Dyad Business Academy Unit 2
Capacity Planning
The concept of capacity is intricately related to the functions of all operations within an organization. How
many persons can be seated in a theatre? How many persons can get their hair cut in an hour at the barber? How
many units can the factor produce within a day? These are all questions of “capacity.” Capacity refers to the
throughput, or total number of units a facility can hold, receive, store or produce in a specified period of time.
The term capacity is commonly used to refer to the peak output or throughput a system, implying many firms do
not normally operate at their capacity.
Design Capacity
Design capacity refers to the total achievable capacity if all equipment and processes are working n perfect
order. However, very few organizations achieve this level of output and few firms would want to operate
consistently at design capacity since the depreciation of equipment and machinery would be significant.
Therefore, this is a theoretical maximum output of a system in a given period of time.
They are many potential draw backs to operating at full capacity.
Staff may feel under pressure due to the workload and this could raise stress levels. Operations
managers cannot afford to make any production scheduling mistakes, as there is no slack time to make
up for lost output. Therefore working at full capacity may create stressed workers and managers,
resulting in increased mistakes, accidents, lower motivation and productivity, absenteeism and higher
labour turnover.
Regular customers who wish to increase their orders will have to be turned away or kept waiting for
long periods. This could encourage them to use other suppliers with the danger that they might be lost as
long-term clients.
Machinery will be working flat out and there may be insufficient time for maintenance and preventative
repairs and this could lead to increased unreliability in the future. Would you like to fly in a plane that
had not be maintained at all for several months, but simply cleaned and refuelled and put back in the air?
Breakdowns are likely to be more expensive than accepting lower capacity.
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Dyad Business Academy Unit 2
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A small amount of spare capacity is accepted as necessary to provide level of flexibility in case of need.
Sudden surges of demand can be catered for in the short run by increasing output, not upsetting potential
customers whose needs could not otherwise be met.
For service companies, especially those offering personal services such as hairdressing or restaurants,
high capacity utilisation may increase queuing times and may lead to poorer customer service.
Overcrowding at holiday resorts and leisure parks will always reduce customer satisfaction levels. Think
of those queues in theme parks!
An overcrowded factory space may be less efficient as the firm suffers from diminishing returns as
people get in each other's way and have to wait for equipment etc. As saying goes, 'too many cooks spoil
the broth'.
Efficiency or Effective Capacity
Effective capacity refers to the estimated capacity that would result in the efficient operation of the business. It
measures the maximum demand that the production system can manage before it becomes inefficient.
Capacity Utilization and its Calculation
In order to maximize the possibility of over or under-utilization of capacity, the organisation can measure its
capacity utilization. This is a measure of the percentage of the firm’s total capacity that is being used. It is
calculated using the following formula.
Present Output
X 100
Total potential output
For example, a manufacturing company is able, with its current resources and facility, to produce 700 units of
product per day in a five day work week. In a particular week it was able to produce 4 300 units of the product.
Its capacity utilization would be:
3300
X 100 = 94%
3500
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Importance of Capacity Utilization and Management
1. It determines if demand can be met: capacity refers to a process’ maximum throughput. As long as
demand is less than capacity, it can be met by the firm. However, if demand exceeds capacity, the firm
will be unable to meet customer needs, and will result in lost sales. Under these circumstances, the
capacity of the firm must be increased to meet the consumer’s requirements.
2. Capacity has major implications on the level of fixed costs which must be paid by the organization:
while fixed costs are generally unaffected by variations in output, varying levels of capacity will impact
on fixed costs. For example, the rent paid does not depend on the number of units store within a
warehouse, but if the warehouse is expanded so to increase its capacity, the rent charged would increase.
Therefore, ceteris paribus, there is a positive relationship between total fixed costs incurred and the
capacity of the organization- the greater the capacity; the greater fixed costs must be paid. Careful
thought must therefore be invested before any capacity plans are executed, to avoid incurring
unnecessary expenses.
3. Potential to reduce per unit (average) fixed cost. - When capacity utilisation is at a high rate, average
fixed costs will be spread out over a large number of units – unit fixed costs will be relatively low.
When utilisation is low, fixed costs will have to be borne by fewer units and unit fixed costs will rise
4. Idle costs: if a facility is too large, portions of it will sit idle and unused. Although unused, it will
generate fixed costs. For example, a large warehouse which is only half full will still incur full rent
expense and full land ax expenses. Therefore capacity utilization is important as idle machinery and
equipment can be put to better use to generate revenue.
5. Labour requirements- the capacity of the organization strongly determines the number of employees
necessary to execute operations. This is also true for capital requirements.
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Methods of Increasing Capacity Utilization
If the firm is producing below its full capacity, it is therefore not cost effective. There are a number of strategies
the firm can employ to improve its capacity.
The business can increase sales through promotional activities such as advertisements or sales
promotions.
