Fundamentals of Operations Management
Chapter 4: Strategic Capacity Planning
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4.0 Learning Outcomes
In this chapter, we will:
• Explain the importance of strategic capacity planning and its role in aligning production capabilities with
market demand.
• Analyze the broader organizational effects of capacity decisions and evaluate their strategic
implications.
• Apply key capacity measures and performance indicators to assess and optimize operational
performance.
• Select and justify appropriate capacity measures for different contexts to ensure accurate capacity
assessment.
• Identify and analyze the determinants that influence effective capacity in an organization.
• Outline the steps in the capacity planning process and apply them to develop effective capacity
strategies.
• Identify bottlenecks in sequential processes and propose strategies to mitigate their impact on overall
process capacity.
• Analyze the bottleneck phenomenon and its implications for process capacity and throughput.
• Perform break-even analysis to evaluate capacity alternatives and make informed capacity decisions.
• Explain the relationship between capacity planning and economies of scale and evaluate their impact on
long-term capacity decisions.
4.1 Introduction
• Businesses develop strategies to increase market share by leveraging their
competitive advantages and understanding market forces.
• Determining the right products and services to produce is crucial, but businesses
must also assess their capacity to meet market demand.
• Strategic capacity planning is essential to align production capabilities with
market demand, requiring consideration of equipment, space, and workforce.
• Inadequate capacity planning can lead to increased costs, resource constraints,
and loss of customers.
• Effective capacity planning contributes to operational efficiency, competitiveness,
customer satisfaction, and long-term sustainability.
• Strategic capacity planning requires a long-term, holistic approach to ensure
resource optimization and support organizational growth and success.
4.2 Organizational Impact of Capacity
Decisions Leading Capacity Strategy:
• Capacity decisions impact various • Proactively increases capacity in anticipation
organizational aspects beyond of future demand, positioning organizations to
operational boundaries, influencing meet demand efficiently.
competitive position and long-term
trajectory.
• Each capacity strategy offers distinct Following Capacity Strategy:
advantages and trade-offs, affecting • Reactively expands capacity after
responsiveness to market dynamics, increased demand to minimize excess
resource utilization, and risk exposure. capacity and costs.
• Capacity decisions must be evaluated
within the broader organizational
context, considering their impact on Tracking Capacity Strategy:
financial performance, operational • Gradually adds capacity to align with evolving
agility, customer satisfaction, and demand patterns, maintaining a balance
strategic objectives. between capacity and demand.
4.3 Key Capacity Measures and Performance
Indicators
• Represents the maximum theoretical output
rate or capacity under ideal conditions as • Monitoring efficiency and
Design Capacity: envisioned by the system’s design utilization provides insights
specifications. into operational
performance, helping identify
• A more realistic measure accounting for real-
areas for improvement and
Effective world constraints like planned downtime and
maintenance, derived by subtracting these informing capacity
Capacity: optimization strategies.
factors from the design capacity.
• High efficiency and
• Measures how effectively the available utilization rates might
Efficiency: effective capacity is utilized, calculated as indicate a need for capacity
(Actual Output ÷ Effective Capacity) × 100%. expansions, while low rates
could highlight bottlenecks,
• Quantifies the extent to which the maximum inefficiencies, or excess
Utilization: design capacity is leveraged, calculated as capacity requiring
(Actual Output ÷ Design Capacity) × 100%. adjustments.
4.4 Capacity Planning: A Holistic Approach for
Products and Services
Capacity refers to a system’s potential to produce goods or deliver services within a
specified timeframe, involving long-term and short-term considerations.
• Excess Capacity: Occurs when
actual production is lower than Key Inputs in Capacity Planning:
potential, indicating lower market Capacity Type: Identifying the specific type
demand than supply capabilities of capacity needed (production facilities,
and leading to increased costs and equipment, human resources, etc.).
inefficiencies.
• Holistic Approach: Considering Capacity Quantity: Determining the precise
these inputs helps optimize amount of capacity required to meet demand.
resource allocation, enhance • Capacity Timing: Establishing the best
operational efficiency, and ensure timing for capacity adjustments to match
long-term success in dynamic market conditions and demand patterns.
markets.
