Chapter 5 Strategic Capacity Planning Slides prepared by

Learning Objectives LO 1 Define capacity, explain the importance of long-term capacity, know how to measure capacity and understand two related performance measures, and describe factors influencing effective capacity. LO 2 Describe the strategic capacity planning process in organizations, know how to forecast demand calculate capacity requirements, and discuss major considerations for developing capacity alternatives, LO 3 Describe the break-even analysis approach for evaluating capacity alternatives, and use it to solve problems. 2 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Chapter Outline ® What is capacity? ® Measuring capacity ® Factors influencing capacity ® Developing capacity alternatives ® Evaluating alternatives 3 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

What is capacity? Capacity is the upper limit on the load that an operating unit can handle. ®The basic questions in capacity handling are: ®What kind of capacity is needed? ®How much is needed? ®When is it needed? 4 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Importance of Long-Term Capacity Impacts ability to meet future demands Affects operating costs Major determinant of initial costs Involves long-term commitment Affects competitiveness 5 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Measuring capacity ®Design capacity ®maximum obtainable output under ideal conditions ®Effective capacity ®Maximum capacity given delays, product mix, scheduling difficulties, and other realities. ®Actual output ®rate of output actually achieved—cannot exceed effective capacity. 6 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Common Measures of Capacity Business Inputs Auto manufacturing Steel mill Oil refinery Farming Restaurant Theatre Retail sales Barrels of crude oil used per day Number of acres Number of tables, number of seats Number of seats Square metres of floor space, sales per sq. ft. Outputs Number of cars per shift Tonnes of steel per day Barrels of gasoline per day Bushels of grain per acres per year, litres of milk per day Number of meals / day Number of tickets sold per day Revenue generated per day 7 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Efficiency and Utilization 8 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All

Efficiency/Utilization Example Design capacity = 50 trucks/day Effective capacity = 40 trucks/day Actual output = 36 units/day 9 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Example: Capacity Actual production last week = 32, 000 units Effective capacity = 35, 000 units Design capacity = 250 units per hour Factory operates 7 days/week, 3 - 8 hour shifts Design capacity = (7 x 3 x 8) x (250) = 42, 000 units ®What is the design capacity for one week? ®Calculate the efficiency and utilization rates. 10 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Example: Capacity Actual production last week = 32, 000 units Effective capacity = 35, 000 units Design capacity = 250 units per hour Factory operates 7 days/week, 3 - 8 hour shifts Design capacity = (7 x 3 x 8) x (250) = 42, 000 units Utilization = 32, 000/42, 000 = 76. 2% 11 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Example: Capacity Actual production last week = 32, 000 units Effective capacity = 35, 000 units Design capacity = 250 units per hour Factory operates 7 days/week, 3 - 8 hour shifts Design capacity = (7 x 3 x 8) x (250) = 42, 000 units Utilization = 32, 000/42, 000 = 76. 2% Efficiency = 32, 000/35, 000 = 91. 4% 12 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Factors Influencing Capacity ® Facilities ®Floor space, layout ® Products or services ®Limited menu in a restaurant ® Human ®Training, skills and experience ® Planning and Operational ®No of shifts per day, inventory, quality control ® External ®Pollution standards, paper work 13 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Factors Influencing Capacity Facilities Products or services Planning and Operational Human External 14 Copyright

Capacity planning process 1. Forecast demand one to five years ahead 2. Determine capacity requirements 3. Measure the capacity now and decide how to bridge the gap a) Generate feasible alternatives b) Evaluate alternatives considering economic and non economic aspects c) Choose the best alternative and implement it 15 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

