51

P H A R M AC E U T I C A L S H AV E
C H A L L E N G I N G C A PAC I T Y D E C I S I O N S

M
anufacturing capacity decision making in pharmaceuticals is complex given
the number of options a company faces. It is an expensive gamble due to
the high capital cost of manufacturing facilities and the opportunity cost of
restricting investment in other projects. Consider a new biotech product in Phase II (this
is the second out of three steps required to prove that the product is safe) with very
high potential sales. The company needed to secure capacity immediately but was
unsure about how much to obtain. Uncertainty over patent infringement problems,

www.dell.com

the organizations marketing ability, and competitor response meant that the range
of sales projections varied by 600 percent and the probability of actually launching
the products was estimated at only 45 percent. It looked like a 200 million gamble.
So how did the consulting company working with the biotech company
handle this problem? They used the exact tools we discuss in this chapter. They
considered the following:
What is the expected value of the drug under different supply scenarios? What
happens if production capacity is constrained?
What is the expected return on investment for different manufacturing options?
What is best between hijacking (sharing) another products capacity and keeping a
fixed capacity constraint?
These are all challenging problems that are addressed at the top levels of the firm.

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 122 section 2 PROCESSES

Manufacturing and service capacity investment decisions can be very complex. Consider
some of the following difficult questions that need to be addressed:
How long will it take to bring new capacity on stream? How does this match with the
time that it takes to develop a new product?
What will be the impact of not having sufficient capacity for a promising product?
Should the firm use third-party contract manufacturers? How much of a premium
will the contract manufacturer charge for providing flexibility in manufacturing
volume?
Vol. VIII In this chapter, we look at these tough strategic capacity decisions. We begin by discussing
JIT at McDonalds the nature of capacity from an OSM perspective.

C A PA C I T Y M A N A G E M E N T I N O P E R AT I O N S
Capacity A dictionary definition of capacity is the ability to hold, receive, store, or accommodate. In
a general business sense, it is most frequently viewed as the amount of output that a system
is capable of achieving over a specific period of time. In a service setting, this might be the
number of customers that can be handled between noon and 1:00 P.M. In manufacturing, this
might be the number of automobiles that can be produced in a single shift.
When looking at capacity, operations managers need to look at both resource inputs and
product outputs. The reason is that, for planning purposes, real (or effective) capacity depends
on what is to be produced. For example, a firm that makes multiple products inevitably can
Service produce more of one kind than of another with a given level of resource inputs. Thus, while
the managers of an automobile factory may state that their facility has 6,000 labor hours
available per year, they are also thinking that these labor hours can be used to make either
150,000 two-door models or 120,000 four-door models (or some mix of the two- and four-
door models). This reflects their knowledge of what their current technology and labor force
inputs can produce and the product mix that is to be demanded from these resources.
An operations management view also emphasizes the time dimension of capacity. That is,
capacity also must be stated relative to some period of time. This is evidenced in the common
distinction drawn between long-range, intermediate-range, and short-range capacity plan-
ning. (See the box Time Horizons for Capacity Planning.)
Finally, capacity planning itself has different meanings to individuals at different levels
Cross within the operations management hierarchy. The vice president of manufacturing is con-
Functional cerned with aggregate capacity of all factories within the firm. The vice presidents concern
relates mainly to the financial resources required to support these factories. You will study
this process when you cover capital budgeting during your finance course.
Although there is no one person with the job title capacity manager, there are several
managerial positions charged with the effective use of capacity. Capacity is a relative term; in

TIME HORIZONS FOR CAPACITY PLANNING

Capacity planning is generally viewed in three time durations:
Long rangegreater than one year. Where productive
resources (such as buildings, equipment, or facilities) take a
long time to acquire or dispose of, long-range capacity plan-
ning requires top management participation and approval.
Intermediate rangemonthly or quarterly plans for the
next 6 to 18 months. Here, capacity may be varied by such
alternatives as hiring, layoffs, new tools, minor equipment
purchases, and subcontracting.
Short rangeless than one month. This is tied into the
daily or weekly scheduling process and involves making
adjustments to eliminate the variance between planned
and actual output. This includes alternatives such as
overtime, personnel transfers, and alternative production
routings.

