OpsStrat4

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Operations StrategySession 4

Dr. Partha P. Datta

Operations Management Group

E-mail: [email protected] 

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A Light Beginning to a Serious Issue

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What is capacity & capacity strategy?

Capacity Strategy involves long term plan for developing

resources and involves decisions on sizing, timing, type andlocation of real assets or resources

Capacity is the maximal sustainable output rate of a resource

Capacity comes in many forms (Burger King, Google, Amazon,

Flextronics) Utilization is the rate at which we choose to operate a resource

at any given time

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Capacity is seldom FREE!

One time investment cost

Operating cost

Additional costs

Investment decisions:

Partially or completely irreversible

Uncertainty over future rewards (Virgin’s $5.5bn order of 13 Airbusplanes in 2004 was nothing but a pure GAMBLE)

Capacity Investments

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Size

Tradeoff between cost and service level

Timing

Cost of adjustment and expected cost ofexcess/shortage capacity

Types/Locations

Different capacity and total output

The Key decisions & trade-offs

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A soft malleable constraint

Black Art

Capacity frictions: leadtimes, lumpiness & fixed costs

Large and irreversible investments

Capacity decisions can be political Measuring and valuing capacity shortages is not

obvious

Capacity Strategy Challenges

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Capacity Timing StrategiesLeading, Chasing, and Lagging Timing Strategies

Advantages of Leading Advantages of Lagging

Decisions to make:

Time = when? (lead or lag) Size = by how much? (many

small, one big)

time

Leading capacity

strategy Lagging

capacity strategy

Volume

(units/wk)

0

Demand 

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Capacity Timing Strategies Hybrid timing strategy between lead and lag:

Smoothing

Two types of smoothing: inventory or backorders

Advantages/disadvantages of smoothing strategies:

Inventory-smoothing

capacity strategy Demand Volume

(units/wk)

Inventory buildup

fills

capacity shortage

time

0

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Lead, Lag or Balance Model of Capacity Timing: How tochoose?

DELL, XBOX, Vodafone, Apple, Rolex, Zara, HP, Agilent Tech9

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Economies of Scale (EoS) in Capacity InvestmentTwo Capacity Investment Cost Models

1. Linear CapEx function: C(K) = c0 + cKK

2. Power CapEx function: C(K) = c0 + (cK/a)Ka with 0 < a < 1

$0

0 Capacity Size K  

   C  a  p  a  c   i   t  y   C  o  s   t   C   (   K   )  o  r   C  a  p   E  x

fixed cost c 0 

slope =c K 

decreasing a

a = 1

a = .6

Linear CapEx

Power CapEx

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Sizing Capacity Increments when Demand isKnown or Certain: Guidelines

As discount rates rise, add capacity in smaller increments

Future expenditures on capacity are relatively less expensive

Thus, delaying expenditures is more economical

As scale factors (alpha) rise, add capacity in smaller increments

Cost per increment of capacity goes down

Making larger investments in capacity up front isn’t worth it 

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The Value of Waiting

Existing

capacity

Time

Demand Scenario 1

Year

0

Demand Scenario 2

Demand Scenario 3

Demand Scenario 4

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Real Option Valuation:Acer Example

Should Acer expand now, or should it wait an additional year before expanding intothe emerging markets? The key reason for waiting is the belief that commercial success in emerging markets is

highly correlated with success in the current Asian market. (Acer already has capacity inplace to serve the Asian market. Aside from providing information regarding its futuresuccess, however, that capacity has no direct impact on our problem here.)

Demand from these emerging markets is highly uncertain; marketing and salesreports predict that Acer's low-price PC will either be a blockbuster, a success, or adud. Assume that the demand forecast for those three scenarios is, respectively: 200thousand units per year with likelihood of 25%, 100 thousand units per year with 50%likelihood, or 30 thousand units per year with 25% likelihood.

The cost structure is assumed to be as follows. Capacity expansion incurs a fixed cost

of $8 million plus a marginal cost of $50 per unit of capacity; i.e., adding productioncapacity of 100,000 units per year costs $13 million. The process and producttechnology is commercially viable for four years (at that point a new technologywould be needed, an issue we will ignore for now). Acer expects each PC tocontribute about $80 in operating profits. A 25% discount rate is used for these typesof investment projects.

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