0 Growth Volume Some Possible Growth Patterns Time 0 Decline Time Cyclical Volume 0

Calculating Capacity Requirements A department works one eight hour shift, 250 days a year, and has these figures for products, their demand, and usage of a type of machine that is currently being considered. How many machines would be needed to handle the required volume? Product Annual Demand Standard Processing time per unit (hr. ) Processing time needed (hr. ) #1 400 5. 0 2, 000 #2 300 8. 0 2, 400 #3 700 2. 0 1, 400 17 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Developing Capacity Alternatives Design flexibility into systems Differentiate between new and mature products Take a “big picture” approach to capacity changes Prepare to deal with capacity “chunks” Attempt to smooth out capacity requirements Use capacity cushion Identify the optimal operating level 18 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Optimal operating level Average cost per unit Minimum cost & optimal operating rate are functions of size of production unit. 0 Small plant Medium plant Large plant Output rate 19 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Economies and Diseconomies of Scale Average cost per unit What makes the unit cost increase? Large Facility Small Facility Medium Facility Economies of scale Best operating level Diseconomies of scale Best operating level Output rate 20 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Economies and Diseconomies of Scale ®Economies of scale ®Fixed costs (facilities, equipment, management) spread out over more units ®Volume purchase discounts ®Diseconomies of scale ®Worker fatigue, equipment breakdown, less room for error, difficulties in coordination 21 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Evaluating alternatives ® Economic considerations ® Cost, useful life, compatibility, revenue ® Non economic considerations ® Public opinion, reactions from employees, community pressure ® Techniques used for evaluation: a) Break Even Analysis b) Payback Period c) Net Present Value 22 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Break Even Analysis 23 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All

Break-Even Analysis Total revenue it of Pr Amount ($) Break-even point Total revenue = Total cost Variable cost s os L Fixed cost Q (quantity in units) Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 24

Example: Break-Even Fixed costs = $40, 000 Labour costs = $3/unit FC QBEP =R - VC 7273 Material = $1. 50/unit Selling price = $10. 00 per unit $40, 000 = 10. 00 - (3 +1. 50) = 25 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Example: Break-even Analysis ®The school cafeteria can make pizza for about $. 30 per slice. ®Cost for kitchen and labour is $200 per day ®The nearby Pizza Den delivers for $9. 00 per pizza (8 slices) ®Cost for labour reduced to $75 per day ®Make or Buy? 26 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Break-Even Problem with Step Fixed Costs 27 Copyright © 2010 by The Mc. Graw-Hill

Multiple Break-Even Points $ TC TC 3 TC 2 TR 1 Quantity Multiple break-even

Assumptions of Break Even Analysis One product is involved Everything produced can be sold Variable cost per unit is the same regardless of volume Fixed costs do not change with volume Revenue per unit constant with volume Revenue per unit exceeds variable cost per unit 29 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Further Financial Analysis ® Cash Flow ®(cash received from sales and other sources) -- (cash outflow for labour, material, overhead, taxes) ® Present Value ®the sum, in current value, of all future cash flows of an investment proposal. ® most used methods of financial analysis: ®Payback period ®Net present value (NPV) ®Internal rate of return (IRR) 30 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

What is Capacity? Capacity usually refers to the upper limit of: A) inventories B) demand C) supplies D) rate of output E) finances Ans: D Page: 141 31 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

What is capacity? Capacity decisions are mostly long term decisions. Ans: False Page: 141 Stating capacity in dollar amounts generally results in a consistent measure of capacity. Ans: False Page: 142 32 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Capacity performance The maximum possible output given a product mix, scheduling difficulties, quality factors, and so on, is: A) utilization B) design capacity C) efficiency D) effective capacity E) available capacity Ans: D Page: 142 33 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Capacity Performance Efficiency is defined as the ratio of: A) actual output to effective capacity B) actual output to design capacity C) design capacity to effective capacity D) effective capacity to actual output E) design capacity to actual output Ans: A Page: 143 34 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Capacity Performance Utilization is defined as the ratio of: A) actual output to effective capacity B) actual output to design capacity C) design capacity to effective capacity D) effective capacity to actual output E) design capacity to actual output Ans: B Page: 143 35 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Learning Checklist þ Define capacity and identify some common ways it is measured. þ Distinguish between efficiency and utilization and be able to calculate them. þ Describe factors that influence effective capacity. þ Describe the steps of the strategic capacity planning process. þ Discuss major considerations for developing capacity alternatives. þ Use break-even analysis to solve problems. 36 Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.