Capacity Planning

Atanu Chaudhuri

Agenda
Criticality of capacity decisions Capacity decisions over different time horizons Factors influencing capacity decisions Different approaches to capacity expansion Concept of break-even volumes Decision Trees and Capacity Decisions Estimating required and available capacity A capacity planning problem Why companies fail to meet demand despite having capacity?

Capacity decisions are tricky! --- One of the toughest decisions which business leaders have to take
Holcim-owned cement major ACC expects the cement industry to add 70 million tonnes (mt) of fresh capacity this year, putting pressure on prices. With the new additions, the cumulative installed cement production capacity of the country may cross the 300 million tonnemark. In 2010, we expect an additional capacity of about 70 mt to materialise, more than half of which is coming up in south-west India. Despite a growing demand for cement, these capacity additions may create surpluses in some parts of the country, said Mr N.S. Sekhsaria, Chairman, ACC What started out as stock outs on the iPod touch at Amazon.com started spreading to other retailers and iPod models. Amazon.com, one of Apple's highest volume iPod resellers, has just recently pushed lead times on the 8 GB second-generation iPod touch to three to five weeks from 11 days while the 16 GB model remains at three to five weeks. iPod touch, iPod nano, and even iPod shuffle are seeing shortages on different colors and capacities this week across several retailers including Best Buy, Target, Wal-Mart, and Crutchfield.com.

"Frankly, we find these sell-outs on iPods surprising given how difficult the macroeconomic environment is, putting a crimp on consumer spending," he told clients in a new report Wednesday. "
http://www.appleinsider.com/articles/08/12/03/apples_unexpected_ipod_shortage_spr eading.html

Source: http://www.thehindubusinessline.com/2010/03/27/stories/2010032752410200.htm

Capacity decisions have long term implications. An illustration from global chemical industry
Significant capacity investments in East Changing roles
Annual ethylene capacity additions by region (as a % of 2008 total capacity)

Expected behaviors
China
Net importer - due to significant demand. However some balance between local production and imports will be set. Net importer and merchant buyer - driven by free market needs. Has potential to influence based on demand. Net exporter - with access to advantaged feedstock. Significant government play in the market. Marginal production - driven by significant excess and older capacity.

China and Middle East contribute to 78% of new capacity during 20092013

India

Middle East

Developed markets

National governments are increasingly playing a role in capacity buildup

Source: CMAI, Deutsche Bank and DTT Chemical Group analysis.

Declining capacity investments in chemical industry in the developed world

Significant asset reductions
An evaluation of 35 major announced capacity closures by leading players

Lower capacity

Capacity reduction in developed markets 2008-2012 Ethylene and Derivatives1

Developing

Developed

Source: Company Websites, Press releases and news, CMAI, Deutsche Bank, and DTT Chemical Group analysis. (1) Ethylene derivatives include HDPE, LDPE, LLDPE, PVC and Ethylene Glycol.

Kt per annum

Indian Auto Component Sector- Some firms are building capacities ahead, some are pegging investment growth to sales growth and some are cutting down investments
Mfg Sales, Capital Employed and Asset Turnover-Bharat Forge
2000 1800 1600 1400 1200 1000 800 600 400 200 0 2002 2003 2004 2005 2006
Mfg Sales Capital Employed Asset Turnover

Mfg Sales Capital Employed Asset Turnover 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0

Mfg Sales, Capital Employed and Asset turnover-Yuken India

90 80 70 60 50 40 30 20 10 0 2002 2003 2004 2005

Mfg Sales Capital Employed Asset Turnover 7 6 5 4 3 2 1 0 2006 Mfg Sales Capital Employed Asset Turover 8 7 6 5 4 3 2 1 0

