Topic-8

1. Topic-8 Long Rang Capacity Planning

2. Long range capacity planning • Capacity-is the productive capability of a production facility • Capacity measurement: aggregate unit of output/input rate * single item: output rate * many items: aggregate unit of output, or aggregate unit of input. In service: input rate • Why capacity planning- matching demand fluctuation.

3. Why Matching Capacity- Matching Demand Fluctuation Output Demand Capacity? Time

4. Measurement of Capacity • Output rate capacity: -- For a facility having a single product or a few homogeneous products, the unit of measure is straightforward (barrels of beer per month) -- For a facility having a diverse mix of products, an aggregate unit of capacity must be established using a common unit of output (sales dollars per week)

5. Measurement of Capacity (II) • Input rate capacity: commonly used for service operations where output measures are particularly difficult. --Hospital use available beds per month. --Airline use available seat miles per month. --Movie theatres use available seats per month.

6. Examples of Capacity Measures

7. Design Capacity vs. Maximum Capacity • Design capacity (Q*): the amount of output at which the AUC (average unit cost) of a product facility is minimum. • Practical maximum capacity : the maximum amount of output that a facility can produce (at a higher AUC) • When Q>Q*,then AUC>AUC* • Q<Q*, also AUC>AUC*

8. Capacity Planning • Measuring Capacity • Capacity can be expressed in terms of output or inputs • Output measures- the usual choice for line flow processes • Input measures- used for flexible flow processes • Peak (Maximum) Capacity: calling for extraordinary effort under ideal conditions that are not sustainable • Effective (Design) Capacity: economically sustainable under normal conditions

9. AVC AVC Q (Output Quantity) Q* Qmax

10. AUC (Average Unit Cost) AUC Variable Cost / Unit Fixed Cost /Unit Q* Qmax Output Quantity Q* - Design Capacity Qmax – Practical Maximum Capacity

11. Economies and Diseconomies of Scale Average per Unit Cost Of Output ($) Diseconomies of scale Economies of scale Best Operating Level Annual Volume Units

12. Capacity Planning • Increasing Designed Capacity: • to remove the “bottleneck”–an operation that has the lowest effective capacity of any operation in the facility and thus limits the system’s output • Expansion of a facility’s capacity occurs only when bottleneck capacity’s increased • Flexible flow processes may have floating bottleneck due to widely varying workload on different operations at different times • Job shops have low equipment utilization rates

13. What is “Economies of Scale” • Best operating level—least average unit cost • Economies of scale—average cost per unit decrease as the volume increases toward the best operating level. • Diseconomies of scale—average cost per unit increase as the volume increase beyond the best operating level

14. Economics of Scale • Increasing a facility’s capacity- to decrease the average unit cost • Spreading fixed costs • Reducing construction costs • Cutting costs of purchased materials • Finding process advantages • As volume increases, processes shift toward a line flows • High volume may justify investment in more efficient technology • Benefits of dedicated resources include reduced inventory, reduced setups, enhanced learning effects, and process improvements

15. Diseconomies of Scale • Excessive capacity can bring complexity, loss of focus, and inefficiencies, which raise the average unit cost • Characterized by loss of agility, less innovation, risk avoidance, and excessive analysis and planning • Increasing costs result from increased congestion of workers and materials, which contribute to: • --increasing inefficiency/difficulty in scheduling • --damaged goods/reduced morale • --increased use of overtime

16. Capacity Economy • Economy of scale: Refer to the cost reduction resulting from the increase in production quantity. “Economies of scale is so vague that it can be used to justify any number of decisions, which all too often turn out to be wrong.”

17. Capacity Economy (II) • Example:

18. Capacity Economy (III) • AUC(A)< AUC(B)—Volume Economy. • AUC(C)< AUC(A)— Capacity Economy • AUC(D)< AUC(C)—Technology Economy.

