Differentiate between design capacity and maximum practical capacity for a production facility

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Explain the relationship between plant size and economies of scale


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Tom Hawkins, president of Textrom, Inc., was pacing up and down his office in the corporate headquarters pondering about the situation facing his company. What bothered him most was that he had little time to gather additional information and had to make a fast decision. The situation involved choosing between three alternative strategies to add much-needed production capacity. The decision is to be made concerned WoodSmith, one of Text from divisions that manufactured industrial woodworking tools. Tom’s concerns were mainly about the assumptions made by his director of Systems Department, Ron Collins, who had originally come up with the analyses and the alternative capacity expansion strategies. The validity of these assumptions was crucial to the outcome of any of the strategies. Tom had asked Ron to present his report to the board’s meeting tomorrow morning. Tom knew that the presentation would involve a great deal of quantitative analysis and was wondering if the board members were quite ready for that. Based on experience, he knew that most of the members were mainly concerned about the qualitative aspects of proposed projects. This was particularly true of Jerry Caldwell, the director of Human Resources.

Company Background and Issues

Last year Textron’s sales were over $255 million making it one of the largest industrial tool manufacturers in the industry. The company supplied large manufacturing firms both domestically and internationally. For the past 10 years, Textron’s sales and earnings had grown at an average rate of 9% a year. Top management had felt that this growth rate was too low and had established a long-range objective of 15 percent growth per year. Achieving this objective was not easy. Competition was intense and the industry somewhat mature. WoodSmith division, which manufactured woodworking tools, was of prime importance in reaching this goal. The primary market for WoodSmith was furniture manufacturing firms and the housing industry. This division’s sales was quite good and the first quarter reports indicated that WoodSmith orders were up 21.7 percent over last years orders. In fact, demand from the current customers alone was already consuming main WoodSmith’s main plant production in Greenville, North Carolina. Additional capacity was clearly necessary. However, the best method for attaining that additional capacity was unclear.


The Alternatives

Three alternatives were under consideration for increasing WoodSmith capacity.

1.Expanding the existing plant in Greenville. Th initial cost of such expansion would be less than any new facilities since the land and most required additional plant space were already available. However, this expansion would be limited to only 10 percent of existing capacity. This would solve the problem of under capacity only for the next 3 to 4 years, whereas a new plant would have such effect for at least 10 years.

2.Jackson, Tennessee. This location would allow Textrom to reduce the $15 per ton freight equalization that it was currently paying to supply its major mid-western customer. Furthermore, Textrom already owned a plant, belonging to another division, in this area that was being phased out of its operations. Therefore land and building were already available at a price well below building a new facility. This location was big enough to allow 25% capacity increase. Production would be possible by next year and half.

3.Birmingham, Alabama. The Birmingham are would provide an estimated $930,000 in sales in 1969, up from $720,000 in 1968 and was considered a very fast growing area in the nation. However, this location was the center of competition and would also increase the freight equalization charge to $18 per ton. It would cost almost $3.4 million for building, land and equipment and new production would not begin for next 3 years. By building the plant specifically for WoodSmith production, however, the company could automate much of the production process and have the most cost efficient facility in the industry.

The Meeting

The board meeting was presided by Tom. Billy Young, vice president for finance, Jerry Caldwell, Ron Collins, and Peter Shapiro, manufacturing vice president, were the other members in the meeting.

Tom: We’ve got to decide and soon. You know the objectives of the company. If we want to reach that 15 percent growth rate, we should do something fast. Ron has done a preliminary analysis of the situation and has come up with three alternatives. Let’s look at these alternatives. Please don’t hold back your comments.

(Ron presents his analysis of the alternatives)

Ron: I personally believe that we need to take advantage of technology and make our plants as cost efficient as possible. Building a new plant in Birmingham, Alabama would allow us that. But you can see it is pretty expensive. What is most important is that the Birmingham location is right in the middle of a rapid expanding new market. We should consider our strengths and how can we fight already established competition in the area.

Peter: But we should also be aware of the present constrain on our capacity and how fast we want it to increase. A new plant in Birmingham would take too long to start production. Maybe we should stick with expanding our plant in Greenville. This way, we will not commit ourselves to too much investment, should the demand pattern change.

Ron: Marketing department forecasts indicate that if there is going to be any demand change it is going to be a step increase. I don’t think we will be talking much risk if we add additional capacity beyond our present needs. Besides, having a plant in Birmingham would make it easier to deliver our products faster to the potential customer. The Birmingham area is growing quite fast, you all know.

Peter: What about our place in Jackson. It certainly has some advantages.

Tom: Yes. But I have a report on that location. It needs substantial renovation, especially if we want to automate the plant. I am not sure if it will cost much less than a new plant.

Ron: Birmingham alternative seems to be the best bet, considering the significance of be cost efficient.

Peter: The trouble is that that plant will not be ready soon enough to remove our present capacity constrain. We need some quick relief.

