17 Capacity Planning: Importance and Measures

Vikas Singla

17.1 OBJECTIVES

This chapter should help students to understand:

• Ways to measure capacity
• Reasons for economies and diseconomies of sale
• Capacity gaps and ways to fill them

17.2 INTRODUCTION 

Capacity planning is an important and complex decision. It is important because capacity to fulfill increased rate of demand is necessary for a firm to earn profits and be successful. It is complex because it requires decisions regarding how much capacity to increase, what-if demand slow down then what should be done of excess capacity, when capacity should be increased etc. For example, a hotel estimating an increased demand in coming tourist season increases its capacity of rooms from 80 to 100. The decision to increase capacity becomes important as building of new rooms and provision of services would incur cost. The manager might be able to earn profits by fulfilling increase in demand but after tourist season when demand tapers down he/she faces with problems  of  underutilization  of  increased  capacity.  Thus,  decision  to  increase capacity becomes a complex decision. For illustration purpose consider example of a pizza manufacturer. Before installing capacity resources to manufacture certain amount of pizzas the firm has to consider following aspects:

• What is the estimated demand of pizzas?
• As the firm would be providing variety of pizzas so what would be the estimated demand of each kind of pizza.
• Are there chances of increase in demand: if it is so then by how much and by when?
• Should the firm use resources of one product’s capacity resulting in lower production of that product?

There are lots of questions related to capacity planning making it one of the most important decisions for management. From above illustrations capacity can be defined as amount of resources required to produce an estimated output. If output increases resources required to produce increased output also increases, but if output decreases then company’s’ resources should be flexible enough that they can be used for production of other products. It should also be noted that demand is a function of market forces which are not in the control of a firm. Whereas whether to increase or decrease capacity is a decision made by management by taking into consideration demand.

17.3 CAPACITY PLANNING CONCEPTS 

Capacity is generally defined as maximum rate of output. Now, different firms measure capacity in different units depending on their rate of output. A car manufacture defines capacity of its manufacturing plant in terms of number of cars it can produce annually. A photocopier may define capacity in terms of number of copies being photocopied per minute or per hour. A restaurant measures its capacity in terms of number of meals it can offer at a particular point in time or number of customers that can be seated in it simultaneously. Thus, there can be different measures of capacity. It is very important to define capacity of a firm in proper terms. Because improper definition can cause company to take wrong decisions. For instance, an airline measured capacity of its aircrafts in number of seats of an aircraft. With an estimated increase in demand of air travel company decided to invest heavily in purchasing costly new aircrafts. Whereas, its competitor measured capacity of aircraft in terms of miles that an aircraft covers per day because an aircraft might be able to take two to and fro trips from Delhi to Bombay in a day increasing its efficiency. Thus, this company was able to increase its profits by having different measures of capacity than measuring in terms of seating capacity.

17.2.1 Measures of Capacity 

Capacity should be measured both in terms of output and input measures. Output measures are directly based on accuracy of estimated demand of a product. A firm would increase its manufacturing capacity if increase in demand is certain and it is for long term. Also, output measure is a good measure of capacity if a company is involved in manufacturing of less variety of products. Manufacturing of standardized products makes a company easier to dedicate resources to increase capacity. India’s largest car manufacturer Maruti Suzuki estimates demand of its largest selling car Maruti Alto in terms of output measures. As demand for cars can be estimated in quite certain terms for over a long term period i.e. for more than a year or two so company can be quite sure in allocating its resources for production of increased units. Also, as Maruti Alto is a standardized product so all the increased capacity of resources is dedicated for production of same kind of product.

Capacity can also be measured by determining the existing resources a firm has for producing a good or service. This method of measuring capacity is termed as evaluating input resources. As discussed in manufacturing one kind of car Maruti Suzuki can dedicate all its resources to manufacture that car. Thus, evaluating input measures is not very much complex. But if a firm is involved in manufacturing variety of goods or services then it has to make a complex decision of allocating its limited resources for production of variety of goods. As discussed a pizza manufacturing firm provides variety of pizza so it requires allocating resources to different products. In such a case the company measures how many resources it has its disposal which can be efficiently allocated to the demand of different type of products. Measuring capacity by determining input are thus used for low volume, high variety and flexible operation systems.

Thus, it can be seen that both determination of demand and input resources to fulfill that demand are necessary and important measures of capacity. Both measures go hand-in-hand and should be done simultaneously. The proper measure of production capacity equated with that of demand would able to indicate the gap if any between demand and production. The gap would be a good indicator to make a decision about increase or decrease in capacity.

