Capacity strategy

Some factors influencing the overall level of capacity Forecast level of demand Consequences of over/under- supply Availability of capital Flexibility of capacity provisions Changes in future demand Uncertainty of future demand Cost structure of capacity increment Economies of scale OPERATIONS RESOURCES MARKET REQUIREMENTS Overall level of capacity

Capacity strategy issues include….. NUMBER OF SITES LOCATION OF EACH SITE ALLOCATION OF TASKS TO EACH SITE CAPACITY OF EACH SITE LONG-TERM CAPACITY CHANGE STRATEGY

Importance of capacity strategy Capacity is regarded by some people as a particularly ‘dry’ subject. The reality is very different. Not only is the idea of capacity at the very heart of what operations management is about, the failure to get capacity decisions right in the long-term (or in the short-term for that matter) can be dramatic and sometimes disastrous. Not only that, but also there are always examples of capacity strategy in the press. News stories that look at location decisions, reducing capacity by reducing the number of jobs in a firm, being surprised by the volume of demand, getting forecasts hopelessly wrong and so on, can all be exploited to illustrate aspects of capacity strategy.

Capacity can be considered as:

Strategic capacity

Strategic capacity (contd.)

NUMBER OF SITES and CAPACITY OF SITES LOCATION OF SITES ALLOCATION OF TASKS TO SITES LONG-TERM CAPACITY CHANGE STRATEGY Many small sites? Few larger sites? QuestionsOptions Supply side dominated? Demand side dominated? All sites make all products/services? Each site focuses on a few products/ services? Capacity leads demand? Capacity lags demand?

Why is capacity strategy important? Without an appropriate capacity strategy, operations will always be struggling to supply markets in a competitive manner Getting capacity strategy right is the starting point for developing competitive operations

Why is capacity strategy important? Without an appropriate capacity strategy, operations will always be struggling to supply markets in a competitive manner Getting capacity strategy right is the starting point for developing competitive operations

LONG-TERM CAPACITY CHANGE STRATEGY NUMBER OF SITES LOCATION OF EACH SITE CAPACITY OF EACH SITE ALLOCATION OF TASKS TO SITES What performance measures will all these decisions have a major impact on? Costs Revenues Cash requirements Service levels How should one judge a capacity strategy ?

The 4 V’s of capacity

Three levels of capacity decisions

Key points in capacity strategy How we manage capacity in the longer term is influenced by both market and operations resource factors. The idea of the break-even point is hugely important. Profitability and volume are not always related in a straightforward manner. The idea of economies of scale and diseconomies of scale apply to all types of operations. In particular, diseconomies of scale are a function of customer perception as well as straightforward cost implications of scale. Various decisions that make up a capacity strategy are interrelated. In particular, the idea of how many sites, how big each site should be, whether it should be specialist or generalist and its location, are all connected.

Key points in capacity strategy The dynamics of capacity change are as important as a static analysis. As volume changes, capacity must also change. Making changes that are too early, too late or of the wrong magnitude can all have serious consequences. Location is becoming a particularly important decision. The economies of location in many industries are changing fundamentally. Easier communication and globalised industries mean that the number of location options available is now often very great.

Required service level Geographical distribution of demand Economies of scale Supply costs OPERATIONS RESOURCES MARKET REQUIREMENTS Size and number of sites Some factors influencing the number and size of sites

Different approaches to location are taken by different types of business

Costs / Revenue ($) Volume in thousands of units Forecast demand = 9,000 units Cost Revenue Cost, volume, profit illustration

Unit cost (total cost / volume) Volume in thousands of units (a) Nominal capacity limit Unit cost curve

Unit cost (total cost/volume) Volume in thousands of units (b) Diseconomies of scale kick in Unit cost curve

Economies of scale Generally, the cost (C y ) of providing capacity in one increment of size y is given by C y = Ky k, Where K is a constant scale factor and k is a factor which indicates the degree of economies of scale for the technology involved (usually between 0.5 and 1.0)

Exploiting economies of scale When Ford took over the car-making division of Sweden’s Volvo for $6.45 billion, it made relatively little difference to Ford’s overall size. Volvo’s modest output of less than 400,000 cars per year was tiny by world standards. Yet the effect on Volvo’s ability to compete was significant. Even in the short term, cost savings could come from tapping into Ford’s logistics and purchasing functions. Ford’s logistics network in the USA could easily cope with Volvo’s products and the United States was Volvo’s biggest market. Similarly with purchasing: although Volvo had its own platform designs, even in the short term, it could substitute some of Ford’s components which it bought from specialist suppliers.

