Amazon and Bonobos move to include bricks and mortar 6
4.5 Diagnostic question: How much capacity should operations plan to have?
The next set of ‘structure’ decisions concern the size or capacity of each part of the supply network. Here we shall treat capacity in a general long-term sense. The specific issues involved in measuring and adjusting capacity in the medium and short terms are examined in Chapter 8.
The optimum capacity level
Most organisations have decisions to make about how big (in terms of capacity) they want to be. A chain of truck service centres, for example, might operate centres that have various capacities. The effective cost of running each centre will depend on the average service-bay occupancy. Low occupancy, because of few customers, will result in a high cost per customer served because the fixed costs of the operation are being shared between few customers. As demand, and therefore service-bay occupancy, increases, the cost per customer will reduce.
However, operating at very high levels of capacity utilisation (occupancy levels close to capac- ity) can mean longer customer waiting times and reduced customer service. There may also be less-obvious penalties for operating centres at levels close to their nominal capacity. For exam-
ple, long periods of overtime may reduce productivity levels, as well as costing more in extra payments to staff; utilising bays at very high levels reduces the time available for maintenance and cleaning, which may increase the number of breakdowns, reduce effective life, and so on. This usually means that aver- age costs start to increase after a point that will often be lower than the theo- retical capacity of the operation.
The blue curves in Figure 4.8 show this effect for the service centres of 5-, 10- and 15-bay capacity. As the nominal capacity of the centres increases, the lowest cost point at first reduces.
This is because the fixed costs of any operation do not increase proportionately as its capacity increases. A 10-bay centre has less than twice the fixed costs of a 5-bay centre. The cap- ital costs of constructing the operations do not increase proportionately to their capacity.
A 10-bay centre costs less to build than twice the cost of building a 5-bay centre. These two factors, taken together, are often referred to as economies of scale – a universal concept that applies (up to a point) to all types of operation. However, economies of scale do not go on forever. Above a certain size, the lowest cost point on curves such as that shown in Figure 4.8 may increase. This occurs because of what are called diseconomies of scale, two of which are OPERATIONS PRINCIPLE
All types of operations exhibit economy-of-scale effects where operating costs reduce as the scale of capacity increases.
OPERATIONS PRINCIPLE Diseconomies of scale increase operating costs above a certain level of capacity, resulting in a minimum cost-level of capacity.
5 10 15
Average service-bay occupancy
Real cost per bay occupied
Cost curve for 5-bay centre
Cost curve for 10-bay centre
Cost curve for 15-bay centre
‘Economy of scale’
curve for service
centre capacity Economies
of scale Diseconomies of scale
4.5 Diagnostic question: How much capacity should operations plan to have? ■ 137 particularly important. First, complexity costs increase as size increases. The communications and coordination effort necessary to manage an operation tends to increase faster than capac- ity. Although not seen as a direct cost, this can nevertheless be very significant. Second, a larger
centre is more likely to be partially underutilised because demand within a fixed location will be limited. The equivalent in operations that process physical items is transportation costs. For example, if a manufacturer supplies the whole of its European market from one major plant in Denmark, all supplies may have to be brought in from several countries to the single plant and all products shipped from there throughout Europe.
Being small may have advantages
Although large-scale-capacity operations will usually have a cost advantage over smaller units, there are also potentially significant advantages that can be exploited by small-scale opera- tions. One significant research study showed that small-scale operations can provide significant advantages in the following four areas:7
1. Locating near to ‘hot spots’ that can tap into local knowledge networks. Often, larger com- panies centralise their research and development efforts, so losing touch with where innova- tive ideas are generated.
2. Responding rapidly to regional customer needs and trends by basing more and smaller units of capacity close to local markets.
3. Taking advantage of the potential for human resource development, by allowing staff a greater degree of local autonomy. Larger-scale operations often have longer career paths with fewer opportunities for ‘taking charge’.
