Notes on Capacity Planning – Importance, Procedure, Determinants

What is Capacity Planning?

Capacity planning refers to determining what kind of labour and equipment capacities are required and when they are required. Capacity is usually planned on the basis of labour or machine hours available within the plant. Thus, capacity planning is planning for quantity or scale of output.

Capacity Planning
Capacity Planning – Meaning, Improtance, Determinants, Procedure

There are four major considerations in capacity planning:

  1. Level of demand
  2. Cost of production
  3. Availability of funds
  4. Management policy.

Production has no meaning unless its products can be sold at a remunerative price. Generally, the capacity of plant is limited by the level of current demand. Stable demand makes the task of capacity planning simple while fluctuations in demand create problems concerning the acquisition of resources and matching them up with demand levels. Estimation of demand is, therefore, the first step in capacity planning. Size of the market depends upon the sales potential rather than on the geographical areas.

Demand Forecasts

Demand forecasting is fundamental to effective capacity and sales planning. A demand forecast establishes link between the internal management of the firm and its external environment. Before making a demand forecast, the period of forecast should be decided and an appropriate method of forecasting should be selected.

The nature of product to be sold, the size and characteristics of population, the disposable income, degree of competition, fashion, trends, political conditions, import, export policy of Government, etc., should be taken into consideration. In case of multiple products, product line forecast is useful in deciding the priority of different products in the allocation of limited resources. For example, Delhi Cotton Mills Ltd., may like to know whether to produce more of sugar or textiles.

The demand for new product can be forecast by making consumer surveys, test marketing, product life cycle analysis etc. The annual demand forecast is broken into monthly or weekly forecasts for production scheduling.

Capacity planning is an integral part of the overall production planning for an enterprise. Capacity planning and control is the process of establishing, measuring, monitoring and adjusting the levels of capacity in order to execute all manufacturing plans and schedules in the best possible manner.

Capacity planning involves the following questions.

  1. What type of capacity is required?
  2. How much capacity is required?
  3. When the capacity is required?

The type of capacity required depends upon the products and services which the enterprise intends to produce or provide. The quantity and timing of capacity is related to the quantity and timing of demand for the product or service. The nature of demand (stable or fluctuating) is another important consideration.

Capacity planning is an important element of production management. Decision concerning capacity are one of the most basics decisions of production. Location, layout, and production technology can be determined only after the capacity is decided. For example, Western Electronics Ltd., can decide the number and type of machines, workers, materials and other inputs only after deciding the number of TV sets to be manufactured by it.

Importance of Capacity Planning

Capacity planning is important due to the following reasons:

1. Capacity limits the rate of output. Therefore, capacity planning determines the ability of an enterprise to meet future demand for its products and services.

2. Capacity influences the operating costs. Capacity is determined on the basis of estimated demand. Actual demand is often different from estimated demand. As a result, there arises excess capacity or under capacity. Excess or idle capacity increases the cost per unit of output. Whereas under capacity results in the loss of sales.

3. Capacity decisions leave a direct impact on the amount of fixed investment made initially.

4. Capacity decisions result in long-term commitment of funds. Such long-term decisions cannot be reversed except at major costs.

The following concepts of capacity are involved in capacity planning:

a. Design Capacity: It refers to the maximum output that can possibly be produced in a given period of time. It is the ideal situation.

b. Effective Capacity: Refers to the maximum possible output, given the changes in product mix, machine maintenance, scheduling and operating problems, labour problems, etc. It is usually less than the design capacity.

c. Actual Output: It is the rate of output actually achieved. It cannot exceed effective capacity due to machine breakdowns, labour absenteeism, irregular supply of raw materials, unusual delay in supply of equipment, power breakdown, etc.

The effectiveness of a production system (system effectiveness) can be measured in two ways:

  1. Efficiency which is the rate of actual output to effective output, and
  2. Utilization which implies the rate of actual output to the design capacity.


Efficiency  = Actual Output  /  Effective Capacity

Utilization  =  Actual Output  /  Design Capacity

Every operating manager should try to increase capacity utilization by increasing effective capacity.

Procedure for Capacity Planning

1. Assessment of Existing Capacity

Capacity of a unit can be measured in terms of output or inputs. Output measure is appropriate in case of manufacturing concerns, e.g., automobile plant (number of cars), iron and steel plant (tons of steel), brewery (barrels of bear), cannery (tons of food), power company, (megawatts of electricity), etc. Service concerns like hospitals (number of beds), airlines (number of seats), theatres (number of seats), restaurants (number of tables), university (number of students), warehouse (cubic feet of space), etc., can measure capacity in terms of inputs.

2. Forecasting Future Capacity Needs

Short term capacity requirements can be estimated by forecasting product demand at different stages of the product life cycle. It is more difficult to anticipate long-term capacity requirements due
to uncertainties of market and technology. Capacity forecast helps to determine the gap between the existing capacity and estimated capacity so that necessary adjustments may be made. For example, a company engaged in manufacturing two products may find that one product has a low demand in summer (e.g. coffee or tea) while another product has low demand in winter (e.g. cold drink).

3. Identifying Alternative ways of Modifying Capacity

In case where the existing capacity is inadequate to meet the forecast demand capacity, the expansion is required to meet the shortage. Additional shifts may be employed to expand the capacity. Expansion will provide economies of scale and help in meeting the forecast demand. But it involves additional investment and danger of fall in forecast demand in future.

When the existing capacity exceeds forecast capacity, there is a need for reduction of excess capacity. Developing new products, selling of existing facilities, layout of workers or getting work from other firms are the methods of overcoming it.

4. Evaluation of Alternatives

Various alternatives for capacity expansion or reduction are evaluated from economic, technical and other viewpoints. Reactions of employees and local community should also be considered. Cost Benefit analysis, Decision theory and Queuing theory are the main techniques of evaluating alternatives.

5. Choice of Suitable Course of Action

After performing the cost-benefit analysis of various alternatives to expand or reduce the capacity, the most appropriate alternative is selected.

Determinants of Effective Capacity

1. Facilities

The design of production facilities is the most important determinant of effective capacity. Design includes the size and also the provision for expansion of the facilities. Design facilities should be such that the employees should feel comfortable at their work place. Location factors such as distance from the market, supply of labour, transport costs, energy sources are also important. Layout of the work area determines how smoothly the work can be performed. Environmental factors such as lighting, ventilation, etc., influence the effectiveness with which employees can perform the assigned work.

2. Products or Services

Design of the company’s products or services exerts a significant influence on capacity utilization. When more uniform is the output, greater can be the standardization of materials and methods and greater can be the utilization of capacity. For instance, a restaurant that offers a limited menu, can prepare and serve meals at a faster rate. Product mix should also be considered because different products have different rates of output.

3. Process

Quantity capacity of a process is the obvious determinant of effective capacity. But if quantity of output does not meet the quality standards, the rate of output is reduced due to the need for inspection and rework activities.

4. Human factors

Job design (tasks that comprise a job), nature of the job (variety of activities involved), training and experience required to perform the job, employee motivation, manager’s leadership style, rate of absenteeism and labour turnover are the main human factors influencing the rate of output.

5. Operational Factors

Materials management, scheduling, quality assurance, maintenance policies and equipment breakdowns are important determinants of effective capacity. Late delivery and low acceptability of materials will reduce effective capacity. Inventory problems are a major hurdle in a capacity utilization. Similarly, when the alternative equipment have different capabilities there may be scheduling problems.

6. External Factors

Product standards (minimum quality and performance standards), pollution control regulations, safety requirements and trade union attributes exercise tremendous influence on effective capacity. Generally, the external factors act as constraints in capacity utilization.