operations management chapter 5

Strategic Capacity Planning for

Products and Services

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

CapacityThe upper limit or ceiling on the load that an operating

unit can handleCapacity needs include

EquipmentSpaceEmployee skills

5-2

GoalTo achieve a match between the long-term supply

capabilities of an organization and the predicted level of long-term demandOvercapacity operating costs that are too highUndercapacity strained resources and possible loss of

customers

5-3

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?

5-4

Capacity decisions1. impact the ability of the organization to meet future demands2. affect operating costs3. are a major determinant of initial cost4. often involve long-term commitment of resources5. can affect competitiveness6. affect the ease of management7. have become more important and complex due to globalization8. need to be planned for in advance due to their consumption of

financial and other resources

5-5

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

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 capacityDesign capacity minus allowances such as personal time and

maintenance

5-7

Actual outputThe rate of output actually achievedIt cannot exceed effective capacity

Efficiency

Utilization

Measured as percentages

capacity effective

output actualEfficiency

capacitydesign

output actualnUtilizatio

5-8

Design Capacity = 50 trucks per dayEffective Capacity = 40 trucks per dayActual Output = 36 trucks per day

%9040

36

capacity effective

output actualEfficiency

%7250

36

capacitydesign

output actualnUtilizatio

5-9

FacilitiesProduct and service factorsProcess factorsHuman factorsPolicy factorsOperational factorsSupply chain factorsExternal factors

5-10

Strategies are typically based on assumptions and predictions about:Long-term demand patternsTechnological changeCompetitor behavior

5-11

Capacity CushionExtra capacity used to offset demand uncertaintyCapacity cushion = 100% - UtilizationCapacity 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

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

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

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

Decision FactorWeight (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

Lender 1 Lender 2 Lender 3 Lender 4

Decision Factor Weight Rank

Score Rank Score Rank Score Rank Score

Interest Rate on

Revolver 8 4 32 2 16 3 24 1 8

Up Front Fees 3 2 6 4 12 3 9 1 3

Size of Line 7 1 7 3 21 4 28 1 7

Covenant Restrictio

ns 7 1 7 2 14 3 21 4 28

Advance Rate 5 4 20 3 15 3 15 4 20

Unused Line Fee 3 3 9 4 12 4 12 3 9

Default Rate 5 2 10 2 10 3 15 4 20

Friendliness of Lender 7 4 28 3 21 2 14 1 7

TotalScore   119   121   138   102

Criterion Weight Alternative A Alternative B Alternative C

Financial

ROI 15% 2 4 10

Payback 10% 3 5 10

NPV 15% 2 4 10

Organizational

Alignment with strategic objectives 10% 3 5 8

Likelihood of achieving project’s MOV 10% 2 6 9

Project

Availability of skilled team members 5% 5 5 4

Maintainability 5% 4 6 7

Time to develop 5% 5 7 6

Risk 5% 3 5 5

External

Customer satisfaction 10% 2 4 9

Increased market share10% 2 5 8

Total Score 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 One Company Two Company Three

Critical Success Factors

Weight Rating Score Rating Score Rating Score

Advertising 0.20 1 0.20 4 0.80 3 0.60

Product Quality 0.10 4 0.40 3 0.30 2 0.20

Price Competitiveness

0.10 3 0.30 2 0.20 4 0.40

Management 0.10 4 0.40 3 0.30 3 0.30

Financial Position 0.15 4 0.60 2 0.30 3 0.45

Customer Loyalty 0.10 4 0.40 3 0.30 2 0.20

Global Expansion 0.20 4 0.80 1 0.20 2 0.40

Market Share 0.05 1 0.05 4 0.20 3 0.15

Total 1.00 3.15 2.60 2.70

Long-term considerations relate to overall level of capacity requirementsRequire forecasting demand over a time horizon and

converting those needs into capacity requirementsShort-term considerations relate to probable variations in capacity requirementsLess concerned with cycles and trends than with

seasonal variations and other variations from average

5-24

Calculating processing requirements requires reasonably accurate demand forecasts, standard processing times, and available work time

horizon planning theduring available timeprocessing

horizon planning theduring product for demand

product for timeprocessing standard

machines required ofnumber

where

1

T

iD

ip

N

T

DpN

i

i

R

k

iii

R

5-25

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 laterThe degree of demand volatility

Volume and timing of demandTime required to service individual customers

5-26

Strategies used to offset capacity limitations and that are intended to achieve a closer match between supply and demandPricingPromotionsDiscountsOther tactics to shift demand from peak periods into

slow periods

5-27

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

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

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

An operation in a sequence of operations whose capacity is lower than that of the other operations

5-31

OptimalOutputRate

5-32

Economies of ScaleIf output rate is less than the optimal level, increasing

the output rate results in decreasing average per unit costs

Diseconomies of ScaleIf the output rate is more than the optimal level,

increasing the output rate results in increasing average per unit costs

5-33

Economies of ScaleIf 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 unitsConstruction costs increase at a decreasing rate as facility

size increasesProcessing costs decrease due to standardization

5-34

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 costsInflexibility can be an issueAdditional levels of bureaucracy