19. AUC B A 12 10 C 5 D 2 60 100 200 Q

20. Increases in Incremental Facility Capacity Average per Unit Cost per Output ($) A B C Small Plant Mid-Sized Plant Large Plant Annual Volume (Units)

21. 250-unit shop 750-unit shop 500-unit shop Average unit cost (dollars per unit) Economies of scale Diseconomies of scale Output rate (units per week) Economies and Diseconomies of Scale

22. Economies of Scope • The ability to produce many product models in one flexible facility more cheaply than in separate facilities • Highly flexible and programmable automation allows quick, inexpensive products-to-product changes • Economies are created by spreading the automation cost over many products

23. Three Level Capacity Planning • 1.Long range capacity planning: T>1 year. • Decisions: planning for capacity that requires a long time to acquire. • e.g. Plant/building/equipment/high cost facility • 2. Intermediate range capacity planning: T(6-18 months). • Decisions: planning for capacity requirement (month or quarterly). • e.g. work force size/new tools/inventory/….. • 3. short range capacity planning: T (1-6moth). • Decisions: weekly (or daily) capacity planning. • e.g. overtime use/personnel transfer/alternative routings/……

24. Ways of Changing Long Range Capacity • Expand Capacity • Subcontract with other companies to become suppliers of the expanding firm’s components or entire products • Acquire other companies, facilities, or resources • Develop sites, buildings, buy equipment • Expand, update, or modify existing facilities • Reactivate facilities on standby status • Reduce Capacity • Sell existing facilities, sell inventories, and layoff or transfer employees • Mothball facilities and place on standby status, sell inventories, and layoff of transfer employees • Develop and phase in new products as other products decline

25. Capacity Planning Process • 1. Determine capacity requirement: * long range demand forecasting. • 2. Generating alternative capacity plans: *when should new capacity be added? (timing) * how much new capacity should be added (sizing) *what kind capacity should be added? (type)

26. The Timing of Capacity Increments Policy A: Capacity Leads Demand Policy B: Capacity lags Demand Units Units Capacity Demand Demand Capacity Time Time

27. Units Capacity Increments { Demand Time The Sizing of Capacity Increments Units Should the capacity be added more often in small increments (Option A) or in large increments less frequently (Option B)? Capacity Increments { Demand Time

28. Forecast of capacity required Planned unused capacity Capacity increment Capacity Time between increments Time Capacity Strategies (a) Expansionist strategy

29. Forecast of capacity required Planned use of short-term options Capacity increment Capacity Time between increments Time Capacity Strategies (b) Wait-and-see strategy

30. Capacity Strategy- I • Factors Leading to Large Capacity Strategy • When demand is variable, uncertain, or product mix changes • When finished goods inventory cannot be stored • When customer service is important • When capacity comes in large increments • When supply of materials or human resources is uncertain • Factors Leading to Small Capacity Strategy • Unused capacity costs money • Large cushions hide inefficiencies, absenteeism, unreliable material supply • When subcontractors are available to handle demand peaks

31. Capacity Strategy- II • Expansionist Strategy • Keeps ahead of demand, maintains a capacity cushion • Large, infrequent jumps in capacity/ Higher financial risk • Lower risk of losing market share/ Economies of scale • Preemptive marketing • Wait-and-See Strategy • Lags behind demand, relying on short-term peak capacity options (overtime, subcontractors) to meet demand • Lower financial risk with overly optimistic demand forecast • Lower risk of a technological advancement making a new facility obsolete • Higher risk of losing market share • Follow-the-Leader Strategy • An intermediate strategy of copying competitors’ actions • Trends to prevent anyone from gaining a competitive advantage

32. Capacity Planning Process (II) • 3. Evaluating alternative capacity plans: *Decision tree *Breakeven analysis 4.Selecting best capacity plan under given objectives 5. Locating new capacity (facility location).

33. Evaluation of Capacity Plans • Major method: • Net present value analysis • Breakeven analysis • Decision tree model • Computer simulation • Queuing Models (Service Capacity Plan)

34. Evaluation of Capacity Plans (II) • Decision model: a simplified representation of a real world problem. There are many decision models developed in the literature for different problems. • Three major elements of a decision model: • Objectives must be measurable • Decision variables must be controllable • Constraints and Assumptions.

35. Decision Tree Model • Decision tree model is primarily developed for problem where: * a series of (multiple) decisions must be made sequentially * all decisions are interrelated and interdependent and * Outcomes associated with each decision are uncertain

36. Decision Tree Model (II) • Assumptions of decision tree model: • Objective is a single measurement • All possible outcomes associated with a decision have a known probability. • Best plan is represented by the optimal expected value. • Tree structure: * Decision point * Even point * Probability of outcome

37. Low demand Don’t expand High demand Small expansion 2 Expand 1 Low demand Large expansion High demand Capacity Decisions Decision Trees

38. Low demand [0.40] $70 Don’t expand $90 High demand [0.60] Small expansion 2 Expand 1 $135 Low demand [0.40] Large expansion $40 High demand [0.60] $220 Capacity Decisions Decision Trees

