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Strategic Capacity PlanningChapter 5MIS 373: Basic Operations Management

#1AnnouncementsWeek 1 problem solving assignment (PSA) has been gradedQ1 (a) 20 pointsQ1 (b) 20 pointsQ2 (a) 20 pointsQ2 (c) 20 pointsQ3 20 points

Future PSAs will be released on TuesdaysSo that you will have one more day to work on themYou can now come to my Tuesday office hours for PSAsEncourage participation in the next contemporary issues discussion (6/30)Team project proposal due date is postponed to 6/27

Tips for getting higher points in PSAs:Read the problem description carefullyAnswer all (sub-) questionsShow your workIf the problem description is not clear to you, let me know ASAPcontemporary issuesIt appears to me that many of you were not particularly excited when peers were sharing contemporary issues.

For the next contemporary issues session:You can go solo or form a team of two for a contemporary issueIn your discussion, give more visual materials, e.g., SlidesVideoPicturePoster Role play any things that can make the issue more vivid and memorable

Learning ObjectivesAfter this lecture, students will be able to Name the three key questions in capacity planningExplain the importance of capacity planningDescribe ways of defining and measuring capacityName several determinants of effective capacityPerform cost-volume analysis

MIS 373: Basic Operations Management44Motivationwsj.com 1/14/14 -- Auto Makers Dare to Boost CapacityA large increase in production capacity poses a serious risk for auto makers. They reap strong profits if their factories are running near 100% of capacity, but their losses mount rapidly if the utilization rate falls below 80%. And when manufacturers build more cars than they sell, they often resort to price wars to boost sales. At the end of 2013, auto dealers had 3.45 million cars and trucks in stock That is enough to last 63 days at the current sales rate, a level the industry considers optimal.

Capacity PlanningCapacityThe upper limit or ceiling on the load that an operating unit can handleCapacity needs includeEquipmentSpaceEmployee skills

Strategic Capacity PlanningTo achieve a match between the long-term supply capabilities of an organization and the predicted level of long-term demandOver-capacity operating costs that are too highUnder-capacity strained resources and possible loss of customers

MIS 373: Basic Operations Management6Capacity Planning QuestionsKey Questions:What kind of capacity is needed?How much is needed to match demand?When is it needed?

Related Questions:How much will it cost?What are the potential benefits and risks?Are there sustainability issues?Should capacity be changed all at once, or through several smaller changesCan the supply chain handle the necessary changes?MIS 373: Basic Operations Management7Capacity Decisions Are StrategicCapacity decisions:impact the ability of the organization to meet future demandsWhen Microsoft introduced its new Xbox in late 2005, there were insufficient supplies, resulting in lost sales and unhappy customers.affect operating costsCosts of over- and under-capacityaffect competitivenesscapacity can affect delivery speedaffect the ease of management(often) involve long-term commitment of resources

MIS 373: Basic Operations Management8CapacityDesign capacityMaximum output rate or service capacity an operation, process, or facility is designed for

Effective capacityDesign capacity minus allowances such as personal time, maintenance, and scrap

Actual outputRate of output actually achieved--cannot exceed effective capacity.

MIS 373: Basic Operations Management9Capacity: Illustration

(Suppose) These are design capacity from Boeing. But you typically wont get to reach this design capacity because some seats are taken out for, say, galley and emergency exit. Thats why you have effective capacity. Actual output would be equal of less than the effective capacity because you dont always have that many passengers on the plane.Measuring System EffectivenessEfficiency(Measured as percentages)

Utilization(Measured as percentages)

MIS 373: Basic Operations ManagementEfficiency = Actual outputEffective capacityUtilization = Actual outputDesign capacity11Example: Efficiency and UtilizationDesign Capacity = 50 trucks per dayEffective Capacity = 40 trucks per dayActual Output = 36 trucks per day

MIS 373: Basic Operations ManagementEfficiency = Actual output=36= 90%Effective capacity40Utilization = Actual output=36= 72%Design capacity5012Determinants of Effective CapacityFacilitiesSize, expansions, layout, transportation costs, distance to market, labor supply, energy sourcesProduct and service factors(non) uniformity of output, product/service mixProcess factorsProductivity, quality, setup-timeHuman factorsTasks, variety of activities, training, skills, learning, experience, motivation, labor turnover

MIS 373: Basic Operations Management13Determinants of Effective CapacityPolicy factorsOvertime, second/third shiftsOperational factorsScheduling, inventory, purchasing, materials, quality assurance/control, breakdowns, maintenanceSupply chain factorsSuppliers, warehousing, transportation, distributorsExternal factorsProduct standards, minimum quality, safety, environment, regulations, unionsMIS 373: Basic Operations Management14Capacity Cushion / Safety CapacityCapacity Cushion / Safety CapacityExtra capacity used to offset demand uncertainty

