Operations Management Supplement 7 – Capacity Planning PowerPoint presentation to accompany Heizer/Render Principles of Operations Management, 6e Operations Management, 8e © 2006 Prentice Hall, Inc.

Outline Capacity Capacity Planning Design and Effective Capacity Capacity and Strategy Capacity Considerations Managing Demand Capacity Planning

Outline – Continued Breakeven Analysis Single-Product Case Multiproduct Case Applying Decision Trees to Capacity Decisions

Outline – Continued Applying Investment Analysis to Strategy-Driven Investments Investment, Variable Cost, and Cash Flow Net Present Value

Learning Objectives When you complete this supplement, you should be able to: Identify or Define: Capacity Design capacity Effective capacity Utilization

Learning Objectives When you complete this supplement, you should be able to: Describe or Explain: Capacity considerations Net present value analysis Break-even analysis Financial considerations Strategy-driven investments

Capacity The throughput, or the number of units a facility can hold, receive, store, or produce in a period of time Determines fixed costs Determines if demand will be satisfied Three time horizons This slide provides some reasons that capacity is an issue. The following slides guide a discussion of capacity.

Planning Over a Time Horizon Modify capacity Use capacity Long-range planning Add facilities Add long lead time equipment * Intermediate-range planning Subcontract Add personnel Add equipment Build or use inventory Add shifts Short-range planning Schedule jobs Schedule personnel Allocate machinery * * Limited options exist Figure S7.1

Design and Effective Capacity Design capacity is the maximum theoretical output of a system Normally expressed as a rate Effective capacity is the capacity a firm expects to achieve given current operating constraints Often lower than design capacity This slide can be used to frame a discussion of capacity. Points to be made might include: - capacity definition and measurement is necessary if we are to develop a production schedule - while a process may have “maximum” capacity, many factors prevent us from achieving that capacity on a continuous basis. Students should be asked to suggest factors which might prevent one from achieving maximum capacity.

Utilization and Efficiency Utilization is the percent of design capacity achieved Utilization = Actual Output/Design Capacity Efficiency is the percent of effective capacity achieved Efficiency = Actual Output/Effective Capacity

Bakery Example Actual production last week = 148,000 rolls Effective capacity = 175,000 rolls Design capacity = 1,200 rolls per hour Bakery operates 7 days/week, 3 - 8 hour shifts Design capacity = (7 x 3 x 8) x (1,200) = 201,600 rolls It might be useful at this point to discuss typical equipment utilization rates for different process strategies if you have not done so before.

Bakery Example Actual production last week = 148,000 rolls Effective capacity = 175,000 rolls Design capacity = 1,200 rolls per hour Bakery operates 7 days/week, 3 - 8 hour shifts Design capacity = (7 x 3 x 8) x (1,200) = 201,600 rolls It might be useful at this point to discuss typical equipment utilization rates for different process strategies if you have not done so before.

Bakery Example Actual production last week = 148,000 rolls Effective capacity = 175,000 rolls Design capacity = 1,200 rolls per hour Bakery operates 7 days/week, 3 - 8 hour shifts Design capacity = (7 x 3 x 8) x (1,200) = 201,600 rolls It might be useful at this point to discuss typical equipment utilization rates for different process strategies if you have not done so before. Utilization = 148,000/201,600 = 73.4%

Bakery Example Actual production last week = 148,000 rolls Effective capacity = 175,000 rolls Design capacity = 1,200 rolls per hour Bakery operates 7 days/week, 3 - 8 hour shifts Design capacity = (7 x 3 x 8) x (1,200) = 201,600 rolls It might be useful at this point to discuss typical equipment utilization rates for different process strategies if you have not done so before. Utilization = 148,000/201,600 = 73.4%

Bakery Example Actual production last week = 148,000 rolls Effective capacity = 175,000 rolls Design capacity = 1,200 rolls per hour Bakery operates 7 days/week, 3 - 8 hour shifts Design capacity = (7 x 3 x 8) x (1,200) = 201,600 rolls It might be useful at this point to discuss typical equipment utilization rates for different process strategies if you have not done so before. Utilization = 148,000/201,600 = 73.4% Efficiency = 148,000/175,000 = 84.6%

Bakery Example Actual production last week = 148,000 rolls Effective capacity = 175,000 rolls Design capacity = 1,200 rolls per hour Bakery operates 7 days/week, 3 - 8 hour shifts Design capacity = (7 x 3 x 8) x (1,200) = 201,600 rolls It might be useful at this point to discuss typical equipment utilization rates for different process strategies if you have not done so before. Utilization = 148,000/201,600 = 73.4% Efficiency = 148,000/175,000 = 84.6%