17.2.2 Types of Capacity 

Design Capacity: is the maximum output that a process or facility can achieve if every process is working under ideal conditions. Achievement of ideal conditions is near impossible because there would be breakdown of machinery, absentees, and other disruptions. Sustenance of such ideal conditions is possible only for small period of time such as for few hours or few days. Maintaining or forcing design capacity conditions would only increase costs for the firm as workers would not want to work without allowances for long period of time and other ideal conditions would not also be sustained for such periods.

Effective Capacity: Maximum output that an operation can achieve if it is carried out under normal conditions. Proper allowances, maintenance of machinery etc. signify working under normal conditions. Effective capacity can be obtained for longer period of times and is more sustainable.

Actual Capacity: A firm might not be even able to achieve its effective capacity because after giving allowances such as leaves, time for lunch etc. there might still be loss of production. Under actual conditions employees go on strike, machines breakdown and there might be some other unexpected events. Actual capacity is measure of that output which takes into consideration production time lost to such unexpected events. While estimating production a firm does take into account such events and then estimate output. That is why, output varies from shift to shift, and day to day as unexpected events vary from time to time. Thus, a proper measure of output is by calculating average of past outputs and then uses it as a future output.

Utilization: Operations might be designed to achieve a certain level of capacity but usage or utilization of resources is directly dependent on average demand or output required. Utilization is defined as the degree to which resources such as machinery or labor is being used. It is expressed in percentage and calculated by using following formula:

Utilization              =              (Actual Capacity / Maximum Capacity) * 100

Example 17.2.2.1: A class room has capacity of 60 students. On a day of delivery of guest lecture 20 more chairs were placed in the room in estimation of increased demand. But only 50 students turned up on the day. What is the utilization of class room relative to peak and effective capacity?

Peak capacity                        = 80 students

Effective Capacity                = 60 students

Actual capacity or output   = 50 students

Thus, Utilization w.r.t. peak capacity               = (50 / 80) * 100

= 62.5%

Thus, Utilization w.r.t. effective capacity        = (50 / 60) * 100

= 83.3%

17.2.3 Economies of Scale 

A firm can increase its capacity in relative to increase in demand. But increase in demand is not constant and repetitive. So in one time period there might be an increase in demand but in other it might decrease. Capacity decisions are long term and once capacity of production by acquiring machinery and labor is enhanced it becomes very difficult to reduce that capacity. This is especially true for manufacturing organizations because it requires investment in equipment and other tools. Thus, to answer the question of how much capacity to increase or in other terms what should be maximum reasonable size for a manufacturing facility  we use concept of economies of scale.

The concept of economies of scale state that with increase in number of units produced average unit cost decreases. This occurs because of spread of fixed costs over a larger number of units. Fixed costs involve cost of machinery, salary, land cost etc. Now if same amount of machinery and labor is used to produce increased number of units then cost per unit would come down. Most manufacturing firms achieve this by operating in more than one shift. Same resources are used repetitively in multiple shifts to produce more units. As fixed costs keeps decreasing with more production  variable costs  increase.  Variable costs include cost  of  electricity, rent,  and salaries for contract workers etc. When a firm operate in more than one shift then consumption of utilities such as electricity increases. Also, more labor is required to manufacture more. All this leads to increase in variable costs. Thus, increased capacity would entail decrease in fixed cost and increase in variable cost. An optimal point has to be identified where firm can produce its maximum at most optimal total cost.

Also fixed cost decrease only in short term. Same amount of resources can be used to produce a certain amount of output. But to produce more after a certain threshold more machinery and labor would be required thus, increasing fixed cost. So, management has to consider what that threshold level should be. This leads to increase in average cost of each unit. Such a concept where in increase in size or capacity leads to increase in cost rather than decrease in average cost of each unit is called as diseconomies of scale. The reason is that excessive size might bring complexity, loss of focus, too many resources to manage which might lead to inefficiencies in the operation that raise the average unit cost of product or service.

For example, a teacher might be asked to take extra classes of a subject in the evening. Now, as building and land is used so there would be no increase in fixed cost but cost of electricity and overtime payment would increase the variable cost. This would lead to decrease in fixed cost as it gets spread over larger number of students. Till a certain point the proportion of decrease in fixed costs is more than proportion of increase in variable costs leading to lower fixed costs. If administration decides to take more such classes then there would be a point where in total costs starts increasing as proportion of increase in variable cost would offset decrease in fixed costs leading to diseconomies of scale.