Capacity cushion = Capacity expected demand

Capacity cushion strategyOrganizations that have greater demand uncertainty typically use greater capacity cushionOrganizations that have standard products and services generally use smaller capacity cushion

MIS 373: Basic Operations Management15Demand Management StrategiesStrategies used to offset capacity limitations and that are intended to achieve a closer match between supply and demandAppointmentsPricingPromotionsDiscountsOther tactics to shift demand from peak periods into slow periods

MIS 373: Basic Operations Management16Bottleneck OperationAn operation in a sequence of operations whose capacity is lower than that of the other operationsAnimation: http://brams.dk/technotes/flash-mx/performance-bottlenect-simulation/

MIS 373: Basic Operations Management17Operation 120/hr.Operation 210/hr.Operation 315/hr.10/hr.BottleneckMaximum output ratelimited by bottleneck?Capacity StrategiesLeadingBuild capacity in anticipation of future demand increasesE.g., lets expand the restaurant because we expect to serve more customers in the next yearFollowingBuild capacity when demand exceeds current capacityE.g., lets expand the restaurant because we have been full up all the time in the past yearTrackingSimilar to the following strategy, but adds capacity in relatively small increments to keep pace with increasing demandE.g., lets expand the restaurant because we have been full up all the time in the past month

MIS 373: Basic Operations Management18Forecasting Capacity RequirementsLong-term considerations relate to overall level of capacity requirementsRequire forecasting demand over a time horizon and converting those needs into capacity requirementsE.g., Our hotel expect to serve 10 thousand customers next year.

Short-term considerations relate to probable variations in capacity requirementsLess concerned with cycles and trends than with seasonal variations and other variations from averageE.g., Our hotel expect to serve 10 thousand customers next year. But the demand will be higher in the summer, lower in the winter, and normal in the spring and fall.

MIS 373: Basic Operations Management19Common demand patternsMIS 373: Basic Operations Management

20ExerciseSuppose that you are a capacity planner in General Motor.

Discuss with a partner. What would you do to make sure you have the right capacity in GM?Prediction? How?Planning? How?What other information do you need?

Example: Advanced Forecasting MethodsChoi, H., and Varian, H. 2012. Predicting the Present with Google Trends. Economic Record 88 29. Predicting sales of motor vehicles and partsWe have found that simple seasonal AR models that include relevant Google Trends variables tend to outperform models that exclude these predictors by 5 per cent to 20 per cent.

Auto-regressive (AR) models:AR(k): Use the values from the past k time periods to predict the current value: Example: AR(4): Use the values from the past 4 time periods to predict the current value: Salest = constant + 1 Salest-1 + 2 Salest-2 + 3 Salest-3 + 4 Salest-4 + 1 Google_Trend_Cart-1 + 2 Google_Trend_Cart-2 + 3 Google_Trend_Cart-3 + 4 Google_Trend_Cart-4 Example: Advanced Forecasting MethodsGoogle Flu Trend

Calculating Processing RequirementsProductAnnual DemandStandard processing time per unit (hr.)Processing time needed (hr.)#140052000#230082400#370021400Total=5800MIS 373: Basic Operations ManagementIf annual capacity is 2,000 hours/machine, thenUnits of capacity needed = 5,800 hours 2,000 hours = 2.90 3 machines 24Units of capacity needed = Processing time neededProcessing time capacity per unitService Capacity PlanningService capacity planning can present a number of challenges related to:The need to be near customersConvenience The inability to store servicesCannot store services for consumption laterThe degree of demand volatilityVolume and timing of demandTime required to service individual customers

MIS 373: Basic Operations Management25in-house or outsourceOnce capacity requirements have been determined, the organization must decide whether to produce a good or provide a service itself, or to outsource from another organization.Factors to consider when deciding whether to operate in-house or outsourceAvailable capacityExpertiseQuality considerationsThe nature of demandCostRisksMIS 373: Basic Operations Management26CASE StudyHow much would an all-American iPhone cost?NPR Marketplacehttp://www.marketplace.org/topics/business/ive-always-wondered/how-much-would-all-american-iphone-cost Audio (4:33)

Pay attention to: Logistic efficiencyCost structureComponentsInternational expertiseConsumer base

While listening, take notes on the above 5 itemsUse the notes, discuss why/when a company decides to outsource?