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 STRATEGIC CAPACITY MANAGEMENT chapter 5 123

JELLY BELLY CANDY COMPANY,

HEADQUARTERED IN FAIRFIELD, CALIFORNIA,
PRODUCES 100,000 POUNDS OF JELLY
BELLY BEANS PER DAY, APPROXIMATELY
347 BEANS PER SECOND. IT TAKES 7 TO
21 DAYS OF CURING ON THESE TRAYS TO
MAKE A JELLY BELLY BEAN.

an operations management context, it may be defined as the amount of resource inputs avail-
able relative to output requirements over a particular period of time. Note that this definition
makes no distinction between efficient and inefficient use of capacity. In this respect, it is
consistent with how the federal Bureau of Economic Analysis defines maximum practical
capacity in its surveys: That output attained within the normal operating schedule of shifts
per day and days per week including the use of high-cost inefficient facilities.1
The objective of strategic capacity planning is to provide an approach for determining Strategic capacity planning
the overall capacity level of capital-intensive resourcesfacilities, equipment, and overall
labor force sizethat best supports the companys long-range competitive strategy. The
capacity level selected has a critical impact on the firms response rate, its cost structure, its
inventory policies, and its management and staff support requirements. If capacity is inad-
equate, a company may lose customers through slow service or by allowing competitors to
enter the market. If capacity is excessive, a company may have to reduce prices to stimulate
demand; underutilize its workforce; carry excess inventory; or seek additional, less profitable
products to stay in business.

PRODUCTION CAPACITY IS AFFECTED

BY FACILITIES, EQUIPMENT, PROCESSING
METHODS, LABOR, AND SUPPLIES. THE
CAPACITY OF THIS ORANGE JUICE PLANT
ALSO HAS TO BE MANAGED FOR SEASONAL
EFFECTS ON BOTH RESOURCE SUPPLIES AND
CUSTOMER DEMAND.

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 124 section 2 PROCESSES

C A PAC I T Y P L A N N I N G C O N C E P T S
The term capacity implies an attainable rate of output, for example, 300 cars per day,
but says nothing about how long that rate can be sustained. Thus, we do not know if
this 300 cars per day is a one-day peak or a six-month average. To avoid this problem,
Best operating level the concept of best operating level is used. This is the level of capacity for which the
process was designed and thus is the volume of output at which average unit cost is
minimized. Determining this minimum is difficult because it involves a complex trade-
off between the allocation of fixed overhead costs and the cost of overtime, equipment
wear, defect rates, and other costs.
Capacity utilization rate An important measure is the capacity utilization rate, which reveals how close a firm is
to its best operating point:

Capacity used
Capacity utilization rate = _________________
Best operating level

So, for example, if our plants best operating level were 500 cars per day and the plant was
currently operating at 480 cars per day, the capacity utilization rate would be 96 percent:

480 = 0.96, or 96%

Capacity utilization rate = ____
500

The capacity utilization rate is expressed as a percentage and requires that the numerator and
denominator be measured in the same units and time periods (such as machine hour/day, bar-
rels of oil/day, dollars of output/day).

ECONOMIES AND DISECONOMIES OF SCALE

The basic notion of economies of scale is that as a plant gets larger and volume increases,
the average cost per unit of output drops. This is partially due to lower operating and capital
cost, because a piece of equipment with twice the capacity of another piece typically does not
cost twice as much to purchase or operate. Plants also gain efficiencies when they become
large enough to fully utilize dedicated resources for tasks such as material handling, computer
equipment, and administrative support personnel.
At some point, the size of a plant becomes too large and diseconomies of scale become a
problem. These diseconomies may surface in many different ways. For example, maintaining
the demand required to keep the large facility busy may require significant discounting of the
product. The U.S. automobile manufacturers continually face this problem. Another typical
example involves using a few large-capacity pieces of equipment. Minimizing equipment
downtime is essential in this type of operation. M&M Mars, for example, has highly auto-
mated, high-volume equipment to make M&Ms. A single packaging line moves 2.6 million
M&Ms each hour. Even though direct labor to operate the equipment is very low, the labor
required to maintain the equipment is high.
In many cases, the size of a plant may be influenced by factors other than the internal equip-
ment, labor, and other capital expenditures. A major factor may be the cost to transport raw
materials and finished product to and from the plant. A cement factory, for example, would
have a difficult time serving customers more than a few hours from its plant. Analogously,
automobile companies such as Ford, Honda, Nissan, and Toyota have found it advantageous
Global to locate plants within specific international markets. The anticipated size of these intended
markets will largely dictate the size of the plants.
Jaguar, the luxury automobile producer, recently found they had too many plants. Jaguar
was employing 8,560 workers in three plants that produced 126,122 cars, about 14 cars per
employee. In comparison, Volvos plant in Torslanda, Sweden, was more than twice as produc-
tive, building 158,466 cars with 5,472 workers, or 29 cars per employee. By contrast, BMW
AGs Mini unit made 174,000 vehicles at a single British plant with just 4,500 workers (39 cars
per employee).