17.3 CAPACITY PLANNING PROCESS 

Following four step procedure is generally adopted for making proper capacity decisions.

Step 1: Estimation of future capacity 

It has been discussed that investing in increasing resources such as equipment, machinery and other tools is a direct function of demand of particular product or service. For instance, a fitness centre estimated that with increasing awareness among urban consumers regarding health and fitness issues it should invest heavily in expanding the center. Some other questions need to be answered were regarding segregating customers according to their need of equipment. Some might require cardiovascular training machines, some for weight training and some for aerobic exercises. The management needs to find out what is the future demand in each category of exercise.

Secondly as investment in enhancing capacity involves long term financial commitment so management must also take into consideration technological changes that might make current machines redundant. For instance, owner of photocopy shop wanted to expand its operations as there was increase in demand of making copies. Now, issue was whether to buy a faster operating new machine which might does the work of existing machine making it redundant or should another machine of existing kind be bought. The owner by considering technological changes extending well into future bought a multiple purpose machine which in addition to photocopying also does other operations such as scanning and printing.

Lastly,  to  meet  increased  future  demand  management  might  consider  increasing  productivity  of  its existing resources. For instance, in case of increased demand of fitness centre management might increase timing of operations or ask its labor to work for more hours. The emphasis is on increasing output by increasing usage from already available resources. It might increase cost in terms of salaries, rent and other variable cost but such increase cost would be less than investing in new resources. But after certain time existing resources might get stretched to their limit and it would not be possible to use them further without breakdowns and loss in productive time. Then question that needs to be answered is investment in new facility. The best indicator for such problem is accurate forecast of demand. If increase in demand in future is certain and for long term as was in case of fitness centre then the firm should increase their capacity by investing in new facilities.

Step 2: Identify Capacity Gaps 

Gap between projected demand as was identified in Step 1 and existing capacity is termed as capacity gap. The gaps can be positive or negative. Negative gap indicates projected demand to be more than existing capacity thus signaling management to invest in capacity expansion. A positive gap would indicate that existing capacity is still more than projected demand thus management should not waste resources in capacity expansion.

The gap would measure accurately if proper capacity measures are identified. Should an airline use input measures or output measures to measure its capacity? This problem becomes more acute if a firm is involved in producing multiple products or services. A service firm such as bank provides multiple services. Should the bank increase its labor capacity by employing for different services or should an employee be assigned to perform variety of services? This can be resolved by converting estimated demand for each service into available resources i.e.   input measures. A wrong measure of capacity would provide erroneous data regarding existing capacity. For example, a restaurant can provide 500 meals daily. The dining hall of restaurant has a seating capacity of fifty people simultaneously. It is estimated that daily on an average 350 customers enjoy the services of restaurant. Now, should the measure of capacity for restaurant be in terms of seating capacity or number of meals produced per day? Restaurants should measure capacity in terms of number of meals produced because there is a high turnover of people in restaurants. So, if one batch of 50 customers is using services then after some time another batch or individuals might be using the service.

Example: In above given illustration if it is estimated that demand is expected to increase at rate of 20% then when should company make a decision on capacity expansion:

Solution: Demand (Year 0)  = 350

Demand (Year 1) = 350 + 350 * 0.20 = 420

Demand (Year 2) = 420 + 420 * 0.20 = 504

As demand is estimated to increase after year 2 from existing capacity of 500 meals so owner of restaurant should invest in capacity expansion after year 2.

Step 3: Develop Alternatives 

The company can select one of the following alternatives regarding capacity expansion to cope with increase in future demand.

A firm might adopt wait-and-see approach.

• In such approach firm observes market response and competition reaction towards launch of new product or service. For instance, not every bank jumped to provide mobile banking services to customers. Most of the banks adopted wait-and-see approach to evaluate consumers’ reaction towards such anew service. Also, investing heavily in providing such costly service might be futile if customers don’t adopt it. Thus, in such cases it is better to observe both customers and competitions’ reaction.
• In wait-and-see approach a firm is cautious and expands capacity in small increments. This allows the firm to avoid the risks of over expansion and adoption of obsolete technologies. Another illustration is manufacturing of electric bikes. With increase in fuel prices customers were ready to adopt new bikes but because of lack of recharging infrastructure and changes in battery technology at a fast rate discouraged firms’ to expand capacity to manufacture e-bikes at a fast rate.

A firm might adopt expansionist approach.