Developing Capacity StrategiesThere are a number of ways to enhance development of capacity strategies:Design flexibility into systemsE.g., SSD and USB Flash DriveTake a big-picture (i.e., systems) approach to capacity changesAttempt to smooth out capacity requirementsTake stage of life cycle into accountIdentify the optimal operating level: economies of scale

MIS 373: Basic Operations Management28Product life cycleIn the introduction phase, organizations should be cautious in making large and/or inflexible capacity investments.In the growth phase, organizations should consider their market share, competitors moves, and establishing competitive advantages.In the maturity phase, organizations may still be able to increase profitability by reducing costs and making full use of capacity. In the decline phase, organizations may eliminate the excess capacity by selling it, or by introducing new products or services.MIS 373: Basic Operations ManagementIntroductionGrowthMaturityDeclineSales29optimal operating levelMIS 373: Basic Operations ManagementMinimumcostAverage cost per unit 0Rate of output Minimum average cost per unitEconomies of ScaleIf output rate is less than the optimal level, increasing the output rate results in decreasing average per unit costsDiseconomies of ScaleIf the output rate is more than the optimal level, increasing the output rate results in increasing average per unit costs30Economies of ScaleEconomies of ScaleIf output rate is less than the optimal level, increasing the output rate results in decreasing average per unit costsReasons for economies of scale:Fixed costs are spread over a larger number of unitsProcessing costs decrease due to standardization

There are two types of economies of scale:Internal. These are cost savings that accrue to a firm regardless of the industry, market or environment in which it operates.It is easier for large firms to carry the overheads of sophisticated research and development (R&D). E.g., pharmaceuticals industry External. These are economies that benefit a firm because of the way in which its industry is organized.E.g., The creation of a better transportation network

MIS 373: Basic Operations Management31Diseconomies of ScaleDiseconomies of ScaleIf the output rate is more than the optimal level, increasing the output rate results in increasing average per unit costsReasons for diseconomies of scaleCongestion (transportation)ComplexityInflexibilityAdditional levels of management

MIS 373: Basic Operations Management32DiscussionsDiscuss with a partner: What are the examples that a company/product failed because it did not achieve economies of scale (i.e., too small to compete)? If possible, also discuss why they failed to achieve economies of scale. Was it because of the problems in marketing, finance, or operations?

What are the examples that a company/product failed because of it encountered diseconomies of scale (i.e., too big to compete)?

Evaluating AlternativesAlternatives should be evaluated from varying perspectivesEconomicIs it economically feasible?How much will it cost?How soon can we have it?What will operating and maintenance costs be?Will it be compatible with present personnel and present operations?Non-economicPublic opinion

MIS 373: Basic Operations Management34Evaluating AlternativesTechniques for Evaluating AlternativesCost-volume analysisBreak-even pointIndifference pointFinancial analysisCash flowPresent valueDecision theoryComparison of alternatives under risk and uncertainty.Waiting-line analysisBalance waiting cost and increased capacity costSimulationEvaluate what-if scenariosMIS 373: Basic Operations Management35Cost-Volume AnalysisCost-volume analysisFocuses on the relationship between cost, revenue, and volume of outputFixed Costs (FC)tend to remain constant regardless of output volumeVariable Costs (VC)vary directly with volume of outputVC = Quantity (Q) x variable cost per unit (v)Total CostTC = FC + VCTotal Revenue (TR)TR = revenue per unit (R) x Q

MIS 373: Basic Operations Management36Break-Even Point (BEP)Break-Even-Point (BEP)The volume of output at which total cost and total revenue are equal (profit = 0)

Profit (P) = 0 = TR TC = (R Q) (FC + v Q)= Q(R v) FC

0 = QBEP(R v) FC

MIS 373: Basic Operations Management37Recall:P: ProfitQ: QuantityTR: Total RevenueTR = revenue per unit (R) x QTC: Total CostTC = FC + VCFC: Fixed CostsVC: Variable CostsVC = Q x variable cost per unit (v)Reformulation of the equationThe equation can be easily reformulated to obtain other components of interest:

P = TR TC = (R Q) (FC + v Q)= Q(R v) FCQ = (P + FC) / (R v)R = (P + FC + v Q) / Q

MIS 373: Basic Operations Management38Recall:P: ProfitQ: QuantityTR: Total RevenueTR = revenue per unit (R) x QTC: Total CostTC = FC + VCFC: Fixed CostsVC: Variable CostsVC = Q x variable cost per unit (v)Cost-volume relationshipsMIS 373: Basic Operations Management

39Cost-volume relationshipsMIS 373: Basic Operations Management

40This line shows the difference between TR and TC.Exercise Problems(Textbook page 203) The owner of Old-Fashioned Berry Pies, S. Simon, is contemplating adding a new line of pies, which will require leasing new equipment for a monthly payment of $6,000. Variable costs would be $2 per pie, and pies would retail for $7 each.How many pies must be sold in order to break even?What would the profit (loss) be if 1,000 pies are made and sold in a month?How many pies must be sold to realize a profit of $4,000?If 2,000 can be sold, and a profit target is $5,000, what price should be charged per pie?