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 STRATEGIC CAPACITY MANAGEMENT chapter 5 125

The Learning Curve exhibit 5.1

A. Costs per unit produced fall by a specific percentage B. It can also be expressed through logarithms:
each time cumulative production doubles. This rela-
tionship can be expressed through a linear scale as
shown in this graph of a 70 percent learning curve:
(A Log-Log Scale)
400
300 300

250 200
Cost or Cost or
price 200 price 150
per unit per unit
150 100
100

0 400 800 1200 1600 200 400 800 1600

Total accumulated production of units Total accumulated production of units

THE LEARNING CURVE

A well-known concept is the learning curve. As plants produce more, they gain experience in
the best production methods, which reduce their costs of production in a predictable manner.
Every time a plants cumulative production doubles, its production costs decline by a specific
percentage depending on the nature of the business. Exhibit 5.1 demonstrates the effect of a
learning curve on the production costs of hamburgers.
The learning curve percentage varies across industries. To apply this concept to the res-
taurant industry, consider a hypothetical fast-food chain that has produced 5 million ham-
burgers. Given a current variable cost of $0.55 per burger, what will the cost per burger be
when cumulative production reaches 10 million burgers? If the firm has a 90 percent learning
curve, costs will fall to 90 percent of $0.55, or $0.495, when accumulated production reaches
10 million. At 1 billion hamburgers, the variable cost drops to less than $0.25.
Note that sales volume becomes an important issue in achieving cost savings. If firm A
serves twice as many hamburgers daily as firm B, it will accumulate experience twice as
fast. (Additional discussion of learning curves is provided in Chapter 5A.)

WHERE ECONOMIES OF SCALE MEET

THE LEARNING CURVE
The astute reader will realize that larger plants can have a two-way cost advantage over
their competitors. Not only does a larger plant gain from economies of scale, but it also will
produce more, giving it learning curve advantages as well. Companies often use this dual
advantage as a competitive strategy by first building a large plant with substantial economies
of scale, and then using its lower costs to price aggressively and increase sales volume. The
increased volume moves them down the learning curve more quickly than their competitors,
allowing the company to lower prices further, gaining still more volume. However, two cri-
teria must be met for this strategy to succeed: (1) The product must fit customers needs and
(2) the demand must be sufficiently large to support the volume.

C A PAC I T Y F O C U S
The concept of the focused factory holds that a production facility works best when it
focuses on a fairly limited set of production objectives.2 This means, for example, that a
firm should not expect to excel in every aspect of manufacturing performance: cost, quality,

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 126 section 2 PROCESSES

THE XEROX FOCUSED FACTORY CREATES

A FLEXIBLE AND EFFICIENT WORK
ENVIRONMENT WHERE TEAMS OF EMPLOYEES
ARE RESPONSIBLE FOR THE END-TO-END
MANUFACTURING OF SPECIFIC PRODUCTS.
THE FACTORY WAS DESIGNED WITH INPUT
FROM THE INDUSTRIAL STAFF, WORKING
IN TANDEM WITH ENGINEERS AND
MANAGEMENT.

flexibility, new product introductions, reliability, short lead times, and low investment.
Rather, it should select a limited set of tasks that contribute the most to corporate objectives.
However, given the breakthroughs in manufacturing technology, there is an evolution in
factory objectives toward trying to do everything well. How do we deal with these apparent
contradictions? One way is to say that if the firm does not have the technology to master
multiple objectives, then a narrow focus is the logical choice. Another way is to recognize
the practical reality that not all firms are in industries that require them to use their full range
of capabilities to compete.
Capacity focus The capacity focus concept also can be operationalized through the mechanism of
plants within plants or PWPs. A focused plant may have several PWPs, each of which
may have separate suborganizations, equipment and process policies, workforce manage-
ment policies, production control methods, and so forth, for different productseven if
they are made under the same roof. This, in effect, permits finding the best operating level
for each department of the organization and thereby carries the focus concept down to the
operating level.

C A PAC I T Y F L E X I B I L I T Y
Capacity flexibility means having the ability to rapidly increase or decrease production levels,
or to shift production capacity quickly from one product or service to another. Such flexibility
is achieved through flexible plants, processes, and workers, as well as through strategies that
use the capacity of other organizations.

F l e x i b l e P l a n t s Perhaps the ultimate in plant flexibility is the zero-changeover-time

plant. Using movable equipment, knockdown walls, and easily accessible and reroutable
utilities, such a plant can quickly adapt to change. An analogy to a familiar service busi-
ness captures the flavor well: a plant with equipment that is easy to install and easy to
tear down and movelike the Ringling Bros.Barnum and Bailey Circus in the old tent-
circus days.3

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 STRATEGIC CAPACITY MANAGEMENT chapter 5 127

F l e x i b l e P r o c e s s e s Flexible processes are epitomized by flexible manufacturing

systems on the one hand and simple, easily set up equipment on the other. Both of these
technological approaches permit rapid low-cost switching from one product line to another,
enabling what are sometimes referred to as economies of scope. (By definition, economies Economies of scope
of scope exist when multiple products can be produced at a lower cost in combination than
they can separately.)

