Operations Management / Supply Chain Management

Module 06.03 Key Concepts: Capacity Investment Decisions

If capacity is insufficient to meet requirements then decisions must be made regarding when to add capacity and how much capacity should be added.  Some of these decisions are relatively low-cost and easily implemented while other decisions relate to Capital Investment and lead to long-term projects.  So, we see here a potential link to our Module on Project Management don’t we?  A basic decision that leaders must make is whether to invest in capacity before demand requires it (lead capacity).  This follows the adage “If we build it they will come.”  Alternatively they can decide to add capacity in line with changes in demand or lag capacity addition behind potential increase in demand “If the come, we will build it.”   The later approach may carry lower capital investment risk but could mean significant loss of opportunities / profits due to a lack of responsiveness to demand growth.

Often, incremental investment n capacity can mitigate the risks somewhat.

The text authors focus on the utility of Break Even and Analysis and some financial investment analysis tools.

Break Even Analysis is a technique for evaluating process and equipment alternatives. The objective is to find the point in dollars and units at which total cost equals total revenue. Therefore the technique requires estimation of fixed costs, variable costs, and revenue.  This can be done easily in a spreadsheet application.

  • Fixed costs are costs that continue even if no units are produced Depreciation, taxes, debt, mortgage payments
  • Variable costs are costs that vary with the volume of units produced Labor, materials, portion of utilities
  • Contribution is the difference between selling price and variable cost
You can see that the revenue function begins at the origin and proceeds upward to the right, increasing by the selling price of each unit. Where the revenue function crosses the total cost line is the break-even point.
Break Even Analysis assumes that costs and revenue are linear functions.  This is generally not the case in the real world.  We actually know these costs Very difficult to verify.  Also, the time value of money is often ignored.
The Break Even Point can also be determined algebraically by setting the Mathematical Expression for Total Cost = the Mathematical Expression for Total Revenue.
One stated limitation of Breakeven Analysis is that it does not usually consider the time value of money.  In fact, a dollar invested today is not equal to a dollar gained in the future.  This is not a finance course so we will just highlight a few approaches that are used to reflect the time value of money into the decision making process.
The Expected Monetary Value (EMV) can be used to compare different decisions (like with our Decision Tree Analysis) and apply analysis of future demand & Market attractiveness.  Probability values are used to determine expected value.
As mentioned earlier, Operations managers may have to decide among various financial options.  Analyzing capacity alternatives should include capital investment, variable cost, cash flows, and net present value (time value of money).
You will not be expected to do these unless you choose a financial career but it is good to see the approaches in case you are called upon to support such analysis in your chosen field.
There are certain limitations of these techniques.  Investments with the same NPV may have different projected lives and salvage values. Investments with the same NPV may have different cash flows.  They also assume that future interest rates are know.  Also,  payments are not always made at the end of a period.  Never-the-less, they are considered valuable tools for financial investment decisions for capacity.