39. Capacity Decisions Decision Trees Low demand [0.40] $70 Don’t expand $90 High demand [0.60] Small expansion $109 2 Expand $135 1 $135 Low demand [0.40] Large expansion $148 $40 High demand [0.60] $148 $220

40. Example Supplement: - Problem #1

41. Payoff ($ millions) (.5) Large Market 3.0 EV = 2.4 Produce & Market (.5) Marginal Mkt. 1.8 EV = 2.4 (.5) Large Market Develop Product || 2.5 Sell Idea || EV = 2.5 (.5) Marginal Mkt. EV = 2.3 2.1 Lease for Royalty (.5) Large Market EV = 2.5 2.8 Sell Idea (.5) Marginal Mkt. Company A || 2.2 EV = 2.5 (.5) Large Market || 2.6 Company B (.5) Marginal Mkt. 2.3 EV = 2.45 1.5

42. Solutions • The company should lease the concept to company A. Notice, however, that other alternatives are very close in their payoffs. • b. If the company follows your recommendation, what returns should the company expect to receive? • If the firm's estimates are correct, it will receive either $2,800,000 or $2,200,000.

43. See Example on your Supplementary – p. 8-15 to 8-17.

44. H,p= 0.7, $900 for 6 years C L,p= 0.3, $300 for 6 years H,p= 0.7, $600 for 6 years D L,p= 0.3, $500 for 6 years H,p= 0.2, $900 for 6 years E L,p= 0.8, $300 for 6 years H,p= 0.2, $600 for 6 years F L,p= 0.8, $500 for 6 years H,p= 0.7, $900 for 6 years G L,p= 0.3, $300 for 6 years H,p= 0.2, $900 for 6 years H L,p= 0.8, $300 for 6 years $4,320 $3,520 Expand, Investment = $800 2 $3,420 Do not expand H,p = 0.6 $3,920 A $2,520 Small plant Investment = $3,400 L,p = 0.4 $520 $3,120 Expand, Investment = $800 1 3 $3,120 Do not expand Large plant, Investment = $4,000 $4,320 $4,260 H,p = 0.6 $900 B L,0 = $300 $2,520 $300

45. We evaluated the three from the right-hand side. Investment and income are given in thousands of dollars. Event C: $900(6)(0.7) + $300 (6)(0.3)= $4,320 Event D: $600(6)(0.7) + $500 (6)(0.3)= $3,420 Event E: $900(6)(0.2) + $300 (6)(0.8)= $2,520 Event F: $600(6)(0.2) + $500 (6)(0.8)= $3,120 Event G: $900(6)(0.7) + $300 (6)(0.3)= $4,320 Event H: $900(6)(0.2) + $300 (6)(0.8)= $2,520

46. Decision Point 2: Expand: Income= $4,320- $800 = $3,520 Do not expand: Income=…………….....= $3,420 At this point the decision will be to expand the plant because the income for this alternative is larger. Event D will therefore be served. Decision Point 3: Expand: Income= $42,520- $800 = $1,720 Do not expand: Income=…………………= $3,120 At this point the decision will be “do not expand” because the income for this alternative is larger. Event E will therefore be served. Decision Point 1: Expand: Income= $3,920- $3,400 = $520 Do not expand: Income= $4,260- $4,00 = $260 At this point the decision will be to build a small plant. Event B therefore will be served. Thus, XYZ should initially build a small plant. At the end of one year, if demand is high, the company should expand the plant. If demand is low, the company should not expand the plant. Expected income is $520,000.

47. Linking Capacity and Other Decisions Capacity cushion, resource flexibility, inventory, and longer lead times all serve as buffers against uncertainty- A change in one area may affect decisions in the other area

48. Linking Capacity and Other Decisions • A Systematic Approach to Capacity • Step 1: Estimate capacity requirements • Step 2: Identify gaps: This is the difference between projected demand and current capacity • Step 3: Develop alternatives • Expansionist strategy • Wait-and-see strategy • Follow-the-leader strategy • Step 4: Evaluate the alternatives • Qualitative concerns: fit with overall capacity strategy/ Uncertainties in demand, competitive reaction, technological change, and cost • Qualitative concerns: net present value of after –tax cash flows

49. Reading AssignmentFor Next Week Your Supplement: p. 8-10 to 8-12.

50. Written Assignment- is due .