Capacity Planning

 

Measures of Capacity. No single capacity measure is applicable to all types of situations. Hospitals measure capacity as the number of patients that can be treated per day; a retailer measures capacity as annual sales dollars generated per square foot; an airline measures capacity as available seat-miles (ASMs) per month; a theater measures capacity number of seats; and a 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.

Output measures are the usual choice for facilities that produce standard products in high volumes, in a limited number of models using production processes with rigid flow patterns. Nissan Motor Company states capacity at its Tennessee plant to be 450,000 vehicles per year. The plant produces only one type of vehicle, making capacity easy to measure. However, the Navistar plant in Springfield Ohio produces vehicles that range from heavy-duty trucks to school busses. The inherent variation in production time requirements makes a single figure for capacity much less meaningful.

Input measures are the usual choice for facilities that produce custom products in low volumes using processes with flexible flow patterns. For example, in a photocopy shop, capacity can be measured in machine hours or number of machines.  Demand, which invariably is expressed as output rate, must be converted to an input measure. Only after making the conversion can a manager compare demand requirements and capacity on an equivalent basis. For example, the manager of a copy center must convert its annual demand for copies from different clients to the number of machines required.

Utilization: Capacity planning requires knowledge of current capacity and utilization. Utilization, or the degree to which equipment, space, or labor is currently being used, is expressed as a percentage:

Utilization=100%*(Average Output Rate/Maximum Capacity)

The average output rate and the capacity must be measured in the same terms (time, customers, units, or dollars). The utilization rate indicates the need for adding extra capacity or eliminating unneeded capacity. The greatest difficulty calculating utilization lies in defining maximum capacity, the denominator in the ratio. Two definitions of maximum capacity are useful: peak capacity and effective capacity.

Peak Capacity. The maximum output that a process or facility can achieve under ideal conditions is called peak capacity. When capacity is measured relative to equipment alone, the appropriate measure is rated capacity: an engineering assessment of maximum annual output, assuming continuous operation except for an allowance for normal maintenance and repair downtime. Peak capacity can be sustained for only a short time, such as a few hours in a day or a few days in a month. A firm reaches it by using marginal methods of production, such as excess overtime, extra shifts, temporarily reduced maintenance activities, overstaffing, and subcontracting. Although they can help with temporary peaks, these options can’t be sustained for long. Employees don’t want to work excessive overtime for extended periods, overtime and night shift premiums drive up costs, and quality drops.

Effective Capacity. The maximum output that a process or firm can economically sustain under normal conditions is its effective capacity. In some organizations, effective capacity implies a one-shift operation; in others it implies a three-shift operation.

Example calculation: If operated around the clock under ideal conditions; the fabrication department of an engine manufacturer can make 100 engines per day. Management believes that a maximum output rate of only 45 engines per day can be sustained economically over a long period of time. Currently the department is producing an average of 50 engines per day. What is the utilization of the department, relative to peak capacity? Effective capacity?

Utilizationpeak = 100%*(50/100) = 50%

Utilizationeffective = 100%*(50/45) = 111%

Even though fabrication department operations fall well short of the peak capacity, they are beyond the output rate judged to be the most economical.

Increasing Maximum Capacity. Most facilities have multiple operations, and often their effective capacities aren’t identical. A bottleneck is an operation that has the lowest effective capacity of any operation in the facility and thus limits the system’s output. The diagram below represents a facility where operation 2 is a bottleneck that limits the output to 50 units per hour.

A facility can produce only as fast as the slowest operation. True expansion of a facility’s capacity occurs only when bottleneck capacity is increased. Initially adding capacity at operation 2 (and not operation 1 or 3) will increase system capacity. However, when operation 2’s capacity reaches 150 units per hour, both operation 2 and 3 must be expanded simultaneously to increase capacity further.

If a process has flexible flows, such as at a job shop, it doesn’t enjoy the simple line flows shown above. Its operations may process many different items, and the demands on any one operation could vary considerably from one day to the next. Bottlenecks can still be identified by computing the average utilization of each operation. However, the variability in workload also creates floating bottlenecks. One week the mix of work may make operation 1 a bottleneck, and the next week it may make operation 3 the constraint. 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: Historically, organizations have accepted a concept known as economies of scale, which states that the average unit cost of a good or service can be reduced by increasing its output rate. There are four principal reasons why economies of scale can drive costs down when output increases: Fixed costs are spread over more units, construction costs are reduced, costs of purchased materials are cut, and process advantages are found.

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. Depreciation of plant and equipment already owned is also a fixed cost 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.

Reducing Construction Costs: Certain activities and expenses are required in building small and large facilities alike: building permits, architects’ 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. For example, the cost of steel to build an oil tanker increases more slowly than the tanker’s capacity increases. Industries such as breweries and oil refineries benefit from strong economies of scale because of this phenomenon.

Cutting Costs of Purchased Materials: Higher volumes can reduce the costs of purchased materials and services. They give the purchaser a better bargaining position and the opportunity to take advantage of quantity discounts. 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. Producers who rely on a vast network of suppliers (e.g., Toyota) and food processors (e.g., Kraft General Foods) also can buy inputs for less because of the quantity they order. In the personal computer business, large firms can negotiate volume discounts on the components that determine up to 80 percent of a PC’s costs. Thus Compaq can sell its base model for just $100 more than it costs a smaller firm, making only 200 to 500 units a month, for materials alone.

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 products. Firms may be able to justify the expense of more efficient technology or more specialized equipment. The benefits from dedicating resources to individual products or services may include speeding up the learning effect, lowering inventory, improving process and job designs, and reducing the number of changeovers. For example, 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 its 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. The reason is that excessive size can bring complexity, loss of focus, and inefficiencies that raise the average unit cost 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 changing demand. Many large companies become so involved in analysis and planning that they innovate less and avoid risks. The result is that small companies or perform corporate giants in numerous industries.