Redeploy unused resources, such as labour from one production location to another to assist with
improving capacity.
Employ seasonal or part time worker. This is often used when there is high seasonal demand, as it helps
the firm to produce more (for example, at Christmas, or in crop season in the sugar industry).
The firm may also outsource aspects of its production process in order to boost production.
1. Calculate the capacity utilisation rates for the following three (3) years.
2014 2015 2015
Maximum Capacity (meters) 5,000,000 5,000,000 5,000,000
Actual Annual Output (meters) 4,000,000 3,700,000 4,000,000
Capacity Utilisation Rates
2 Last year, Melchester Rovers Football Club achieved 98% capacity utilisation when 42,140 supporters
attended for the visit of local rivals, Melborough United. What is the capacity of Melchester Rovers
stadium?
3. Port of Call, Sunderland’s newest bar/ restaurant opened last year in a wave of publicity. The average
capacity utilisation on a Friday night is 92% serving 2576 customers. The owners are considering
extending the premises which will increase capacity by 15%. The owners estimate that this will lead to
an extra 250 customers visiting on a Friday night. Calculate the new capacity utilisation of Port of Call
on a Friday night based on the proposed expansion and increase in customer numbers.
4. Phillippe Flop operates a small factory that produces beach footwear, retailing at £5 per pair. Phillippe’s
variable costs are £2 per unit and his factory can produce a maximum of 5,000 units per month. Fixed
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costs are £10,000 per month. Calculate how much monthly profit Phillippe will make if the factory
operated at 80% capacity utilisation assuming all units are sold.
Economies and Diseconomies of Scale
Economies of scale are the cost advantages that enterprises obtain due to their scale (quantity) of operation,
(typically measured by amount of output produced), with cost per unit of output decreasing with increasing
scale. Therefore, economies of scale occur when increasing output leads to lower long-run average costs.
Economies of Scale can fall into the following categories:
Purchasing economies
These economies are often known as bulk-buying economies. Suppliers often offer substantial discounts for
large orders. This is because it is cheaper for them to process and deliver one large order rather than several
smaller ones.
Technical economies
There are two main sources of technical economies. Large firms are more likely to be able to justify the cost of
flow production lines. If these are worked at a high capacity level, then they offer lower unit costs than other
production methods. The latest and most advanced technical equipment – such as computer systems – is often
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expensive and can usually only be afforded by big firms. Such expense can only be justified by larger firms
with high output levels – so that average fixed costs can be reduced.
Financial economies
Large organisations have two cost advantages when it comes to raising finance. First, banks often show
preference for lending to a big business with a proven track record and a diversified range of products. Interest
rates charged to these firms are often lower than the rate charged to small, especially newly formed, businesses.
Secondly, raising finance by ‘going public’ or by further public issues of shares for existing public limited
companies is very expensive.
Therefore, the average cost of raising the finance will be lower for larger firms selling many millions of dollars’
worth of shares.
Marketing economies
Marketing costs obviously rise with the size of a business, but not at the same rate. Even a small firm will need
a sales force to cover the whole of the sales area. It may employ an advertising agency to design adverts and
arrange a promotional campaign. These costs can be spread over a higher level of sales for a big firm and this
offers a substantial economy of scale.
Managerial economies
Small firms often employ general managers who have a range of management functions to perform. As a firm
expands, it should be able to afford to attract specialist functional managers who should operate more efficiently
than general managers, helping to reduce average costs.
Diseconomies of Scale
If there were no disadvantages to large-scale operations, nearly all industries would be dominated by huge
corporations. Diseconomies of scale are those factors that increase unit costs as a firm’s scale of operation
increases beyond a certain size. These diseconomies are related to the management problems of trying to
control and direct an organisation with many thousands of workers, in many separate divisions, often operating
in several different countries. There are three main causes of management problems.
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Communication problems
Large-scale operations will often lead to poor feedback to workers, excessive use of non-personal
communication media, communication overload with the volume of messages being sent, and distortion of
messages caused by the long chain of command. Poor feedback reduces worker incentives. These problems may
lead to poor decisions being made, due to inadequate or delayed information, and management inefficiency.
Alienation of the workforce
The bigger the organisation, the more difficult it is to directly involve every worker and to give them a sense of
purpose and achievement. They may feel insignificant in the overall business plan and become demotivated,
failing to do their best. Larger manufacturing firms are the ones most likely to adopt flow-line production and
workforce alienation is a real problem due to repetitive and boring tasks.
Poor co-ordination and slow decision-making
Business expansion often leads to many departments, divisions and products. The number of countries a firm
operates in often increases too. The problems for senior management are to co-ordinate these operations and
take rapid decisions in such a complex organisation. Smaller businesses with much tighter control over
operations and much quicker and more flexible decision-making may benefit from lower average production
costs as a result.
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Dyad Business Academy Unit 2
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