F l e x i b l e W o r k e r s Flexible workers have multiple skills and the ability to switch eas-
ily from one kind of task to another. They require broader training than specialized workers
and need managers and staff support to facilitate quick changes in their work assignments.

C A PAC I T Y P L A N N I N G
C O N S I D E R AT I O N S IN A D D I N G C A PAC I T Y
Many issues must be considered when adding capacity. Three important ones are maintaining
system balance, frequency of capacity additions, and the use of external capacity.

M a i n t a i n i n g S y s t e m B a l a n c e In a perfectly balanced plant, the output of stage 1

provides the exact input requirement for stage 2. Stage 2s output provides the exact input
requirement for stage 3, and so on. In practice, however, achieving such a perfect design is
usually both impossible and undesirable. One reason is that the best operating levels for each
stage generally differ. For instance, department 1 may operate most efficiently over a range of
90 to 110 units per month, whereas department 2, the next stage in the process, is most efficient
at 75 to 85 units per month, and department 3 works best over a range of 150 to 200 units per
month. Another reason is that variability in product demand and the processes themselves gen-
erally leads to imbalance except in automated production lines, which, in essence, are just one
big machine.
There are various ways of dealing with imbalance. One is to add capacity to stages that
are bottlenecks. This can be done by temporary measures such as scheduling overtime, leas-
ing equipment, or purchasing additional capacity through subcontracting. A second way is
through the use of buffer inventories in front of the bottleneck stage to ensure that it always
has something to work on. A third approach involves duplicating the facilities of one depart-
ment on which another is dependent.

F r e q u e n c y o f C a p a c i t y A d d i t i o n s There are two types of costs to consider when

adding capacity: the cost of upgrading too frequently and that of upgrading too infrequently.
Upgrading capacity too frequently is expensive. Direct costs include removing and replacing
old equipment and training employees on the new equipment. In addition, the new equipment
must be purchased, often for considerably more than the selling price of the old. Finally, there
is the opportunity cost of idling the plant or service site during the changeover period.
Conversely, upgrading capacity too infrequently is also expensive. Infrequent expansion
means that capacity is purchased in larger chunks. Any excess capacity that is purchased must
be carried as overhead until it is utilized. (Exhibit 5.2 illustrates frequent versus infrequent
capacity expansion.)

E x t e r n a l S o u r c e s o f C a p a c i t y In some cases, it may be cheaper to not add capac-

ity at all, but rather to use some existing external source of capacity. Two common strategies
used by organizations are outsourcing and sharing capacity. An example of outsourcing is
Japanese banks in California subcontracting check-clearing operations. An example of shar-
ing capacity is two domestic airlines flying different routes with different seasonal demands
exchanging aircraft (suitably repainted) when ones routes are heavily used and the others
are not. A new twist is airlines sharing routesusing the same flight number even though the
airline company may change through the route.

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 128 section 2 PROCESSES

exhibit 5.2 Frequent versus Infrequent Capacity Expansion

Demand
forecast

Capacity level
(infrequent expansion)
Capacity level
(frequent expansion)

Volume

Small chunk Large chunk

Years

D E T E R M I N I N G C A PAC I T Y R E Q U I R E M E N T S
In determining capacity requirements, we must address the demands for individual product
lines, individual plant capabilities, and allocation of production throughout the plant network.
Typically this is done according to the following steps:

1. Use forecasting techniques to predict sales for individual products within each product
line.
2. Calculate equipment and labor requirements to meet product line forecasts.
3. Project labor and equipment availabilities over the planning horizon.

Capacity cushion Often the firm then decides on some capacity cushion that will be maintained between the pro-
jected requirements and the actual capacity. A capacity cushion is an amount of capacity in excess
of expected demand. For example, if the expected annual demand on a facility is $10 million in
products per year and the design capacity is $12 million per year, it has a 20 percent capacity
cushion. A 20 percent capacity cushion equates to an 83 percent utilization rate (100%/120%).
When a firms design capacity is less than the capacity required to meet its demand, it is
said to have a negative capacity cushion. If, for example, a firm has a demand of $12 million
in products per year but can produce only $10 million per year, it has a negative capacity
cushion of 16.7 percent.
We now apply these three steps to an example.

EXAMPLE 5.1: Determining Capacity Requirements

The Stewart Company produces two flavors of salad dressings: Pauls and Newmans. Each is available
in bottles and single-serving plastic bags. Management would like to determine equipment and labor
requirements for the next five years.