Bakery Example Actual production last week = 148,000 rolls Effective capacity = 175,000 rolls Design capacity = 1,200 rolls per hour Bakery operates 7 days/week, 3 - 8 hour shifts Efficiency = 84.6% Efficiency of new line = 75% Expected Output = (Effective Capacity)(Efficiency) It might be useful at this point to discuss typical equipment utilization rates for different process strategies if you have not done so before. = (175,000)(.75) = 131,250 rolls

Bakery Example Actual production last week = 148,000 rolls Effective capacity = 175,000 rolls Design capacity = 1,200 rolls per hour Bakery operates 7 days/week, 3 - 8 hour shifts Efficiency = 84.6% Efficiency of new line = 75% Expected Output = (Effective Capacity)(Efficiency) It might be useful at this point to discuss typical equipment utilization rates for different process strategies if you have not done so before. = (175,000)(.75) = 131,250 rolls

Capacity and Strategy Capacity decisions impact all 10 decisions of operations management as well as other functional areas of the organization Capacity decisions must be integrated into the organization’s mission and strategy You might point out to students that this slide links capacity to work measurement (standard times).

Managing Demand Demand exceeds capacity Capacity exceeds demand Curtail demand by raising prices, scheduling longer lead time Long term solution is to increase capacity Capacity exceeds demand Stimulate market Product changes Adjusting to seasonal demands Produce products with complimentary demand patterns

Economies and Diseconomies of Scale Number of Rooms 25 50 75 (dollars per room per night) Average unit cost 25 - Room Roadside Motel 75 - Room Roadside Motel 50 - Room Roadside Motel Economies of scale Diseconomies of scale Figure S7.2

Capacity Considerations Forecast demand accurately Understanding the technology and capacity increments Find the optimal operating level (volume) Build for change

Tactics for Matching Capacity to Demand Making staffing changes Adjusting equipment and processes Purchasing additional machinery Selling or leasing out existing equipment Improving methods to increase throughput Redesigning the product to facilitate more throughput

Complementary Demand Patterns By combining both, the variation is reduced 4,000 – 3,000 – 2,000 – 1,000 – J F M A M J J A S O N D J F M A M J J A S O N D J Sales in units Time (months) Snowmobile sales Jet ski sales Figure S7.3

Approaches to Capacity Expansion (a) Leading demand with incremental expansion Demand Expected demand New capacity (b) Leading demand with one-step expansion Demand New capacity Expected demand (c) Capacity lags demand with incremental expansion Demand New capacity Expected demand (d) Attempts to have an average capacity with incremental expansion Demand New capacity Expected demand This slide probably requires some discussion or explanation. Perhaps the best place to start is the left hand column where capacity either leads or lags demand incrementally. As you continue to explain the options, ask students to suggest advantages or disadvantages of each. Figure S7.4

Approaches to Capacity Expansion (a) Leading demand with incremental expansion Demand Time (years) 1 2 3 New capacity Expected demand This slide probably requires some discussion or explanation. Perhaps the best place to start is the left hand column where capacity either leads or lags demand incrementally. As you continue to explain the options, ask students to suggest advantages or disadvantages of each. Figure S7.4

Approaches to Capacity Expansion (b) Leading demand with one-step expansion Demand Time (years) 1 2 3 New capacity Expected demand This slide probably requires some discussion or explanation. Perhaps the best place to start is the left hand column where capacity either leads or lags demand incrementally. As you continue to explain the options, ask students to suggest advantages or disadvantages of each. Figure S7.4

Approaches to Capacity Expansion (c) Capacity lags demand with incremental expansion Demand Time (years) 1 2 3 New capacity Expected demand This slide probably requires some discussion or explanation. Perhaps the best place to start is the left hand column where capacity either leads or lags demand incrementally. As you continue to explain the options, ask students to suggest advantages or disadvantages of each. Figure S7.4

Approaches to Capacity Expansion (d) Attempts to have an average capacity with incremental expansion Demand Time (years) 1 2 3 New capacity Expected demand This slide probably requires some discussion or explanation. Perhaps the best place to start is the left hand column where capacity either leads or lags demand incrementally. As you continue to explain the options, ask students to suggest advantages or disadvantages of each. Figure S7.4

Break-Even Analysis Technique for evaluating process and equipment alternatives Objective is to find the point in dollars and units at which cost equals revenue Requires estimation of fixed costs, variable costs, and revenue This chart introduces breakeven analysis and the breakeven or crossover chart. As you discuss the assumptions upon which this techniques is based, it might be a good time to introduce the more general topic of the limitations of and use of models. Certainly one does not know all information with certainty, money does have a time value, and the hypothesized linear relationships hold only within a range of production volumes. What impact does this have on our use of the models?