Tom: There is a way to do both. I think we could publicly announce that we are going to build a plant in Birmingham This will preempt the competitors from entering that market. It is important to release such information to the public, since it is an industry practice to develop one’s strategy on competitor’s strategies. We already have some report indicating that one of our major competitors is doing a feasibility study for a new plant in the Birmingham area. Meanwhile we could expand the plant in Greenville just enough to meet short-term demand. This doe not have to be announced to the public. You understand.

Peter: It sounds like a very good idea.

Ron and Billy: Yes. This is very good.

Jerry: I don’t question your financial analysis and your figures, I just don’t feel comfortable about this publicly announcing something and doing something else. What do you all think about this?


Discussion Questions

(1)  Define the capacity planning problem.  Explain the relationship between plant size and economies of scale.

(2) Differentiate between “design capacity” (also called: “best operating level”) and “maximum practical capacity” for a production facility.

(3)  What impact will increased automation usually have on the shape and positioning of the “average cost per unit” curve (as a function of operating volume)?

(4)  What factor is usually the most important in locating a service facility – proximity to raw materials or proximity to customers?

(5) What breakdown of the phrase “economy of scale” proposed to avoid ambiguity?  Explain and differentiate the three sub-components of “economy of scale” identified.


Long-Range Facility Planning Exercises

1.A company has formalized a new-product concept and must now decide whether to provide for long-range production capacity in its five year plan. The company has three opportunities for profiting from the new product: sell the idea outright now to another company, lease the concept for a royalty, or develop the product in-house. If the concept is sold outright, it will bring $1,500,000. A consulting firm has surveyed the potential markets for the idea. If the concept is leased for royalty, two companies have submitted proposals and this information applies:

Size of MarketProbabilityPayoffs
Company A
Company B


If the company develops the concept into a new product, it can sell the rights out to the product. If this alternative is selected this information applies:

Size of MarketProbabilityPayoffs


If the company develops the new product and then produces and markets it, this information applies:

Size of MarketProbabilityPayoffs


a.Use a decision tree analysis and recommend a course of action for this new product idea.

b.If the company follows your recommendation, what returns should the company expect to receive


2.A home product discount store is considering expanding its capacity to meet a growing demand for its products. The alternatives are to build a new store at a side nearby, expand and refurnish the old store, or do nothing. Economists have projected the regional economic outlook: a 50 percent probability that the economy will remain unchanged, a 20 percent of an economic upturn, and a 30 percent probability of an economic downturn. The following estimates of annual returns have been prepared (in millions of dollars):

Market DownturnStable MarketMarket Upturn
Build new store$(0.8)$0.5$2.1
Expand old store(0.4)0.81.4
Do nothing(0.1)0.20.5


a.Use a decision tree to analyze these decision alternatives.

b.What should the company do based on your decision three analysis?

c.What returns will accrue to the company if the recommendation is followed?


3.A company manufactures stamped steel products. Increasingly, foreign producers are undercutting the company’s price for these stamping, and the company is studying the technology of its production capacity to determine if it should be upgraded to become competitive with foreign firms. If production processes are automated, the net present value of the returns (net present value means that the returns are expressed in terms of today’s dollars) to the company is dependent on the market for the plant’s products:

ProcessMarket LevelLikelihoodReturn



If the company decides to do nothing now and review the situation in five years, two alternatives will probably be present then- continue operating with the existing production processes or shut the plant down and liquidate its assets. If the plant continues to be operated in its existing condition after five years, the net present value of the returns is dependent on the market for the plant’s products at that time:

AlternativeMarket LevelLikelihoodReturn
Do nothing now, continue operating in existing conditionsHigh0.3$3,000,000


If the company shuts the plant down and liquidates its assents after five years, the net present value of the returns is estimated to be $2,000,000.

a.Use a decision tree analysis and recommend a course of action for the company.

b.What returns should the company actually expect from following your recommendations?

Use <POM-Window> for Decision-Tree Problems


Step-1: Start <POM-Windows> – click <Decision Analysis> from the [Module] menu.

 Step-2: Under <File>, Click<New> – you will see a downward menu – listing available two options:

  1. Decision Table
  2. Decision Tree

Now, selecting the <Decision Tree>.

Step-3:  Now you well see data input screen <Creating a new data>:

Before you can start to input, now you must draw the tree on the paper first (like the ones you see in your Sup. Text, and PPT files) in which, labeling each decision point (Square) with numbers (like, 1, 2, ..) and event point (Node) with letters (like A, B, C, ..).  You have the power to decide on this labeling process, just making your tree looks good.

Then, on this screen,

Type in:  <Problem #1 > in the [Title] box

(or any name you like)

Typing in the [No. of  Branches] box (you count the number of branches in your tree)

Selecting a name for each row data [like, Branch1, Branch 2, ….]

Then, Click on [OK], you will see data input matrix screen.

Step-4: On <Data input matrix screen>:

I can tell you too much for this screen.  You need typing in based the one on your paper tree – you made earlier. Be aware – look at the top-right corner for the specific instructions the program will provide to you.

Step-5:   Now, click on <Solve>  – you will see <Output> screen.



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