Economies of scale vary by industry, which affects plant size. Thus, managers often set policies regarding the maximum size for any one facility. Plant size ceilings of 300 employees are common for industries such as metalworking. For example, Dana Corporation, a $5 billion supplier of steel to U.S., European, and Japanese automakers, has a cap of 200 employees at all but a few of its 120 plants. When a 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.

Economies of Scope: Typically, capital intensity and resource flexibility vary inversely. If capital intensity is high, resource flexibility is low. In certain types of manufacturing operations, such as machining and assembly, programmable automation breaks this traditional inverse relationship between resource flexibility and capital intensity. It makes possible both high capital intensity and high resource flexibility, creating economies of scope. Economies of scope reflect the ability to produce multiple products more cheaply in combination than separately. In such situations, two conflicting competitive priorities-customization and low price–become more compatible. However, taking advantage of economies of scope requires that a family of parts or products have enough collective volume to utilize equipment fully. Adding a product to the family results in one-time programming (and sometimes fixture) costs.

Capacity Strategies: Operations managers must examine three dimensions of capacity strategy before making capacity decisions: sizing capacity cushions, timing and sizing expansion, and linking capacity and other operating decisions.

Sizing Capacity Cushions: Average utilization rates should not get too close to 100 percent. When they do, that usually is a signal to increase capacity or decrease order acceptance so as to avoid declining productivity. The capacity cushion is the amount of reserve capacity that a firm maintains to handle sudden increases in demand or temporary losses of production capacity; it measures the amount by which the average utilization (in terms of effective capacity) falls below 100 percent. Specifically,

            Capacity cushion = 100% - Utilization rate (%)

Since 1948 U.S. manufacturers have maintained an average cushion of 18 percent, with a low of 9 percent in 1966 and a high of 27 percent in 1982. The appropriate size of the cushion varies by industry. In the capital-intensive paper industry, machines can cost hundreds of millions of dollars each; cushions well under 10 percent are preferred. Electric utilities also are capital intensive but consider cushions of 15 to 20 percent in electric generating capacity to be optimal to avoid brownouts and loss of service to customers.

Businesses find large cushions appropriate when demand varies. Large cushions also are necessary when future demand is uncertain, particularly if resource flexibility is low. 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. High degrees of product customization also lead to uncertainty.

Supply uncertainty also favors large capacity cushions. Capacity often comes in large increments, so expanding even by the minimum amount possible may create a large cushion. Firms also need to build in excess capacity to allow for employee absenteeism, vacations, holidays, and any other delays. 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. For capital-intensive firms, minimizing the capacity cushion is vital. Since the mid 1970s, airlines have expanded capacity by cramming about 20 percent more seats into the same size aircraft. Studies indicate that businesses with high capital intensity achieve a low return on investment when the capacity cushion is high.

Timing and Sizing Expansion: The second issue of capacity strategy is when to expand and by how much. There are two extreme strategies: the expansionist strategy, which involves large, infrequent jumps in capacity, and the wait-and-see strategy, which 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. The expansionist strategy, which stays ahead of demand, minimizes the chance of sales lost to insufficient capacity. The wait-and-see strategy lags 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 drawbacks. For example, overtime requires payment of time-and-a-half wages for some employees and may result in lower productivity or quality during overtime hours; union agreements may even limit the amount of allowable overtime. Nonetheless, some mix of short-term options might make the wait-and-see strategy best in certain situations.

Several factors favor the expansionist strategy. Expansion may result in economies of scale and a faster rate of learning, thus helping a firm reduce its costs and compete on price. 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 competition can act.

The conservative wait-and-see strategy is to expand in smaller increments, such as by renovating existing facilities rather than building new ones. Because the wait-and-see strategy follows demand, it reduces the risks of over expansion based on overly optimistic demand forecasts, obsolete technology, or inaccurate assumptions regarding the competition. However, this strategy has different risks, such as being preempted by a competitor or being unable to respond if demand is unexpectedly high. The wait-and-see strategy has been criticized as a short-term strategy typical of some U.S. management styles. Managers on the fast track to corporate advancement tend to take fewer risks. They earn promotions by avoiding the big mistake and maximizing short-term profits and return on investment. The wait-and-see strategy fits this short-term outlook but can erode market share over the long run.

Management may choose one of these two strategies or one of the many between these extremes. With strategies in the more moderate middle, firms may expand more frequently (on a smaller scale) than with the expansionist strategy, but do not always lag behind demand as with the wait-and-see strategy. 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 overcapacity.

Linking Capacity and Other Decisions: Capacity decisions should he intricately linked to strategies and operations throughout the organization. When managers make decisions about location, resource flexibility, and inventory, they must consider the impact on capacity cushions. Capacity cushions buffer the organization against uncertainty, as do resource flexibility, inventory, and longer customer lead times. 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.

· 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.

· Quality management: A drive that has obtained higher levels of quality allows for a smaller capacity cushion because there will be less uncertainty caused by yield losses.

· Capital intensity: An investment in expensive new technologies makes process more capital-intensive and increases pressure to have a smaller capacity cushion to get an acceptable return on the investment.

· Resource flexibility: A change to 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.

· Inventory: A change to less reliance on inventory in order to smooth output rate requires a larger capacity cushion to meet increased demand during peak periods.

· Scheduling: A change to a more stable environment allows a smaller cushion because products or services can be scheduled with more assurance.

Another crucial linkage is between capacity and location decisions. A firm that is expanding eventually must add new facilities and find suitable locations for the new facilities whereas a multisite firm that is downsizing often must identify which locations to eliminate.