Break-Even Analysis Fixed costs are costs that continue even if no units are produced Depreciation, taxes, debt, mortgage payments Variable costs are costs that vary with the volume of units produced Labor, materials, portion of utilities Contribution is the difference between selling price and variable cost This chart introduces breakeven analysis and the breakeven or crossover chart. As you discuss the assumptions upon which this techniques is based, it might be a good time to introduce the more general topic of the limitations of and use of models. Certainly one does not know all information with certainty, money does have a time value, and the hypothesized linear relationships hold only within a range of production volumes. What impact does this have on our use of the models?

Break-Even Analysis Assumptions Costs and revenue are linear functions Generally not the case in the real world We actually know these costs Very difficult to accomplish There is no time value of money This chart introduces breakeven analysis and the breakeven or crossover chart. As you discuss the assumptions upon which this techniques is based, it might be a good time to introduce the more general topic of the limitations of and use of models. Certainly one does not know all information with certainty, money does have a time value, and the hypothesized linear relationships hold only within a range of production volumes. What impact does this have on our use of the models?

Total cost = Total revenue Break-Even Analysis – 900 – 800 – 700 – 600 – 500 – 400 – 300 – 200 – 100 – | | | | | | | | | | | | 0 100 200 300 400 500 600 700 800 900 1000 1100 Cost in dollars Volume (units per period) Total revenue line Profit corridor Loss corridor Total cost line Break-even point Total cost = Total revenue Variable cost This chart introduces breakeven analysis and the breakeven or crossover chart. As you discuss the assumptions upon which this techniques is based, it might be a good time to introduce the more general topic of the limitations of and use of models. Certainly one does not know all information with certainty, money does have a time value, and the hypothesized linear relationships hold only within a range of production volumes. What impact does this have on our use of the models? Fixed cost Figure S7.5

Break-Even Analysis TR = TC F or BEPx = P - V Px = F + Vx BEPx = Break-even point in units BEP$ = Break-even point in dollars P = Price per unit (after all discounts) x = Number of units produced TR = Total revenue = Px F = Fixed costs V = Variable costs TC = Total costs = F + Vx Break-even point occurs when This chart introduces breakeven analysis and the breakeven or crossover chart. As you discuss the assumptions upon which this techniques is based, it might be a good time to introduce the more general topic of the limitations of and use of models. Certainly one does not know all information with certainty, money does have a time value, and the hypothesized linear relationships hold only within a range of production volumes. What impact does this have on our use of the models? TR = TC or Px = F + Vx BEPx = F P - V

Break-Even Analysis BEP$ = BEPx P = P = Profit = TR - TC P - V BEPx = Break-even point in units BEP$ = Break-even point in dollars P = Price per unit (after all discounts) x = Number of units produced TR = Total revenue = Px F = Fixed costs V = Variable costs TC = Total costs = F + Vx BEP$ = BEPx P = P = F (P - V)/P P - V 1 - V/P Profit = TR - TC = Px - (F + Vx) = Px - F - Vx = (P - V)x - F This chart introduces breakeven analysis and the breakeven or crossover chart. As you discuss the assumptions upon which this techniques is based, it might be a good time to introduce the more general topic of the limitations of and use of models. Certainly one does not know all information with certainty, money does have a time value, and the hypothesized linear relationships hold only within a range of production volumes. What impact does this have on our use of the models?