4.5 Defining and Measuring Capacity
• Stable Metrics: Choose capacity measures that don’t require frequent updates, avoiding metrics like
dollar amounts which are affected by price fluctuations.
• Product-Specific Capacity: Measure capacity in terms of each product, such as stating the capacity to
produce 100 microwaves or 75 refrigerators, for greater clarity and accuracy.
• Input-Based Measures: Consider using input availability, such as labor hours or floor space, especially
when dealing with diverse output types.
• Context-Specific Measures: Select the capacity measure based on the specific context, including the
nature of products/services, production processes, and operational complexities.
• Accurate Understanding: Adopting a tailored approach to capacity measurement enables better
understanding of production capabilities, informing effective decision-making and capacity planning.
Type of Business Input Measures of Capacity Output Measures of Capacity
Car manufacturer Labour hours Cars per shift
Hospital Available beds Patients per month
Pizza parlour Labour hours Pizzas per day
Retail store Floor space (sq. ft.) Revenue per sq. ft.
4.6 Determinants of Effective Capacity
Facilities Policy Factors
•Size, expansion potential, location (transportation •Management policies on overtime, shifts, and work
costs, market proximity, labor availability, energy arrangements influence capacity.
access), and layout impact efficiency.
Product and Service Factors Operational Factors
•Uniformity allows for standardization and increased •Equipment capabilities, inventory decisions,
capacity; diversity introduces complexity. delivery schedules, purchasing, and quality control
impact capacity.
Process Factors Supply Chain Factors
•Quality and productivity improvements enhance •Capacity changes affect suppliers, warehousing,
capacity; changeover time between transportation, and distributors.
products/services is crucial.
Human Factors External Factors
•Tasks, training, skills, experience, motivation, •Regulatory requirements and minimum
absenteeism, and labor turnover affect output. quality/performance standards restrict capacity
options.
4.7 The Capacity Planning Process: A
Systematic Approach
• Effective capacity planning
is a systematic process Estimate Future Select the Implement the
involving several key steps Capacity Optimal Long- Selected
to ensure alignment Requirements Term Alternative Alternative
between an organization’s
production capabilities and
strategic objectives. Evaluate Assess
• By following this systematic Existing Qualitative Monitor Results
approach, organizations Capacity and Factors for and Adjust
can proactively manage Identify Gaps Alternatives
their capacity levels,
optimize resource
utilization, and position Identify Conduct
themselves for long-term Alternatives for Financial
success in dynamic market Meeting Analyses of
environments. Requirements Alternatives
4.7 The Capacity Planning Process (cont.)
Estimate Future Evaluate Existing Identify Alternatives for Conduct Financial
Capacity Requirements: Capacity and Identify Meeting Requirements: Analyses of
Analyze demand Gaps: Assess current Explore options such as Alternatives: Perform
forecasts, market trends, capacity (facilities, expansions, upgrades, financial evaluations
and growth plans to equipment, human process improvements, (capital investments,
predict future capacity resources) and compare outsourcing, or operating costs, NPV,
needs. with forecasted reductions to align IRR, payback period) to
requirements to find gaps capacity with future assess economic viability
or surpluses. needs. of each alternative.
Assess Qualitative Select the Optimal Implement the Selected Monitor Results and
Factors for Long-Term Alternative: Alternative: Develop and Adjust: Continuously
Alternatives: Evaluate Choose the alternative execute a plan for track performance,
strategic alignment, that best aligns with acquiring resources, monitor demand
operational flexibility, risk, strategic objectives and modifying processes, changes, and adjust as
environmental impact, balances financial and training personnel, and needed to maintain
and cultural fit of each operational managing change. alignment between
alternative. considerations. capacity and
requirements.
4.8 Sequential Processes and the Bottleneck
• Sequential processes involve steps performed in a specific order, where the output of one step is the
input for the next, as seen in manufacturing assembly lines.
• Balanced cycle times across all steps are crucial to avoid issues like inventory accumulation and
resource idleness, caused by significant time variations between steps.
• Bottlenecks, the steps with
the longest cycle times,
constrain overall throughput,
leading to inefficiencies such
as inventory buildup and idle
resources.
• Identifying and addressing
bottlenecks through capacity
expansions, process
improvements, or resource
reallocation can optimize
process flow and enhance
operational efficiency.