• By adopting such an approach firms intend to stay ahead of demand expansion and thus minimize its losses because of inadequate capacity. For instance, technological advances drive sales of mobile phones and various internet applications. IT firms increase their labor and technological capacity to develop such applications so that when customers adopt them then immediate increase in demand can be readily fulfilled. In such cases firms adopting wait-and-see approach loses out to such firms.
• In short term expansionist strategy may lead to over capacity and thus loses. But, these loses are easily recovered by meeting first the exponential increase in demand. It has been observed that online retail companies such as Flip kart etc. have benefitted a lot by adopting expansionist strategy. In the beginning people had apprehensions buying online resulting in loses and overcapacity for the company. But now when industry is growing at a fast rate companies such as Flip kart who were ahead of demand curve have become prime player in the industry. This approach allows company to establish all resources and keep them ready in anticipation of increased orders.

Step 4: Evaluate Various Alternatives 

Various alternatives developed can be evaluated both qualitatively and quantitatively. Qualitative method involves managers’ experience, judgment and intuition. Experience is a great tool in case of variables which are uncertain or cannot be measured accurately. These include  long  term  demand,  competitors’ reaction, technological changes causing disruption, customer acceptance cycle etc. In such cases management create scenarios involving various alternatives by taking all the variables into consideration. For instance, what would be the impact on sales if increase in demand is low, competition is high and introduction of new product is risky? Or, how consumers would react to new technology? Such what-if analysis helps managers to evaluate various alternatives and compare implications of each alternative.

Calculating cash flows is one of basic quantitative methods. This method compares various alternatives by calculating difference between their cash inflows and outflows. The alternative which provides maximum benefit in terms of profits is selected. Waiting line models and Decision trees are other quantitative methods used in evaluating capacity decisions. Waiting line models take into consideration random and independent behavior of many customers. In airports, ticket counters, payment counters at fast food restaurants each customer arrives at different time and time taken to process their needs vary. So decision to increase payment counters or increase capacity depends on proper estimation of such random events. Waiting line models use various probability distributions to accurately resolve such issues. Decision trees anticipate competitors’ reaction to certain events. When demand is uncertain then each player in the industry becomes cautious of expanding their operations. In such cases different capacity expansion alternatives are evaluated by considering different probable scenarios of competitors’ reactions. For instance, if a company launches a product and probability of increase in demand is 40% and probability of competitor providing similar product is 30% then should company invest in capacity expansions. Similarly other scenarios are created to reach a proper capacity decision.

17.4 SUMMARY 

Capacity planning is central to the long-term success of an organization. Decision to invest and expand capacity can result in loses if there is fall in demand whereas decision not to expand might result in losing customers. Problems of capacity expansion become more acute when a firm is involved in producing multiple types of products and demand is uncertain and short term. This chapter discusses the importance of capacity expansion and also some important aspects such as how to measure capacity and what should be reasonable maximum size of a facility. Reaching to a decision of capacity expansion can be understood by adopting a systematic approach involving four discussed steps. Estimating future demand, identifying gaps with respect to existing capacity, studying alternatives and evaluating them quantitatively is the sequential process of capacity planning.

17.5 GLOSSARY 

• Capacity: is defined as maximum rate of output.
• Design Capacity: is the maximum output that a process or facility can achieve if every process is working under ideal conditions.
• Effective Capacity: is the maximum output that an operation can achieve if it is carried out under normal conditions.
• Actual  capacity:  is  measure  of  that  output  which  takes  into  consideration  production  time  lost  to unexpected events such as machinery breakdown etc.
• Utilization: is defined as the degree to which resources such as machinery or labor is being used.

17.6 REFERENCES/ SUGGESTED READINGS 

• Chase, B.R., Shankar, R., Jacobs, F.R. and Aquilano, N.J., Operations & Supply Chain Management, 12th Edition, McGraw Hill.
• Stevenson, W.J., Operations Management, 9th Edition, Tata McGraw Hill.
• Lee J. Krajewski, Operations Management, Prentice-Hall of India, New Delhi, 8th Edition.

17.7 SHORT ANSWER QUESTIONS 

1. Capacity can be measured by using…………….and…………….measures.

Answer: input, output

2. Operations are carried out in sustainable way under which capacity measure?

a.  Peak capacity                    b. Effective capacity                            c. Actual capacity

Answer: b

3. Capacity gap is the difference between…………….capacity and…………….demand.

Answer: existing, estimated

17.8 MODEL QUESTIONS

1. Management may choose to increase capacity in anticipation of demand or in response to developing demand. List the advantages and disadvantages of both approaches.
2. What are the various steps involved in capacity planning? Explain.
3. Explain various limits to growth of plant in terms of economies of scale.