Mfg sales, capital employed and asset turnover-Talbros Automotive Component

160 140 120 100 80 60 40 20 0 2002 2003 2004 2005

Mfg sales, capital employed and asset turnover-Munjal Auto

350 300 250 200 150 100 50 0 2002 2003 2004 2005

7 6 5 4 3 2 1 0 2006

2006

Firms in Electronics and Chemicals industries in India also show different patterns in capital investments
Mfg sales, capital employed and asset turnover-TVS Electronics
250 200 150 100 50 0 2002 2003 2004 2005 2006 SalesManf CapEmp Asset Turnover 12 10 8 6 4 2 0

Mfg Sales, Capital Employed and Asset Turnover-Zicom Electronic Security Systems
100 90 80 70 60 50 40 30 20 10 0 2002 2003 2004 2005

SalesManf CapEmp Asset Turnover

2.000 1.800 1.600 1.400 1.200 1.000 0.800 0.600 0.400 0.200 0.000 2006
Mfg Sales Capital Employed Asset Turnover

Mfg sales, capital employed and asset turnover-Kavveri Telecom

30 25 20 15 10 5 0 2002 2003 2004

SalesManf CapEmp Asset Turnover 8 7 6 5 4 3 2 1 0 2005

Mfg Sales, Capital Employed and Asset TurnoverJubilant Organosys

1600 1400 1200 1000 800 600 400 200 0 2003 2004 2005

2.000 1.950 1.900 1.850 1.800 1.750 1.700 2006

Long waiting times for products usually indicate long term capacity planning or aggregate planning problems
With competition hotting up, this might result in lost sales

Bajaj Auto has a waiting list of three weeks for their top- selling product Pulsar, pushing demand for these bikes up to 80,000 units per month from 55,000 units. Honda Motorcycle & Scooter India (HMSI) has a waiting period of four weeks for their scooters Activa and Deo. Two-wheeler majors clearly did not expect this surge in demand. Since January, demand has surged by 20%.
Source: http://economictimes.indiatimes.com/news/news-by-industry/auto/twowheelers/Rising-consumer-optimism-to-drive-bike-demand/articleshow/5895736.cms

Significance of capacity decisions

The throughput (quantity to be sold), or the number of units a facility can hold, receive, store, or produce in a period of time Determines fixed costs Determines whether demand will be satisfied or not Planning over three time horizons

Capacity decisions over different time horizons

Long term decisions include:
When, how much, and in what form to alter capacity

Medium term decisions include:

How much inventory to hold Level of manpower required Whether to sub-contract or not? To buy new equipment or not

Short term decisions include:

Scheduling specific jobs, orders, allocating resources (manpower, equipment)

Considerations for capacity decisions

Forecast demand with reasonable accuracy Understand the technology and capacity increments Find the optimum operating level (volume)

Capacity decisions are influenced by economies and diseconomies of scale

Average unit cost (Rupees per room per night)

25 - room roadside motel

50 - room roadside motel

75 - room roadside motel

Economies of scale

Diseconomies of scale

25

50 Number of Rooms

75

Companies also need to understand learning effects while planning capacity

Capacity should be calculated considering the standard time

0.3 Standard time

0.25
Processing time per unit in hours

0.20

0 0 100 200 300 400 Cumulative Units Produced

500

Companies can use flexible facilities to address demand variability across products
Percent of North American Vehicles Made on Flexible Assembly Lines

100% 80% 60% 40% Chrysler Toyota Nissan Honda 20% 0 Ford GM

How can companies manage demand?

Demand exceeds capacity
Curtail demand by raising prices, scheduling longer lead time

Catering to only specific segment

Long term solution is to increase capacity

Capacity exceeds demand

Stimulate market through product launches, advertising etc
Product changes and upgrades

Adjusting to seasonal demands

Produce products with complementary demand patterns, if possible

How can companies match capacity with demand?

1. Making staffing changes 2. Adjusting equipment
Purchasing additional machinery

May not always be necessary, instead balance flow of product/services through the facility

Selling or leasing out existing equipment

3. Closing facilities 4. Improving processes to increase throughput 5. Redesigning products to facilitate more throughput 6. Adding process flexibility to meet changing product preferences

Different approaches to capacity expansion

(a) Leading demand with incremental expansion
New capacity Demand Expected demand Demand

(b) Leading demand with one-step expansion

New capacity Expected demand

(c) Capacity lags demand with incremental expansion

New capacity Demand Expected demand

Where will this capacity expansion approach be suitable?