Figure 4.5.1: A diagram displaying the effects of a bottleneck.
4.9 The Bottleneck Phenomenon and Its
Impact on Process Capacity
The bottleneck, or the slowest step, determines the capacity of the entire process.
For example, step 2, with a cycle time of 10 minutes, limits the overall output rate to
one unit every 10 minutes.
• Capacity Calculation Example: In an 8-hour shift (480 minutes), step 1 can produce 160
units, step 2 can produce 48 units, and step 3 can produce 96 units. Due to the bottleneck
at step 2, the total process output is limited to 48 units per day.
• Bottleneck Identification Importance: Recognizing and addressing the bottleneck is
essential, as investments in non-bottleneck areas do not improve overall process capacity.
• Strategies to Address Bottlenecks: Solutions include bottleneck elimination, capacity
expansion, and resource reallocation, which can enhance throughput and operational
efficiency.
• Evaluating Capacity Alternatives: Consider economic factors (e.g., break-even analysis,
payback period, NPV) and non-economic factors (e.g., public opinion, employee reactions,
community pressure) to make balanced and strategic decisions.
4.10 Break-Even Analysis: A Fundamental
Tool for Capacity Evaluation
Break-even analysis identifies the output quantity at which total revenue equals total
costs, helping evaluate capacity alternatives.
• Break-even Point (BEP): The BEP is where total revenue (TR) equals total cost (TC),
meaning the organization neither makes a profit nor incurs a loss.
• Fixed and Variable Costs: Fixed costs remain constant regardless of output quantity,
while variable costs change with production levels.
• Break-even Quantity Calculation: The break-even quantity (QBEP) is calculated using
the formula: Break-Even Quantity = Fixed Cost ÷ (Revenue per Unit – Variable Cost per
Unit)
• Decision-Making Tool: Break-even analysis helps organizations assess the risks and
returns of capacity alternatives, guiding informed decision-making.
• Application in Make-or-Buy Decisions: Break-even analysis can determine whether it is
more cost-effective to produce in-house or outsource by comparing the total costs at
different production levels.
4.11 Capacity Planning & Economies of Scale
Capacity Planning Challenge Economies of Scale Multi-Shift Operations
• Aligning production capacity with • Average unit costs decrease as • Operating in multiple shifts
fluctuating demand is difficult production increases, spreading leverages economies of scale by
due to the long-term nature and fixed costs over more units. For utilizing resources longer,
inflexibility of capacity decisions, example, using one machine to reducing average fixed costs per
involving substantial upfront produce 100 units results in unit. However, this increases
investments. lower average costs per unit variable costs, such as utilities
compared to producing 10 units. and temporary labour.
Optimal Capacity Level Diseconomies of Scale Strategic Capacity Planning
• The goal is to find the capacity • Beyond a certain production • Effective capacity planning
level that minimizes total costs threshold, additional output requires balancing economies
(fixed and variable) while increases fixed costs, leading to and diseconomies of scale,
maximizing production, diseconomies of scale. optimizing production capacity,
balancing the decrease in fixed Overexpansion can cause minimizing costs, and
costs with the rise in variable inefficiencies, increased maintaining flexibility to adapt to
costs. bureaucratic hurdles, and higher demand changes.
average unit costs.
Summary & Review
• Importance of Strategic Capacity Planning: Aligning production capabilities with market
demand from a long-term perspective is crucial for effective resource utilization.
• Capacity Strategies: Organizations can adopt leading, following, and tracking strategies
based on anticipated demand to ensure responsiveness and efficiency.
• Capacity Measures and Performance Indicators: Design capacity (maximum theoretical
output) and effective capacity (real-world constraints), along with efficiency and utilization, are
essential for assessing operational performance.
• Capacity Planning Process: A systematic approach includes estimating future capacity
needs, evaluating current capacity, identifying gaps, analyzing alternatives, and implementing
optimal solutions, with continuous monitoring and adjustments.
• Bottleneck Management: Addressing bottlenecks is vital to balance cycle times, improve
throughput, and enhance overall efficiency.
• Economies and Diseconomies of Scale: Understanding the balance between fixed and
variable costs is essential to determine the optimal capacity level and avoid overexpansion,
ensuring long-term competitiveness and sustainability.