Break-Even Example Fixed costs = $10,000 Material = $.75/unit Direct labor = $1.50/unit Selling price = $4.00 per unit BEP$ = = F 1 - (V/P) $10,000 1 - [(1.50 + .75)/(4.00)]

Break-Even Example Fixed costs = $10,000 Material = $.75/unit Direct labor = $1.50/unit Selling price = $4.00 per unit BEP$ = = F 1 - (V/P) $10,000 1 - [(1.50 + .75)/(4.00)] = = $22,857.14 $10,000 .4375 BEPx = = = 5,714 F P - V $10,000 4.00 - (1.50 + .75)

Break-Even Example Revenue Break-even point Total costs Fixed costs 50,000 – 40,000 – 30,000 – 20,000 – 10,000 – – | | | | | | 0 2,000 4,000 6,000 8,000 10,000 Dollars Units Revenue Break-even point Total costs Fixed costs

∑ 1 - x (Wi) Break-Even Example Multiproduct Case F BEP$ = Vi Pi where V = variable cost per unit P = price per unit F = fixed costs W = percent each product is of total dollar sales i = each product

Multiproduct Example Fixed costs = $3,500 per month Annual Forecasted Item Price Cost Sales Units Sandwich $2.95 $1.25 7,000 Soft drink .80 .30 7,000 Baked potato 1.55 .47 5,000 Tea .75 .25 5,000 Salad bar 2.85 1.00 3,000

Multiproduct Example Fixed costs = $3,500 per month Annual Forecasted Item Price Cost Sales Units Sandwich $2.95 $1.25 7,000 Soft drink .80 .30 7,000 Baked potato 1.55 .47 5,000 Tea .75 .25 5,000 Salad bar 2.85 1.00 3,000 Sandwich $2.95 $1.25 .42 .58 $20,650 .446 .259 Soft drink .80 .30 .38 .62 5,600 .121 .075 Baked 1.55 .47 .30 .70 7,750 .167 .117 potato Tea .75 .25 .33 .67 3,750 .081 .054 Salad bar 2.85 1.00 .35 .65 8,550 .185 .120 $46,300 1.000 .625 Annual Weighted Selling Variable Forecasted % of Contribution Item (i) Price (P) Cost (V) (V/P) 1 - (V/P) Sales $ Sales (col 5 x col 7)

Multiproduct Example ∑ 1 - x (Wi) BEP$ = F Vi Pi = = $67,200 = = $67,200 $3,500 x 12 .625 Fixed costs = $3,500 per month Annual Forecasted Item Price Cost Sales Units Sandwich $2.95 $1.25 7,000 Soft drink .80 .30 7,000 Baked potato 1.55 .47 5,000 Tea .75 .25 5,000 Salad bar 2.85 1.00 3,000 Daily sales = = $215.38 $67,200 312 days Sandwich $2.95 $1.25 .42 .58 $20,650 .446 .259 Soft drink .80 .30 .38 .62 5,600 .121 .075 Baked 1.55 .47 .30 .70 7,750 .167 .117 potato Tea .75 .25 .33 .67 3,750 .081 .054 Salad bar 2.85 1.00 .35 .65 8,550 .185 .120 $46,300 1.000 .625 Annual Weighted Selling Variable Forecasted % of Contribution Item (i) Price (P) Cost (V) (V/P) 1 - (V/P) Sales $ Sales (col 5 x col 7) .446 x $215.38 $2.95 = 32.6  33 sandwiches per day

Decision Trees and Capacity Decision -$14,000 -$90,000 Market unfavorable (.6) Market favorable (.4) $100,000 Large plant $18,000 Market favorable (.4) Market unfavorable (.6) $60,000 -$10,000 Medium plant Market favorable (.4) Market unfavorable (.6) $40,000 -$5,000 Small plant $0 Do nothing $13,000

Strategy-Driven Investment Operations may be responsible for return-on-investment (ROI) Analyzing capacity alternatives should include capital investment, variable cost, cash flows, and net present value This slide suggests that the process selection decision should be considered in light of the larger strategic initiative

Net Present Value (NPV) F (1 + i)N where F = future value P = present value i = interest rate N = number of years

NPV Using Factors F P = = FX (1 + i)N where X = a factor from Table S7.1 defined as = 1/(1 + i)N and F = future value Year 5% 6% 7% … 10% 1 .952 .943 .935 .909 2 .907 .890 .873 .826 3 .864 .840 .816 .751 4 .823 .792 .763 .683 5 .784 .747 .713 .621 Portion of Table S7.1

Present Value of an Annuity An annuity is an investment which generates uniform equal payments S = RX where X = factor from Table S7.2 S = present value of a series of uniform annual receipts R = receipts that are received every year of the life of the investment

Present Value of an Annuity Portion of Table S7.2 Year 5% 6% 7% … 10% 1 .952 .943 .935 .909 2 1.859 1.833 1.808 1.736 3 2.723 2.676 2.624 2.487 4 4.329 3.465 3.387 3.170 5 5.076 4.212 4.100 3.791