(a) Leading demand with incremental expansion
New capacity

Demand

Expected demand

2 Time (years)

Where will this capacity expansion approach be suitable?

(b) Leading demand with one-step expansion

New capacity Demand Expected demand

2 Time (years)

Where will this capacity expansion approach be suitable?

(c) Capacity lags demand with incremental expansion
New capacity Demand Expected demand

2 Time (years)

Companies should also account for lifecycle stages while evaluating capacity alternatives
Should be careful in making large, irreversible investments, need more flexibility

Need of flexibility of Focus on efficient Systematically build utilization of existing equipment and manpower capacity without increases overshooting by large extent capacity

Break even volumes many times become the focal point of a business plan
Ratan Tata on Nano
When we were planning facilities for the car and working out a business plan, the business plan shown to me was looking at a figure of 200,000. I said 200,000 cars is crazy. If we can do this we should be looking at a million cars a year, and if we can't do a million then we shouldn't be doing this kind of car at all. But such a figure (a million cars) has never been achieved in the country before. If it had to be done the conventional way, it would have meant investing many billions of dollars. So we looked at a new kind of distributed manufacturing, creating a low-cost, low break-even point manufacturing .

Source: http://tatanano.inservices.tatamotors.com/tatamotors/index.php?option=com_content&task=view&id=96&Itemid=169

Break-Even Analysis
Technique for evaluating process and equipment alternatives

Objective is to find the point in rupees and units at which cost equals revenue
Requires estimation of fixed costs, variable costs, and revenue

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

Break-Even Analysis
Assumptions Costs and revenue are linear functions

We actually know these costs

Time value of money not considered

Break-Even Analysis
900 800 700 Cost in rupees 600 Total revenue line

Break-even point Total cost = Total revenue

Total cost line

500
400 300 200 100 0
| | | | | | | | |

Variable cost

Fixed cost
| | |

100 200 300 400 500 600 700 800 900 1000 1100 Volume (units per period)

Break-Even Analysis
BEPx = break-even point in units BEP = break-even point in rupees P = price per unit (after all discounts) x = number of units produced TR F V TC = = = = total revenue = Px fixed costs variable cost per unit total costs = F + Vx

Break-even point occurs when

TR = TC or Px = F + Vx

F BEPx = P-V

Break-Even Analysis
BEPx = break-even point in units BEP = break-even point in rupees P = price per unit (after all discounts) x = number of units produced TR F V TC = = = = total revenue = Px fixed costs variable cost per unit total costs = F + Vx

BEP = BEPx P F P = P-V F = (P - V)/P F = 1 - V/P

Profit = TR - TC = Px - (F + Vx) = Px - F - Vx = (P - V)x - F

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

Rs.10,000 1 - [(1.50 + .75)/(4.00)]

Break-Even Example
Fixed costs = Rs.10,000 Direct labor = Rs1.50/unit BEP = F = 1 - (V/P) Material = Rs.75/unit Selling price = Rs. 4.00 per unit

$10,000 1 - [(1.50 + .75)/(4.00)]

$10,000 = = $22,857.14 .4375 BEPx = F = P-V $10,000 4.00 - (1.50 + .75) = 5,714

Break-Even Example
50,000

40,000
30,000 Dollars 20,000 10,000
| 0

Revenue Break-even point

Total costs

Fixed costs

2,000

4,000 Units

6,000

8,000

10,000

Break-Even Example
Multiproduct Case
BEP = F

Vi 1x (Wi) Pi

where

V P F W i

= variable cost per unit = price per unit = fixed costs = percent each product is of total dollar sales = each product

