12) + .20(12) = 10.5
EMVlarge
= .30(-4) + .50(2) + .20(16) = $3
Build a medium facility
5S-64
65. Decision Tree
⚫ Decision tree
⚫ A schematic representation of the available alternatives and
their possible consequences
⚫ Useful for analyzing sequential decisions
5S-65
66. Decision Tree
⚫ Composed of
⚫ Nodes
⚫ Decisions – represented by square nodes
⚫ Chance events – represented by circular nodes
⚫ Branches
⚫ Alternatives– branches leaving a square node
⚫ Chance events– branches leaving a circular node
⚫ Analyze from right to left
⚫ For each decision, choose the alternative that will yield the
greatest return
⚫ If chance events follow a decision, choose the alternative that
has the highest expected monetary value (or lowest expected
cost)
5S-66
67. ⚫ A manager must decide on the size of a video arcade to construct. The
manager has narrowed the choices to two: large or small. Information has
been collected on payoffs, and a decision tree has been constructed.
Analyze the decision tree and determine which initial alternative (build small
or build large) should be chosen in order to maximize expected monetary
value.
Example– Decision Tree
1
2
2
$40
$40
$50
$55
($10)
$50
$70
B
u
i
l
d
S
m
a
l
l
Low
Demand (.40)
Low Demand (.40)
High Demand (.60)
High Demand (.60)
B
u
i
l
d
L
a
r
g
e
Do Nothing
Cut Prices
Do Nothing
Overtime
Expand
5S-67
69. ⚫ Expected value of perfect information (EVPI)
⚫ The difference between the expected payoff with perfect
information and the expected payoff under risk
⚫ Two methods for calculating EVPI
⚫ EVPI = expected payoff under certainty – expected payoff under risk
⚫ EVPI = minimum expected regret
Expected Value of Perfect Information
5S-69
70. Possible Future Demand
Alternatives Low (.30) Moderate (.50) High (.20)
Small Facility $10 $10 $10
Medium Facility 7 12 12
Large Facility (4) 2 16
Example – EVPI
EVwith perfect information
= .30(10) + .50(12) + .20(16) = $12.2
EMV = $10.5
EVPI = EVwith perfect information
– EMV
= $12.2 – 10.5
= $1.7
You would be willing to spend up to $1.7 million to
obtain perfect information
5S-70
71. Regrets
Alternatives Low (.30) Moderate (.50) High (.20)
Small Facility $0 $2 $6
Medium Facility 3 0 4
Large Facility 14 10 0
Example– EVPI
• Expected Opportunity Loss
• EOLSmall
= .30(0) + .50(2) + .20(6) = $2.2
• EOLMedium
= .30(3) + .50(0) + .20(4) = $1.7
• EOLLarge
= .30(14) + .50(10) + .20(0) = $9.2
• The minimum EOL is associated with the building the
medium size facility. This is equal to the EVPI, $1.7
million
5S-71
72. Sensitivity Analysis
⚫ Sensitivity analysis
⚫ Determining the range of probability for which an
alternative has the best expected payoff
5S-72
