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Strategic Capacity Planning for Products and Services

McGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Capacity
The upper limit or ceiling on the load that an operating

unit can handle Capacity needs include


Equipment

Space
Employee skills

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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

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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?

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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

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Design capacity

Maximum output rate or service capacity an operation, process, or facility is designed for Design capacity minus allowances such as personal time, maintenance, and scrap Rate of output actually achieved--cannot exceed effective capacity.

Effective capacity

Actual output

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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

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Actual output
The rate of output actually achieved
It cannot exceed effective capacity

Efficiency

actual output Efficiency effective capacity actual output Utilizatio n design capacity
Measured as percentages
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Utilization

Design Capacity = 50 trucks per day

Effective Capacity = 40 trucks per day


Actual Output = 36 trucks per day

actual output 36 Efficiency 90 % effective capacity 40 actual output 36 Utilizatio n 72 % design capacity 50
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Facilities

Product and service factors


Process factors Human factors

Policy factors
Operational factors Supply chain factors

External factors

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Strategies are typically based on assumptions

and predictions about:


Long-term demand patterns Technological change Competitor behavior

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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

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1. 2. 3. 4. 5. 6. 7. 8.

Estimate future capacity requirements Evaluate existing capacity and facilities; identify gaps Identify alternatives for meeting requirements Conduct financial analyses Assess key qualitative issues Select the best alternative for the long term Implement alternative chosen Monitor results

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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

Decision Factor Interest Rate on Revolver Up Front Fees Size of Line Covenant Restrictions Advance Rate Unused Line Fee Default Rate Friendliness of Lender

Weight (1-10) 8 3 7 7 5

3
5

Decision Factor Interest Rate on Revolver Up Front Fees

Weight (1-10) 8 3

Lender 1 Lender 2 Lender 3 Lender 4 1 2 3 1 2 3 4 4

Size of Line
Covenant Restrictions Advance Rate Unused Line Fee Default Rate Friendliness of Lender

7
7 5 3 5 7

3
4 1 2 2 1

2
3 2 1 1 2

1
2 2 1 2 3

4
1 1 2 1 4

Lender 1 Decision Factor Interest Rate on Revolver Up Front Fees Size of Line Covenant Restrictions Advance Rate Unused Line Fee Default Rate Friendliness of Lender Weight 8 3 7 7 5 3 5 7 Total Score Rank 4 2 1 1 4 3 2 4 Score 32 6 7 7 20 9 10 28 119

Lender 2 Rank 2 4 3 2 3 4 2 3 Score 16 12 21 14 15 12 10 21 121

Lender 3 Rank 3 3 4 3 3 4 3 2 Score 24 9 28 21 15 12 15 14 138

Lender 4 Rank 1 1 1 4 4 3 4 1 Score 8 3 7 28 20 9 20 7 102

Criterion
ROI

Weight
15% 10% 15%

Alternative A
2 3 2

Alternative B Alternative C
4 5 4 10 10 10

Financial

Payback NPV Alignment with strategic objectives

10%

Organizational

Likelihood of achieving projects MOV Availability of skilled team members

10%

5% 5% 5% 5% 10% 10%

5 4 5 3 2 2

5 6 7 5 4 5

4 7 6 5 9 8

Project

Maintainability Time to develop Risk Customer satisfaction

External Total Score

Increased market share

100%

2.65

4.85

8.50

Notes: Risk scores have a reverse scale i.e., higher scores for risk imply lower levels of risk

Company Critical Success Factors Weight Rating

One Score

Company Rating

Two Score

Company Rating

Three Score

Advertising
Product Quality Price Competitiveness Management Financial Position

0.20
0.10 0.10 0.10 0.15

1
4 3 4 4

0.20
0.40 0.30 0.40 0.60

4
3 2 3 2

0.80
0.30 0.20 0.30 0.30

3
2 4 3 3

0.60
0.20 0.40 0.30 0.45

Customer Loyalty
Global Expansion Market Share Total

0.10
0.20 0.05 1.00

4
4 1

0.40
0.80 0.05 3.15

3
1 4

0.30
0.20 0.20 2.60

2
2 3

0.20
0.40 0.15 2.70

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

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Calculating processing requirements requires

reasonably accurate demand forecasts, standard processing times, and available work time
NR

pD
i 1 i

where N R number of required machines pi standard processing time for product i Di demand for product i during the planning horizon T processing time available during the planning horizon
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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

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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

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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

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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

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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

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An operation in a

sequence of operations whose capacity is lower than that of the other operations

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Minimum cost

Average cost per unit

Optimal Output Rate

Rate of output

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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

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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

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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

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Minimum cost & optimal operating rate are functions of size of production unit.
Average cost per unit

Small
plant

Medium plant

Large plant

Output rate

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Constraint Something that limits the performance of a process or system in achieving its goals Categories Market Resource Material Financial Knowledge or competency Policy

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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

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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

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Techniques for Evaluating Alternatives


Cost-volume analysis
Financial analysis Decision theory Waiting-line analysis

Simulation

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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

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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

QBEP

FC Rv

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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.


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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

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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

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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 organizations 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

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Decision Theory

McGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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

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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

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1. 2. 3. 4. 5.

Identify the possible future states of nature Develop a list of possible alternatives Estimate the payoff for each alternative for each possible future state of nature If possible, estimate the likelihood of each possible future state of nature Evaluate alternatives according to some decision criterion and select the best alternative

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A table showing the expected payoffs for each alternative in every possible state of nature
Possible Future Demand
Alternatives Small facility Medium facility Large Facility Low $10 7 (4) Moderate $10 12 2 High $10 12 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
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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

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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

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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

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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

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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

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Possible Future Demand Alternatives Small Facility Medium Facility Large Facility Low $10 7 (4) Moderate $10 12 2 High $10 12 16

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

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Possible Future Demand Alternatives Small Facility Medium Facility Large Facility Low $10 7 (4) Moderate $10 12 2 High $10 12 16

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

Possible Future Demand Alternatives Small Facility Medium Facility Large Facility Low $10 7 (4) Moderate $10 12 2 High $10 12 16

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

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Possible Future Demand Alternatives Small Facility Medium Facility Large Facility Low $10 7 (4) Moderate $10 12 2 High $10 12 16

Construct a regret (or opportunity loss) table The difference between a given payoff and the best payoff for a state of nature Regrets Alternatives Small Facility Medium Facility Large Facility Low $0 3 14 Moderate $2 0 10 High $6 4 0
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Regrets Alternatives Small Facility Medium Facility Large Facility Low $0 3 14 Moderate $2 0 10 High $6 4 0

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

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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

Possible Future Demand Alternatives Small Facility Medium Facility Large Facility Low (.30) $10 7 (4) Moderate (.50) $10 12 2 High (.20) $10 12 16

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

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Decision tree A schematic representation of the available alternatives and their possible consequences Useful for analyzing sequential decisions

5S-65

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)

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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. $40
$40

2
1 2

Overtime

$50 $55 ($10)

$50

$70

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$40 $40

2
1

Overtime

$50 $55 ($10)

2
$50

$70

EVSmall = .40(40) + .60(55) = $49 EVLarge = .40(50) + .60(70) = $62 Build the large facility
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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

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Possible Future Demand Alternatives Small Facility Medium Facility Large Facility Low (.30) $10 7 (4) Moderate (.50) $10 12 2 High (.20) $10 12 16

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
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Regrets Alternatives Small Facility Medium Facility Large Facility Low (.30) $0 3 14 Moderate (.50) $2 0 10 High (.20) $6 4 0

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
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Sensitivity analysis
Determining the range of probability for which an

alternative has the best expected payoff

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