SOLUTION
Cross Step 1. Use forecasting techniques to predict sales for individual products within each product line. The
Functional marketing department, which is now running a promotional campaign for Newmans dressing, provided

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 STRATEGIC CAPACITY MANAGEMENT chapter 5 129

the following forecast demand values (in thousands) for the next five years. The campaign is expected
to continue for the next two years.

YEAR

1 2 3 4 5

Pauls
Bottles (000s) 60 100 150 200 250
Plastic bags (000s) 100 200 300 400 500
Newmans
Bottles (000s) 75 85 95 97 98
Plastic bags (000s) 200 400 600 650 680

Step 2. Calculate equipment and labor requirements to meet product line forecasts. Currently, three
machines that can package up to 150,000 bottles each per year are available. Each machine requires two
operators and can produce bottles of both Newmans and Pauls dressings. Six bottle machine operators
are available. Also, five machines that can package up to 250,000 plastic bags each per year are avail-
able. Three operators are required for each machine, which can produce plastic bags of both Newmans
and Pauls dressings. Currently, 20 plastic bag machine operators are available.
Total product line forecasts can be calculated from the preceding table by adding the yearly demand
for bottles and plastic bags as follows:
YEAR

1 2 3 4 5

Bottles 135 185 245 297 348

Plastic bags 300 600 900 1,050 1,180

We can now calculate equipment and labor requirements for the current year (year 1). Because
the total available capacity for packaging bottles is 450,000/year (3 machines 150,000 each), we
will be using 135/450 = 0.3 of the available capacity for the current year, or 0.3 3 = 0.9 machine.
Similarly, we will need 300/1,250 = 0.24 of the available capacity for plastic bags for the current year,
or 0.24 5 = 1.2 machines. The number of crew required to support our forecast demand for the fi rst
year will consist of the crew required for the bottle and the plastic bag machines.
The labor requirement for year 1s bottle operation is

0.9 bottle machine 2 operators = 1.8 operators

1.2 bag machines 3 operators = 3.6 operators

Step 3. Project labor and equipment availabilities over the planning horizon. We repeat the preceding
calculations for the remaining years:
YEAR

1 2 3 4 5

Plastic Bag Operation

Percentage capacity utilized 24 48 72 84 94
Machine requirement 1.2 2.4 3.6 4.2 4.7
Labor requirement 3.6 7.2 10.8 12.6 14.1
Bottle Operation
Percentage capacity utilized 30 41 54 66 77
Machine requirement .9 1.23 1.62 1.98 2.31
Labor requirement 1.8 2.46 3.24 3.96 4.62

A positive capacity cushion exists for all five years because the available capacity for both opera-
tions always exceeds the expected demand. The Stewart Company can now begin to develop the
intermediate-range or sales and operations plan for the two production lines.

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 130 section 2 PROCESSES

U S I N G D E C I S I O N T R E E S TO E VA L U AT E
C A PAC I T Y A LT E R N AT I V E S
A convenient way to evaluate a capacity investment decision is through the use of decision
trees. The tree format helps not only in understanding the problem but also in finding a
solution. A decision tree is a schematic model of the sequence of steps in a problem and the
conditions and consequences of each step. In recent years, a few commercial software pack-
ages have been developed to assist in the construction and analysis of decision trees. These
packages make the process quick and easy.
Decision trees are composed of decision nodes with branches to and from them. Usually
squares represent decision points and circles represent chance events. Branches from decision
points show the choices available to the decision maker; branches from chance events show
the probabilities for their occurrence.
In solving decision tree problems, we work from the end of the tree backward to the start
of the tree. As we work back, we calculate the expected values at each step. In calculating the
expected value, the time value of money is important if the planning horizon is long.
Once the calculations are made, we prune the tree by eliminating from each decision point
all branches except the one with the highest payoff. This process continues to the first deci-
sion point, and the decision problem is thereby solved.
We now demonstrate an application to capacity planning for Hackers Computer Store. The
Program DATA exhibits used to solve this problem were generated using a program called DATA by TreeAge
TreeAge Software. (A demonstration version of the software, capable of solving the problems given in
Software this chapter, is included on the book DVD.)