5-35

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

5-36

Constraint Something that limits the performance of a process or system in

achieving its goals Categories

MarketResourceMaterialFinancialKnowledge or competencyPolicy

5-37

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

5-38

Alternatives should be evaluated from varying perspectivesEconomic

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

Techniques for Evaluating AlternativesCost-volume analysisFinancial analysisDecision theoryWaiting-line analysisSimulation

5-40

Cost-volume analysisFocuses on the relationship between cost, revenue,

and volume of outputFixed Costs (FC)

tend to remain constant regardless of output volumeVariable Costs (VC)

vary directly with volume of outputVC = Quantity(Q) x variable cost per unit (v)

Total CostTC = FC + VC

Total Revenue (TR)TR = revenue per unit (R) x Q

5-41

BEPThe volume of output at which total cost and total

revenue are equalProfit (P) = TR – TC = R x Q – (FC +v x Q)

= Q(R – v) – FC

vRQBEP

FC

5-42

5-43

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

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

Cash flowThe difference between cash received from sales and

other sources, and cash outflow for labor, material, overhead, and taxes

Present valueThe sum, in current value, of all future cash flow of an

investment proposal

5-46

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

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 decisionsCapacity planningProduct and service designEquipment selectionLocation planning

5S-49

Characteristics of decisions that are suitable for using decision theoryA set of possible future conditions that will have a

bearing on the results of the decisionA list of alternatives from which to chooseA known payoff for each alternative under each

possible future condition

5S-50

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

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

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 ofMistakes in the decision processBounded rationalitySuboptimization

5S-53

Steps:1. Identify the problem2. Specify objectives and criteria for a solution3. Develop suitable alternatives4. Analyze and compare alternatives5. Select the best alternative6. Implement the solution7. 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

Bounded rationalityThe limitations on decision making caused by costs,

human abilities, time, technology, and availability of information

SuboptimizationThe results of different departments each attempting

to reach a solution that is optimum for that department

5S-55

There are three general environment categories:Certainty

Environment in which relevant parameters have known values

RiskEnvironment in which certain future events have

probabilistic outcomesUncertainty

Environment in which it is impossible to assess the likelihood of various possible future events

5S-56

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

Possible Future Demand

Alternatives Low Moderate High

Small Facility $10 $10 $10

Medium Facility 7 12 12

Large Facility (4) 2 16

•The worst payoff for each alternative isSmall facility: $10 millionMedium facility $7 millionLarge facility -$4 million

•Choose to construct a small facility

5S-58

Possible Future Demand

Alternatives Low Moderate High

Small Facility $10 $10 $10

Medium Facility 7 12 12

Large Facility (4) 2 16

•The best payoff for each alternative isSmall facility: $10 millionMedium facility $12 millionLarge facility $16 million

•Choose to construct a large facility

5S-59

Possible Future Demand

Alternatives Low Moderate High

Small Facility $10 $10 $10

Medium Facility 7 12 12

Large Facility (4) 2 16

•The average payoff for each alternative isSmall facility: (10+10+10)/3 = $10 millionMedium facility (7+12+12)/3 = $10.33 millionLarge facility (-4+2+16)/3 = $4.67 million

•Choose to construct a medium facility

5S-60

Possible Future Demand

Alternatives Low Moderate High

Small Facility $10 $10 $10

Medium Facility 7 12 12

Large Facility (4) 2 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 Low Moderate High

Small Facility $0 $2 $6

Medium Facility

3 0 4

Large Facility 14 10 0 5S-61

Regrets

Alternatives Low Moderate High

Small Facility $0 $2 $6

Medium Facility 3 0 4

Large Facility 14 10 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

5S-62

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 Low (.30) Moderate (.50) High (.20)

Small Facility $10 $10 $10

Medium Facility 7 12 12

Large Facility (4) 2 16

EMVsmall = .30(10) +.50(10) +.20(10) = 10EMVmedium = .30(7) + .50(12) + .20(12) = 10.5EMVlarge = .30(-4) + .50(2) + .20(16) = $3

Build a medium facility

5S-64

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)

5S-66

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.

1

2

2

$40

$40

$50

$55

($10)

$50

$70

Bui

ld S

mal

l

Low Demand (.40)

Low Demand (.40)

High Demand (.60)

High Demand (.60)

Build Large

Do Nothing

Cut Prices

Do Nothing

Overtime

Expand

5S-67

1

2

2

$40

$40

$50

$55

($10)

$50

$70

Bui

ld S

mal

l

Low Demand (.40)

Low Demand (.40)

High Demand (.60)

High Demand (.60)

Build Large

Do Nothing

Cut Prices

Do Nothing

Overtime

Expand

EVSmall = .40(40) + .60(55) = $49EVLarge = .40(50) + .60(70) = $62

Build the large facility 5S-68

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

5S-69

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

EVwith perfect information = .30(10) + .50(12) + .20(16) = $12.2

EMV = $10.5

EVPI = EVwith perfect information – EMV

= $12.2 – 10.5

= $1.7You would be willing to spend up to $1.7 million to obtain perfect information

5S-70

Regrets

Alternatives Low (.30) Moderate (.50) High (.20)

Small Facility $0 $2 $6

Medium Facility 3 0 4

Large Facility 14 10 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

5S-71

Sensitivity analysisDetermining the range of probability for which an

alternative has the best expected payoff

5S-72