4. Exploring radically new technologies by acting in the same way as a smaller more entrepre- neurial rival. Larger, more centralised development activities are often more bureaucratic than smaller-scale agile centres of development.
The timing of capacity change
Changing the capacity of any operation in a supply network is not just a matter of deciding on its optimum capacity. The operation also needs to decide when to bring ‘on-stream’ new capacity. For example, Figure 4.9 shows the forecast demand for a manufacturer’s new prod- uct. In deciding when new capacity is to be introduced the company can mix three strategies:
1. Capacity is introduced to generally lead demand, timing the introduction of capacity in such a way that there is always sufficient capacity to meet forecast demand.
2. Capacity is introduced to generally lag demand, timing the introduction of capacity so that demand is always equal to or greater than capacity.
3. Capacity is introduced to sometimes lead and sometimes lag demand, but inventory built up during the ‘lead’ times is used to help meet demand during the ‘lag’ times. This is called
‘smoothing with inventory’.
Each strategy has its own advantages and disadvantages. These are shown in Table 4.2.
The actual approach taken by any company will depend on how it views these advantages and disadvantages. For example, if the company’s access to funds for capital expenditure is limited, it is likely to find the delayed capital expenditure require- ment of the capacity-lagging strategy relatively attractive. Of course, the third strategy, ‘smoothing with inventory’, is only appropriate for operations that produce products that can be stored. Customer-processing operations such as OPERATIONS PRINCIPLE
Capacity-leading strategies increase opportunities to meet demand. Capacity-lagging
4.5 Diagnostic question: How much capacity should operations plan to have?
The next set of ‘structure’ decisions concern the size or capacity of each part of the supply network. Here we shall treat capacity in a general long-term sense. The specific issues involved in measuring and adjusting capacity in the medium and short terms are examined in Chapter 8.
The optimum capacity level
Most organisations have decisions to make about how big (in terms of capacity) they want to be. A chain of truck service centres, for example, might operate centres that have various capacities. The effective cost of running each centre will depend on the average service-bay occupancy. Low occupancy, because of few customers, will result in a high cost per customer served because the fixed costs of the operation are being shared between few customers. As demand, and therefore service-bay occupancy, increases, the cost per customer will reduce.
However, operating at very high levels of capacity utilisation (occupancy levels close to capac- ity) can mean longer customer waiting times and reduced customer service. There may also be less-obvious penalties for operating centres at levels close to their nominal capacity. For exam-
ple, long periods of overtime may reduce productivity levels, as well as costing more in extra payments to staff; utilising bays at very high levels reduces the time available for maintenance and cleaning, which may increase the number of breakdowns, reduce effective life, and so on. This usually means that aver- age costs start to increase after a point that will often be lower than the theo- retical capacity of the operation.
The blue curves in Figure 4.8 show this effect for the service centres of 5-, 10- and 15-bay capacity. As the nominal capacity of the centres increases, the lowest cost point at first reduces.
This is because the fixed costs of any operation do not increase proportionately as its capacity increases. A 10-bay centre has less than twice the fixed costs of a 5-bay centre. The cap- ital costs of constructing the operations do not increase proportionately to their capacity.
A 10-bay centre costs less to build than twice the cost of building a 5-bay centre. These two factors, taken together, are often referred to as economies of scale – a universal concept that applies (up to a point) to all types of operation. However, economies of scale do not go on forever. Above a certain size, the lowest cost point on curves such as that shown in Figure 4.8 may increase. This occurs because of what are called diseconomies of scale, two of which are OPERATIONS PRINCIPLE
All types of operations exhibit economy-of-scale effects where operating costs reduce as the scale of capacity increases.
OPERATIONS PRINCIPLE Diseconomies of scale increase operating costs above a certain level of capacity, resulting in a minimum cost-level of capacity.