EXAMPLE 5.2: Decision Trees

The owner of Hackers Computer Store is considering what to do with his business over the next five
years. Sales growth over the past couple of years has been good, but sales could grow substantially if
a major electronics firm is built in his area as proposed. Hackers owner sees three options. The first is
to enlarge his current store, the second is to locate at a new site, and the third is to simply wait and do
nothing. The decision to expand or move would take little time, and, therefore, the store would not lose
Service revenue. If nothing were done the first year and strong growth occurred, then the decision to expand
would be reconsidered. Waiting longer than one year would allow competition to move in and would
make expansion no longer feasible.
The assumptions and conditions are as follows:

1. Strong growth as a result of the increased population of computer fanatics from the new electron-
ics firm has a 55 percent probability.
2. Strong growth with a new site would give annual returns of $195,000 per year. Weak growth with
a new site would mean annual returns of $115,000.
3. Strong growth with an expansion would give annual returns of $190,000 per year. Weak growth
with an expansion would mean annual returns of $100,000.
4. At the existing store with no changes, there would be returns of $170,000 per year if there is
strong growth and $105,000 per year if growth is weak.
5. Expansion at the current site would cost $87,000.
6. The move to the new site would cost $210,000.
7. If growth is strong and the existing site is enlarged during the second year, the cost would still
be $87,000.
8. Operating costs for all options are equal.

SOLUTION
We construct a decision tree to advise Hackers owner on the best action. Exhibit 5.3 shows the decision
tree for this problem. There are two decision points (shown with the square nodes) and three chance
occurrences (round nodes).
The values of each alternative outcome shown on the right of the diagram in Exhibit 5.4 are calcu-
lated as follows:

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 STRATEGIC CAPACITY MANAGEMENT chapter 5 131

Decision Tree for Hackers Computer Store Problem exhibit 5.3

Strong growth
Revenue-Move_Cost
Move .55
Weak growth
Revenue-Move_Cost
.45
Strong growth
Revenue-Expansion_Cost
Hackers Computer Expand .55
Store
Weak growth
Revenue-Expansion_Cost
.45
Expand
Revenue-Expansion_Cost
Strong growth
.55 Do nothing
Do nothing Revenue

Weak growth
Revenue
.45

Decision Tree Analysis Using DATA (TreeAge Software, Inc.) exhibit 5.4

Strong growth
Revenue-Move_Cost ! $765,000
.0.550
Move
$585,000
Weak growth
Revenue-Move_Cost ! $365,000
0.450
Strong growth
Revenue-Expansion_Cost ! $863,000
0.550
Hackers Computer Expand
Store $660,500
Do nothing; $703,750 Weak growth
Revenue-Expansion_Cost ! $413,000
0.450
Expand
Revenue-Expansion_Cost ! $843,000
Strong growth
Do nothing; $850,000
0.550 Do nothing
Do nothing Revenue ! $850,000; P ! 0.550
$703,750
Weak growth
Revenue ! $525,000; P ! 0.450
0.450

ALTERNATIVE REVENUE COST VALUE

Move to new location, strong growth $195,000 5 yrs $210,000 $765,000

Move to new location, weak growth $115,000 5 yrs $210,000 $365,000
Expand store, strong growth $190,000 5 yrs $87,000 $863,000
Expand store, weak growth $100,000 5 yrs $87,000 $413,000
Do nothing now, strong growth, expand next year $170,000 1 yr + $87,000 $843,000
$190,000 4 yrs
Do nothing now, strong growth, do not expand next year $170,000 5 yrs $0 $850,000
Do nothing now, weak growth $105,000 5 yrs $0 $525,000

Working from the rightmost alternatives, which are associated with the decision of whether to expand,
we see that the alternative of doing nothing has a higher value than the expansion alternative. We therefore

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 132 section 2 PROCESSES

exhibit 5.5 Decision Tree Analysis Using Net Present Value Calculations

Strong growth
Revenue-Move_Cost ! $428,487
.0.550
Move
$310,613
Weak growth
Revenue-Move_Cost ! $166,544
0.450
Strong growth
Revenue-Expansion_Cost ! $535,116
0.550
Hackers Computer Expand
Store $402,507
Weak growth Revenue-Expansion_Cost ! $240,429
0.450
Expand
Revenue-Expansion_Cost ! $529,874
Strong growth
Do nothing; $556,630
0.550 Do nothing
Do nothing Revenue ! $556,630; P ! 0.550
$460,857
NPV Analysis
Rate ! 16% Weak growth
Revenue ! $343,801; P ! 0.450
0.450