Changes in demand Long-term demand lower than short- term demand Short-term demand lower than long-term demand Decision varies with circumstances

Physical capacity of facilities Effective capacity Demand Volume Time Expanding physical capacity in advance of effective capacity can bring greater returns in the longer term

Cash flow with extended physical capacity Cash flow with two identical capacity increments Cumulative cash flow Time Expanding physical capacity in advance of effective capacity can bring greater returns in the longer term

Required service level Resource costs Community factors Some factors influencing the location of sites Suitability of site Image of location Land and facilities investment Resource availability OPERATIONS RESOURCES MARKET REQUIREMENTS Location of sites

Location decisions We could try contrasting the different approaches to location taken by different types of business. For example, we could compare the location decision facing a company wishing to build a new factory in a region, with a fast-food restaurant looking for a location in a town where it has no existing outlets. The idea here is to contrast two very different types of location decision.

The new factory location The new factory location would follow the ideas as set out in the chapter. These tend to assume that location is being chosen primarily on the grounds of minimizing the costs associated with the site. The amount of products sold by the company is unlikely to be very much affected by its location, but its costs could be very much affected by location factors. Furthermore, there are likely to be a very large number of sites that the company could choose from.

The fast food restaurant The fast-food restaurant, on the other hand, involves a different sort of location decision. Both revenue and costs will be affected by the location. Locating the restaurant away from other restaurants and/or away from passing trade is likely to mean a reduction in revenue. Some locations are better than others at attracting customers. Also, the costs of the location (such as rent, rates etc.) are affected by location. Finally, there are rarely a large number of options to choose the location from. Usually location is more opportunistic. The fast-food restaurant might wait until a site becomes available and then take the decision as to whether to have that site or to wait in case a better one becomes available.

Labour Transport Fabric Supplies Customs duties 15.55€ France 14.33€ Portugal 11.43€ Turkey 11.43€ Thailand 11.13€ Morocco 10.82€ Romania 10.37€ China 9.60€ Myanmar Cost in euros The cost breakdown of a shirt made in various countries and sold in France Source: Slack, N., Chambers, S. and Johnston, R. (2007) Operations Management, 5th edn. Harlow: financial Times Prentice Hall. Reproduced with permission from Pearson Education Ltd.

Forecast level of demand Required level of service Lead-time of capacity change Some factors influencing the timing of capacity change Competitor activity Uncertainty of future demand Ability to cope with change Economies of scale OPERATIONS RESOURCES MARKET REQUIREMENTS Overall level of capacity

,200 1,600 2,000 2,400 Volume (Units / week) Time Demand Capacity plans for meeting demand using either 800- or 400-unit capacity plants Capacity plan using 800-unit plants Capacity plan using 400-unit plants

Forecast demand Smaller-scale capacity increments allow the capacity plan to be adjusted to accommodate changes in demand Actual demand Capacity plan using 800-unit plants Capacity plan using 400-unit plants ,200 1,600 2,000 2,400 Volume (Units/week) Time

Current capacity = 1,010 units Required new capacity = 1,800 units Current capacity = 1,000 units Required new capacity = 1,800 units Current capacity = 900 units Required new capacity = 1,800 units Current capacity = 1,100 units Required new capacity = 1,800 units Capacity increment Operating cost Capacity increment Operating cost Capacity increment Operating cost Capacity increment Operating cost 800 units 600 units Parts manufacture Assembly plant Warehouse Distribution Rarely does each stage of a supply chain have perfectly balanced capacity because of different optimum capacity increments

Costs / Revenue ($) Volume in thousands of units Forecast demand = 9,000 units Cost Revenue Cost, volume, profit illustration

Strategies for expanding long-term capacity

The three options ….. Time Demand Capacity Volume Time Capacity Leading Strategy Demand Capacity Volume Time Capacity Lagging Strategy Demand Capacity Volume Time Capacity Smoothing Strategy

The advantages and disadvantages of pure leading, pure lagging and smoothing with inventories strategies of capacity timing

Capacity-leading strategy

Capacity-lagging strategy

Smoothing-with-inventories strategy

Capacity planning with certain forecasts and capacity introduction Output Planned capacity Forecast demand Capacity increment 1 Capacity increment 2 Capacity increment 3 Capacity increment 4 Time

Expand Yr1 Demand grows Demand level Demand grows Demand level Don’t Expand Yr1 ($8m) (0.5) A B $10m $3m $5m Decision tree for simple capacity expansion example

Decision tree for two-year analysis Growth (0.7) Level Growth (0.3) Growth (0.3) Growth (0.7) Growth (0.3) Growth (0.3) Growth (0.7) Growth (0.7) (0.3) Level (0.3) Level (0.7) Level (0.7) Level (0.7) Level (0.3) Level (0.3) Level $32m $18m $24m $15m $8m $17m $9m $18m $8m $18m $14m $8m Expand Yr 1 ($8m) Demand grows (0.5) (0.5) Demand level Expand Yr 2 ($8m) Don’t expand Yr2 B F E D C A Don’t expand Yr1