Restaurant with multiple products

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

Restaurant with multiple products

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

Restaurant with multiple products

BEP$ = F

Vi 1x (Wi) Pi

Fixed costs = $3,500 per month $3,500 x 12 Annual Forecasted = = $67,200 .625 Units Item Price Cost Sales Sandwich $2.95 $1.25 7,000 $67,200 Daily Soft drink .80 .30 7,000 = = $215.38 sales 312 5,000 Weighted Baked potato 1.55 .47 Annual days % of Tea Selling Variable .75 .25 Forecasted 5,000 Contribution Item (i) Price (P) Cost (V) (V/P) 1 - (V/P) Sales $ Sales (col 5 x col 7) Salad bar 2.85 1.00 x $215.383,000 .446 = 32.6 33 Sandwich $2.95 $1.25 .42 .58 $20,650 .446 .259 $2.95 sandwiches
Soft drink Baked potato Tea Salad bar .80 1.55 .75 2.85 .30 .47 .38 .30 .33 .35 .62 .70 .67 .65 5,600 7,750 .121 .075 per day .167 .117 .054 .120 .625

.25 1.00

3,750 8,550 $46,300

.081 .185 1.000

Decision Trees and Capacity Decision

Market favorable (.4) Market unfavorable (.6)

$100,000 -$90,000

Market favorable (.4) Medium plant Market unfavorable (.6)

$60,000 -$10,000

Market favorable (.4)

$40,000 -$5,000 $0

Market unfavorable (.6)

Decision Trees and Capacity Decision

Market favorable (.4) Market unfavorable (.6) $100,000 -$90,000

Market favorable (.4) Medium plant

$60,000 -$10,000

Large Plant

Market unfavorable (.6)

EMV = (.4)($100,000) + (.6)(-$90,000) EMV = -$14,000

Market favorable (.4)

$40,000 -$5,000 $0

Market unfavorable (.6)

Decision Trees and Capacity Decision

-$14,000 Market favorable (.4) Market unfavorable (.6) $18,000 Market favorable (.4) Medium plant Market unfavorable (.6) $13,000 Market favorable (.4) $40,000 -$5,000 $0 $60,000 -$10,000 $100,000 -$90,000

Market unfavorable (.6)

Estimating Required Capacity

Projected demand = D Standard labour hours required per unit =SL Efficiency of labour =EL Labor required = D*SL/EL Similarly required capacity can be calculated for machine

A contract manufacturer makes products for large food companies It got orders to make 800 bottles of 500 gm tomato ketchup and 1200 bottles of 500 gm jam every day. In a year there are 300 working days The ketchup and jam can be bottled using similar machines. It takes 2 minutes to bottle 12 ketchup bottles and 3 minutes to bottle 10 jam bottles. Efficiency of bottling machine is 95% Find out the required number of bottling machine hours per annum for the contract manufacturer

Solution to the problem Number of ketchup bottles in a year = 800*300 Number of jam bottles in a year = 1200*300 Bottling machine hours for ketchup in a year = 800*300*(2/12)/(0.95*60) = 701.75 Bottling machine hours for jam in a year = = 1200*300*(3/10)/(0.95*60) = 1894.74 Total bottling machine hours required per annum= 701.75+1894.74 = 2596.49

Comparing required and available capacity

Currently one bottling machine is available with the manufacturer which runs 2 shifts of 8 hours each. Historical data shows that machine is under breakdown and maintenance 10% of the available hours in a year and other 10 % of the time is spent in setting up the machine while changing from ketchup to jam and vice versa What is the available capacity? What will be the machine utilization in a year? Can it take further orders from the same or different manufacturer to fill up the bottling machine capacity?

Available capacity = 300*2*8*(1-0.2) = 3840 hours Utilization = 2596.49/3840 =0.67 or 67% Apparently yes, 33 % of bottling machine capacity is available to take further orders Will depend on capacity of other processes and bottleneck capacity (nothing to do with bottles!!!)