eliminate the expansion in the second year alternatives. What this means is that if we do nothing in the
first year and we experience strong growth, then in the second year it makes no sense to expand.
Now we can calculate the expected values associated with our current decision alternatives. We
simply multiply the value of the alternative by its probability and sum the values. The expected value
for the alternative of moving now is $585,000. The expansion alternative has an expected value of
$660,500, and doing nothing now has an expected value of $703,750. Our analysis indicates that our
best decision is to do nothing (both now and next year)!
Due to the five-year time horizon, it may be useful to consider the time value of the revenue and cost
streams when solving this problem. Details concerning the calculation of the discounted monetary values
are given in Supplement A (Financial Analysis). For example, if we assume a 16 percent interest rate,
the first alternative outcome (move now, strong growth) has a discounted revenue valued at $428,487
(195,000 3.274293654) minus the $210,000 cost to move immediately. Exhibit 5.5 shows the analysis
considering the discounted flows. Details of the calculations are given below. Present value table G.3 (in
Appendix G) can be used to look up the discount factors. In order to make our calculations agree with
those completed by the computer program, we have used discount factors that are calculated to 10 digits of
precision (it is easy to do this with Excel). The only calculation that is a little tricky is the one for revenue
when we do nothing now and expand at the beginning of next year. In this case, we have a revenue stream
of $170,000 the first year, followed by four years at $190,000. The first part of the calculation (170,000
0.862068966) discounts the first-year revenue to the present. The next part (190,000 2.798180638) dis-
counts the next four years to the start of year two. We then discount this four-year stream to present value.
The computer program used to generate Exhibit 5.5 performed the calculations automatically.

ALTERNATIVE REVENUE COST VALUE

Move to new location, strong growth $195,000 3.274293654 $210,000 $428,487

Move to new location, weak growth $115,000 3.274293654 $210,000 $166,544
Expand store, strong growth $190,000 3.274293654 $87,000 $535,116
Expand store, weak growth $100,000 3.274203654 $87,000 $240,429
Do nothing now, strong growth, $170,000 0.862068966 $87,000 $529,874
expand next year $190,000 2.798180638 0.862068966
0.862068966
Do nothing now, strong growth, $170,000 3.274293654 $0 $556,630
do not expand next year
Do nothing now, weak growth $105,000 3.274293654 $0 $343,801

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 STRATEGIC CAPACITY MANAGEMENT chapter 5 133

P L A N N I N G S E RV I C E C A PAC I T Y
C A PAC I T Y P L A N N I N G I N S E RV I C E
VERSUS MANUFACTURING
Although capacity planning in services is subject to many of the same issues as manufac-
turing capacity planning, and facility sizing can be done in much the same way, there are
several important differences. Service capacity is more time- and location-dependent, it Service
is subject to more volatile demand fluctuations, and utilization directly impacts service
quality.

T i m e Unlike goods, services cannot be stored for later use. The capacity must be avail-
able to produce a service when it is needed. For example, a customer cannot be given a seat
that went unoccupied on a previous airline flight if the current flight is full. Nor could the
customer purchase a seat on a particular days flight and take it home to be used at some Vol. XII Service Management
later date. Featuring Levin BMW

L o c a t i o n The service capacity must be located near the customer. In manufacturing,

production takes place, and then the goods are distributed to the customer. With services,
however, the opposite is true. The capacity to deliver the service must first be distributed
to the customer (either physically or through some communications medium such as the
telephone); then the service can be produced. A hotel room or rental car that is available in
another city is not much use to the customerit must be where the customer is when that
customer needs it.

V o l a t i l i t y o f D e m a n d The volatility of demand on a service delivery system is

much higher than that on a manufacturing production system for three reasons. First, as
just mentioned, services cannot be stored. This means that inventory cannot smooth the
demand as in manufacturing. The second reason is that the customers interact directly with
the production systemand these customers often have different needs, will have different
levels of experience with the process, and may require different numbers of transactions.
This contributes to greater variability in the processing time required for each customer and
hence greater variability in the minimum capacity needed. The third reason for the greater
volatility in service demand is that it is directly affected by consumer behavior. Influences
on customer behavior ranging from the weather to a major event can directly affect demand
for different services. Go to any restaurant near your campus during spring break and it will
probably be almost empty. Or try to book a room at a local hotel during homecoming week-
end. This behavioral effect can be seen over even shorter time frames such as the lunch-hour
rush at a banks drive-through window or the sudden surge in pizza orders during halftime
on Superbowl Sunday. Because of this volatility, service capacity is often planned in incre-
ments as small as 10 to 30 minutes, as opposed to the one-week increments more common
in manufacturing.

C A PAC I T Y U T I L I Z AT I O N AND
SERVICE QUALITY
Planning capacity levels for services must consider the day-to-day relationship between
service utilization and service quality. Exhibit 5.6 shows a service situation cast in wait-
ing line terms (arrival rates and service rates).4 As noted by Haywood-Farmer and Nollet,
the best operating point is near 70 percent of the maximum capacity. This is enough
to keep servers busy but allows enough time to serve customers individually and keep
enough capacity in reserve so as not to create too many managerial headaches.5 In the
critical zone, customers are processed through the system, but service quality declines.
Above the critical zone, the line builds up and it is likely that many customers may never
be served.