Time
Forecast demand Forecast demand
Capacity lags demand
Capacity sometimes leads,
sometimes lags demand Capacity
leads demand
Volume/capacity Volume/capacity
Time
(a) (b)
Figure 4.9 Capacity-leading and capacity-lagging strategies; (a) smoothing with inventories (b) means using the excess capacity in one period to produce inventory that supplies the under-capacity period
Source: From Slack, N. Operations Management, 8e, © 2016 Pearson Education Limited, UK.
Advantages Disadvantages
Capacity-leading strategies
Always sufficient capacity to meet demand, therefore revenue is maximised and customers are satisfied
Utilisation of the plants is always relatively low, therefore costs will be high
Most of the time there is a ‘capacity cushion’
that can absorb extra demand if forecasts are pessimistic
Risks of even greater (or even permanent) over-capacity if demand does not reach forecast levels
Any critical start-up problems with new operations are less likely to affect supply
Capital spending on capacity will be early
Capacity-lagging strategies
Always sufficient demand to keep the operation working at full capacity, therefore unit costs are minimised
Insufficient capacity to meet demand fully, therefore reduced revenue and dissatisfied customers
Over-capacity problems are minimised if forecasts prove optimistic
No ability to exploit short-term increases in demand
Capital spending on the operation is delayed Under-supply position even worse if there are start-up problems with the new operations Smoothing with inventory strategies
All demand is satisfied, therefore customers are satisfied and revenue is maximised
The cost of inventories in terms of working capital requirements can be high; this is especially serious at a time when the company requires funds for its capital expansion
Utilisation of capacity is high and therefore costs are low
Risks of product deterioration and obsolescence
Very short-term surges in demand can be met from inventories
Table 4.2 The arguments for and against pure leading, pure lagging and smoothing with inventory strategies of capacity timing
4.5 Diagnostic question: How much capacity should operations plan to have? ■ 139
Break-even analysis of capacity expansion
An alternative view of capacity expansion can be gained by examining the cost implications of adding increments of capacity on a break-even basis. Figure 4.10 shows how increasing capac- ity can move an operation from profitability to loss. Each additional unit of capacity results in a fixed-cost break that is a further lump of expenditure that will have to be incurred before any further activity can be undertaken in the operation. The operation is unlikely to be profitable at very low levels of output. Eventually, assuming that prices are greater than marginal costs, revenue will exceed total costs. However, the level of profitabil- ity at the point where the output level is equal to the capacity of the operation may not be sufficient to absorb all the extra fixed costs of a further increment in capacity. This could make the operation unprofitable in some stages of its expansion.
OPERATIONS PRINCIPLE Using inventories to overcome demand–capacity imbalance tends to increase working capital requirements.
Revenue
Total costs Fixed-cost breaks
Volume of output
Figure 4.10 Incurring fixed costs repeatedly can raise total costs above revenue over some ranges of output
Worked example
De Vere Graphics
De Vere Graphics is investing in a new machine that ena- bles it to make high-quality prints for its clients. Demand for these prints is forecast to be around 100,000 units in year 1 and 220,000 units in year 2. The maximum capacity of each machine the company will buy to process these
prints is 100,000 units per year. They have a fixed cost of
€200,000 per year and a variable cost of processing of €1 per unit. The company believes it will be able to charge
€4 per unit for producing the prints. What profit is it likely to make in the first and second years?
▲
Year 1 demand = 100,000 units; therefore the company will need one machine Cost of producing prints = fixed cost for one machine + variable cost * 100,000
= €200,000 + (€1 * 100,000)
= € 300,000 Revenue = demand * price
= 100,000 * €4
= €400,000
Therefore profit = €400,000 - €300,000
= €100,000
Year 2 demand = 220,000; therefore the company will need three machines Cost of manufacturing = fixed cost for three machines + variable cost * 220,000
= (3 * €200,000) + (€1 * 220,000)
= €820,000 Revenue = demand * price
= 220,000 * €4
= €880,000
Therefore profit = €880,000 - €820,000
= €60,000
Note: the profit in the second year will be lower because of the extra fixed costs associated with the investment in the two extra machines.