Demand and Capacity

In Policy A, the strategy is to build and maintain extra capacity (analogous to an inventory safety stock) so that the likelihood of running short is less than that of having too much.  The greater the capacity provided, the smaller will be the likelihood of running short. The amount of capacity in excess of expected demand is the operation’s capacity cushion. For example, if the expected monthly demand on a facility is $ 500,000 worth of goods or services and it can produce as much as $ 550,000 it has a 10 per cent capacity cushion.
Unused capacity generally is expensive. Why, then, might a company be willing to incur this added cost? The primary reason is that such a cushion makes it possible to respond to unexpected demand surges, like those that come from sudden large orders placed by existing customers, or first orders from new ones. In addition, when faced with volatile demand, such a cushion (if managed properly)  may make  it possible to maintain delivery/ customer response times without the expense of overtime and disruptions resulting from the need to reschedule work or delay the servicing of other customers. In a market that is growing faster than expected it might enable you to attract new customers who are not getting the service they desire from their suppliers (your competitors) who are short of capacity. It also might allow you to take market share from competitors who are concerned more about their near term profitability and return on investment than their long term market position.
Thinking in terms of capacity cushions provides a useful way to begin developing a long term capacity strategy. Such analyses are complicated, however, by the fact that the capacity of an operating   system often is determined by the interaction of several different subsystems. The amount of work that can be performed in a given amount of floor space, for example, is affected by the capacity and flexibility of the equipment employed, and the speed with which one can receive accurate information from customer’s process orders, and request and receive supplies of component parts and services. As a result, one may need to determine several such cushions.
If a firm in highly capital intensive industry adds capacity before its competitors do (pre-empting them), the competitors might decide to delay their own expansions. This is because adding capacity in an industry that already has enough can lead to price wars and thereby reduces the new capacity addition’s return on investment.
Under this policy over time one should attempt to match, as nearly as possible, capacity to the anticipated demand for one’s products or services.
If for example an operation’s current capacity were expected to be fully utilized in three years, and if the lead time to build a new facility was two years then the firm might delay beginning construction for about a year. If demand grew more rapidly than forecast, or if construction took longer than expected, demand would outstrip capacity. As a result, the company would lose potential sales if it did not react by expanding the capacity of existing facilities (through overtime, weekend shifts etc.)  or by subcontracting the deficit to outside companies. On the other  hand, if demand fell short of expectations the company might find itself stretching construction lead times to minimize the excess capacity. However, on average, it would prefer to have about the right amount of capacity – the likelihood of having too much being about the same as the likelihood of a shortfall. As we have seen however, such a policy, runs the risk of incurring all the ancillary cost (increased inventories, changeovers, confusion, and overhead), associated with operating close to a capacity limit.
This policy implies that the company’s capacity plan will contain a negative cushion, so that the likelihood of running short is greater than the likelihood of having excess capacity.
This system sometimes referred to as a conservative capacity strategy, in that it requires less investment than would be required to maintain a positive capacity cushion. It also assures higher average utilization of capacity than do the other two policies, and therefore provides a higher average rate of return on facilities investment. In addition, when new capacity becomes available, it tends to be fully utilized almost immediately. On the other hand such a policy may also lead to higher average operating costs and a slow deterioration in one’s market share over time. For this reason this policy is not conservative in the sense of being, low risk. It simply substitutes one type of risk (losing potential sales) for another (having underutilized facilities).
We explore the circumstances under which a company might choose each of these contrasting strategies.
Up to now we have used the word capacity to refer to processing capacity, but if we think of capacity in its most sense as the ability of a business to meet customer demand one can see that such capacity can be provided in several ways.