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 134 section 2 PROCESSES

exhibit 5.6 Relationship between the Rate of Service Utilization (") and Service Quality

# " ! 100%

Zone of nonservice
($ < #)
Critical
zone " ! 70%

Mean arrival
rate (#)

Zone of service

$
Mean service rate ($)

SOURCE: J. HAYWOOD-FARMER AND J. NOLLET, SERVICES PLUS: EFFECTIVE SERVICE

MANAGEMENT (BOUCHERVILLE, QUEBEC, CANADA: G. MORIN PUBLISHER LTD., 1991). P. 59.

Haywood-Farmer and Nollet also note that the optimal

MULTIMEDIA CONTACT CENTER SOFTWARE SUCH AS SOLIDUS ECARE FROM ERICSSON
ALLOWS DISPERSED CUSTOMER SERVICE ORGANIZATIONS TO BEHAVE AS A SINGLE UNIT. THE
SOFTWARE ROUTES CALLS TO AGENTS BASED ON THEIR SKILL SETS, BLENDING CALLS WITH
E-MAIL, WEB-CHAT, WEB BROWSING WITH CUSTOMERS, AND AUTOMATED RESPONSES
FOR FREQUENTLY ASKED QUESTIONS. THIS FLEXIBILITY EFFECTIVELY EXPANDS CAPACITY OF
CUSTOMER SERVICE.
utilization rate is very context specific. Low rates are appro-
priate when both the degree of uncertainty and the stakes
are high. For example, hospital emergency rooms and fire
departments should aim for low utilization because of the
high level of uncertainty and the life-or-death nature of their
activities. Relatively predictable services such as commuter
trains or service facilities without customer contact, such as
postal sorting operations, can plan to operate much nearer
100 percent utilization. Interestingly, there is a third group
for which high utilization is desirable. All sports teams like
sellouts, not only because of the virtually 100 percent con-
tribution margin of each customer, but because a full house
creates an atmosphere that pleases customers, motivates the
home team to perform better, and boosts future ticket sales.
Stage performances and bars share this phenomenon. On
the other hand, many airline passengers feel that a flight
is too crowded when the seat next to theirs is occupied.
Airlines capitalize on this response to sell more business-
class seats.6

CONCLUSION
Strategic capacity planning involves an investment decision that must match resource
capabilities to a long-term demand forecast. As discussed in this chapter, factors to be
taken into account in selecting capacity additions for both manufacturing and services
include

The likely effects of economies of scale.

The effects of learning curves.

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 STRATEGIC CAPACITY MANAGEMENT chapter 5 135

The impact of changing facility focus and balance among production stages.
The degree of flexibility of facilities and the workforce.

For services in particular, a key consideration is the effect of capacity changes on the qual-
ity of the service offering. In a later chapter, we discuss the related issue of where to locate
the firms facilities. Service

KEY TERMS
Capacity The amount of output that a system is capable of achiev-
ing over a specific period of time.
Strategic capacity planning Determining the overall capacity level
of capital-intensive resources that best supports the companys
long-range competitive strategy.
Best operating level The level of capacity for which the process
was designed and the volume of output at which average unit cost
is minimized.
Capacity focus Can be operationalized through the plants-within-
plants concept, where a plant has several suborganizations spe-
cialized for different productseven though they are under the
same roof. This permits finding the best operating level for each
suborganization.
Economies of scope Exist when multiple products can be produced
at a lower cost in combination than they can separately.
Capacity cushion Capacity in excess of expected demand.

Capacity utilization rate Measures how close a firm is to its best

operating level.

SOLVED PROBLEM
E-Education is a new start-up that develops and markets MBA courses offered over the Internet.
The company is currently located in Chicago and employs 150 people. Due to strong growth,
the company needs additional office space. The company has the option of leasing additional
space at its current location in Chicago for the next two years, but after that will need to move
to a new building. Another option the company is considering is moving the entire operation to
a small Midwest town immediately. A third option is for the company to lease a new building in
Chicago immediately. If the company chooses the first option and leases new space at its current
location, it can, at the end of two years, either lease a new building in Chicago or move to the
small Midwest town.
The following are some additional facts about the alternatives and current situation:

1 The company has a 75 percent chance of surviving the next two years.
2 Leasing the new space for two years at the current location in Chicago would cost $750,000
per year.
3 Moving the entire operation to a Midwest town would cost $1 million. Leasing space would
run only $500,000 per year.
4 Moving to a new building in Chicago would cost $200,000, and leasing the new buildings
space would cost $650,000 per year.
5 The company can cancel the lease at any time.
6 The company will build its own building in five years, if it survives.
7 Assume all other costs and revenues are the same no matter where the company is located.

What should E-Education do?

Solution
Step 1: Construct a decision tree that considers all of E-Educations alternatives. The following
shows the tree that has decision points (with the square nodes) followed by chance occurrences
(round nodes). In the case of the first decision point, if the company survives, two additional deci-
sion points need consideration.

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