Exercise Solutions(Textbook page 203) The owner of Old-Fashioned Berry Pies, S. Simon, is contemplating adding a new line of pies, which will require leasing new equipment for a monthly payment of $6,000. Variable costs would be $2 per pie, and pies would retail for $7 each.How many pies must be sold in order to break even?

FC = $6000 VC = $2 per pie R = $7 per pieQBEP = FC / (R VC) = 6000 / (7 2) = 1200 pies/monthExercise Solutions(Textbook page 203) The owner of Old-Fashioned Berry Pies, S. Simon, is contemplating adding a new line of pies, which will require leasing new equipment for a monthly payment of $6,000. Variable costs would be $2 per pie, and pies would retail for $7 each.What would the profit (loss) be if 1,000 pies are made and sold in a month?

FC = $6000 VC = $2 per pie R = $7 per pieFor Q = 1000, P = Q(R v) FC = 1000(7 2) 6000 = 1000Exercise Solutions(Textbook page 203) The owner of Old-Fashioned Berry Pies, S. Simon, is contemplating adding a new line of pies, which will require leasing new equipment for a monthly payment of $6,000. Variable costs would be $2 per pie, and pies would retail for $7 each.How many pies must be sold to realize a profit of $4,000?

FC = $6000 VC = $2 per pie R = $7 per pieQ = (P + FC) / (R v) = (4000 + 6000) / (7 2) = 2000 piesExercise Solutions(Textbook page 203) The owner of Old-Fashioned Berry Pies, S. Simon, is contemplating adding a new line of pies, which will require leasing new equipment for a monthly payment of $6,000. Variable costs would be $2 per pie, and pies would retail for $7 each.If 2,000 can be sold, and a profit target is $5,000, what price should be charged per pie?

FC = $6000 VC = $2 per pie R = $7 per pieProfit = Q(R v) FC 5000 = 2000(R 2) 6000 R = $7.5R = (P + FC v Q) / Q = (5000 + 6000 + 2 2000) / 2000 = 7.5Another way to solve it:MIS 373: Basic Operations Management

Choose BIndifference Point (Profit)Two (multiple) Alternatives

The quantity at which a decision maker would be indifferent between two competing alternatives

Alternative A (in-house)R >> vv lowFC highBEP high Alternative B (outsource) R > v v high FC low BEP lowChoose A46Example: Indifference PointA manufacturer has 3 options:Use process A with FC=$80,000 and v=$75/unitUse process B with FC=$200,000 and v=$15/unitPurchase for $200/units (in other words, FC=$0 and v=$200/unit)

MIS 373: Basic Operations Management80,000+75Q=200,000+15QQAB=2,000 units80,000+75Q=200QQPA=640 unitsChoose lowest cost:0-640 units : Purchase640-2,000 units: Process AAbove 2,000 units: Process B47Example: Indifference PointA manufacturer has 3 options:Use process A with FC=$80,000 and v=$75/unitUse process B with FC=$200,000 and v=$15/unitPurchase for $200/units (in other words, FC=$0 and v=$200/unit)

MIS 373: Basic Operations Management80,000+75Q=200,000+15QQAB=2,000 units80,000+75Q=200QQPA=640 unitsChoose lowest cost:0-640 units : Purchase640-2,000 units: Process AAbove 2,000 units: Process B48Exercise ProblemsA firm's manager must decide whether to make or buy a certain item used in the production of vending machines. Cost and volume estimates are as follows:

a. Given these numbers, should the firm buy or make this item?b. There is a possibility that volume could change in the future. At what volume would the manager be indifferent between making and buying?

Exercise Solutionsa. Given these numbers, should the firm buy or make this item?

Total cost = Fixed cost + Volume Variable costMake: $150,000 + 12,000 $60 = $870,000Buy: $0 + 12,000 $80 = $960,000Because the annual cost of making the item is less than the annual cost of buying it, the manager would reasonably choose to make the item. Exercise Solutionsb. There is a possibility that volume could change in the future. At what volume would the manager be indifferent between making and buying?

To determine the volume at which the two choices would be equivalent, set the two total costs equal to each other and solve for volume:

TC make = TC buyThus, $150,000 + Q($60) = 0 + Q($80).

Solving, Q = 7,500 units.

For lower volumes, the choice would be to buy, and for higher volumes, the choice would be to makeKey PointsCapacity decisions can be critical to the success of a business organization because capacity is the supply side of the supply-demand equation, and too little or too much capacity is costly.The key issues in capacity planning relate to determining what kind of capacity is needed, how much is needed, and when it is needed.Volatile demand and long lead times to achieve capacity changes can be challenging.Cost-volume analysis (break-even point and indifference point) can give useful information for capacity planning. MIS 373: Basic Operations Management52Marketplace Segment 18 for May 20, 2014American Public Medianull2014277570.28