Ketchup manufacturing process

3 hours 45 minutes

2.5 hours Cooking

2 hours

Pulping
2 hours

Filtering
2 hours 15 minutes Bottling

Labeling and Packing

Finishing

Time mentioned are for 400 kg of tomato ketchup i.e. 800 bottles of 500 gm each For ketchup manufacturing, process with bottleneck capacity is pulping as it takes maximum time to process 400 kg of tomato ketchup

Jam manufacturing process

3.0 hours Crushing and chopping 1.5 hours

4.5 hours Cooking

6 hours

Pasteurizing
3 .5 hours Labeling and Packing

Bottling

Time mentioned are for 600 kg of mixed fruit jam i.e. 1200 bottles of 500 gm each For jam manufacturing, process with bottleneck capacity is bottling as it takes maximum time to process 600 kg of mixed fruit jam

Further calculations
Remember, there is only 1 bottling machine which is being used for both ketchup and jam manufacturing When are the ketchup and jam arriving at the bottling machine? Ketchup will arrive at bottling machine 8 hrs 15 minutes after start of process while jam will arrive at bottling machine 9 hours after start of process

3 hours Pulping

45 minutes

2.5 hours Cooking

Filtering

2 hours Labeling and Packing

2 hours 15 minutes Bottling

2 hours Finishing 3 .5 hours Labeling and Packing

3.0 hours Crushing and chopping

1.5 hours Pasteurizing

4.5 hours Cooking

You can play this game of maximizing throughput

How much quantity of jam and ketchup can the manufacturer produce in a day? You have to take decisions about scheduling jam and ketchup manufacturing, batch size of jam and ketchup manufacturing Objective will be to maximize total profit This will also depend on profit made from jam and ketchup So, will the manufacturer produce more jam or more ketchup?

Capacity issues in service industry

Need of responsiveness- customers may not wait for long Managing demand volatility- no option of inventory Manage both peak hour and non-peak hour demand Trade off between utilization and performance measures like waiting time

Demand and Capacity Management in the Service Sector

Demand management
Appointment, reservations, FCFS rule

Capacity management
Full time, temporary, part-time staff

Capacity planning alternatives for service firms

Issues for consideration Operations Strategy Service Portfolio Demand Management Resources Management Peak Hour/High Demand Period Standard offering Narrow offering Reservations Multi-skilled workforce Adding temporary workforce Increasing working time Non Peak Hour/Lean Period Customized offerings Wide offering Special tariffs, offers Dedicated tasks Training and development Reduced work hours

A bank teller example

Arrival rate of customers at the teller counter = 15 per hour =

ra
Service rate at the teller = 20 per hour =re Utilization of the teller facility = 15/20 =0.75 =u What is the probability that there are atmost 2 persons in front of the teller counter? Pn = long run probability of having the system with n jobs/customers in process sequence For the system to be stable, P n-1*ra = Pn *re

Thus, Pn = u* P n-1 P0 = 1-u , P1 = u*P0 = u(1-u)

probability that there are atmost 2 persons in front of the teller counter = P0+P1+P2 = 0.25 + 0.25*0.75+ 0.75^2*0.25 =0.578

Service growth stages and capacity addition

Entrepreneurial Multisite rationalization Growth Maturity

Limited service at a single location Based on some novel idea Or filling the gaps based on customer needs Multi-skilled personnel

Tries adding additional Volume increases services to the current significantly location At some point, After exhausting local operational complexity market, ventures to outstrips growth grow beyond original related benefits location Need fresh ideas Complexity of managing multiple Existing facilities need sites increase remodeling With multi-site operations, operating costs increase

Operational efficiency takes precedence May be necessary to modify the service concept Capacity planning must address the issue of duplicating changes across the entire business

Wrap-up Significance of capacity decisions Capacity planning over different time horizons Considerations for capacity planning Capacity expansion strategies and applicability Break-even analysis and decision tree Estimating required and available capacity Why companies fail to meet demand despite having capacity Capacity planning in services