The capacity cushion is the ratio of capacity used to the best capacity level

Agdex#:	810
Publication Date:	December 2016
Order#:	16-059
Last Reviewed:	December 2016
History:
Written by:	Nick Betts, Business Management Specialist/OMAFRA, Guelph

Table of Contents

• What is Capacity?
• Measuring Capacity and Utilization
• Economies of Scale
• Calculating Capacity Cushions
• Expanding Capacity
• Long-Term Capacity Decisions
• Where do I Start?
• Resources

How much do you want to produce? How much money do you want to make? Most often the answer is, "as much as I can!" - which is the wrong answer. This answer signifies there are aspects of your business that are not understood well. Knowing how much your farm business can handle and what is needed to increase your capacity or enable you to produce more is essential to a sustainable, profitable and lower-stress business built on strong management, not market guessing and luck.

What is Capacity?

The capacity of your farm operation is defined as the maximum level of value-developing activity, under "normal" conditions.

Consider a simple example: a parking garage that has 100 parking spots. The volume of cars the garage can hold is 100; however, the processing capacity is dependent on how the garage is used. If the garage is only open 8 hours a day, full of commuting office workers, the capacity is 100 vehicles per day. Alternatively, if it is open to shoppers at a mall, with each shopper averaging 2 hours at the mall, the capacity of the garage is expanded four times in the same number of hours, having a capacity of 400 vehicles per day. Your farm is no different than a garage in this respect; your capacity will change depending on how you use your resources and what you produce on your farm.

If you look at your farm as a system, you will get a good idea of how close to maximum capacity you are operating. Aspects of your business will be running at capacity, others may be operating under capacity. These two processes need to be managed differently. The parts of your farm operating at their maximum capacity can be a significant risk - what happens if something goes wrong? The whole system could collapse because of an over-capacity issue. On the other hand, if you are operating significantly below capacity, there is significant waste in the system, effecting profitability and conservation practices.

There is an optimum efficiency that enables you to manage effectively with limited waste, but with sufficient capacity to manage risk, if unforeseen circumstances require you to change operations in a crisis. It is critical that you ensure your farm has enough capacity to meet all current and future demands placed upon it.

Measuring Capacity and Utilization

Planning your farm's long-term capacity is a big task that is critical to the success of your business, one that involves investment of both time and money. In order to make effective progress in understanding and developing your capacity for expansion, you must be able to measure your current capacity.

Capacity is expressed in one of two ways: output measures or input measures.

Output measures of capacity are best suited when applying to individual processes within your operation. For example, the number of lambs produced in a year. As the complexity increases (e.g., number of ewes housed, amount of feed produced, etc.), this method becomes less useful.

Input measures of capacity are generally used for low-volume and flexible processes. For example, if you are considering changing from an annual lambing schedule to an accelerated system.

Utilization refers to the proportion of time a process is in actual use, compared to its design capacity. It is measured as the ratio of average output rate to maximum capacity and is expressed as a percent.

This formula allows you to determine whether or not you should have extra capacity or eliminate unneeded capacity. Examples of where this could be applied on-farm include machinery, equipment, fields, barns and staff.

Utilization = average output rate/maximum capacity x 100%

For example, if a factory has a 60% utilization rate, it is making 60 goods over a specific time, when maximum capacity of the machinery making the goods is 100 items over the same time period. Another example could be the number of lambs finished per year/barn capacity x 100%.

When using this formula, the average output rate and the maximum capacity must be measured in the same units (e.g., time, units, dollars, etc.).

Maximum capacity is the peak level of output that a process can sustain for a long period of time, over a year or longer. For example, a farmer may be able to work 20 hours a day during harvest, but would not be able to sustain this level of work - at least not effectively - over the course of a year or an entire growing season.

Economies of Scale

This is a concept that states that the average cost per unit produced can be reduced by increasing the rate of output. Economies of scale successfully demonstrate how you can drive costs down when output is increased. Examples include:

• fixed costs are spread over more units
• construction costs are reduced per unit output
• costs of purchased materials are less per unit output
• process advantages are found

This increase is not unlimited and it also has a peak. Once a farm becomes too large, diseconomies of scale set in, where the average cost per unit increases as the size of the farm continues to increase. At this point, excessive size brings complexity, loss of focus and inefficiencies that raise the average unit cost of a product. Larger operations are not necessarily more productive or better at managing risk; economies of scale are diverse across operations and tend to be dependent on the management ability of the operator more so than on infrastructure or market forces.

Calculating Capacity Cushions

One of the things you must consider before making any capacity decisions is the desired amount of buffer you want in your operations.

The capacity cushion is the amount of reserve capacity built into your farm business to handle sudden increases in demand or temporary losses of production capacity.

As a general guide, the average utilization rate should not be too close to 100% over a long-term period. As your operation approaches 100%, you will need to make a decision to either scale back the business or increase your capacity. This may be done through various ways that address the processes that are stretched to capacity. This could be through your employees, machinery used or barn size, for example.

If demand for your product keeps increasing, you should consider increasing the overall long-term capacity of your business in order to provide some buffer against uncertainties, as demand increases.

The appropriate size of the cushion varies by industry, by sector and by farm operator (e.g., large cushions are ideal for front-office processes where customers expect fast service times, like a strawberry farm that must handle significant volume of product and customers on-farm during harvest season, but not for the rest of the year). Some other considerations that should be factored into cushion decisions include your personal family events. If you are expecting significant life events (e.g., kids leaving home, new baby, retirement) within your family, it will affect your capacity. Life events change levels of stress for farm operators, as well as their priorities and ability to address challenges on-farm, both administratively and operationally. This should be factored into your analysis. While big cushions seem safe, small cushions are preferable because every bit of unused capacity costs you and your business money.

Expanding Capacity

There are two extreme theories for when to consider expanding your business through building capacity and managing risk. These two strategies are on opposite ends of the spectrum and your business strategy should take on an approach somewhere between these two, learning and borrowing from both.

Expansionist strategy

The expansionist strategy involves staying ahead of demand and minimizing profit loss due to insufficient capacity. This strategy is often favoured as it can result in strong economies of scale, allowing a farm to reduce its costs and compete on price.

Implementing this strategy can either result in increasing your overall output and market-share, or act to pre-empt the market in order to be first-to-market with your goods. For example, if you decide to make a large capacity expansion or announce that you have plans to do so, you can pre-empt the expansion of other competing jurisdictions or focus buyers on your geographic area as they plan their business strategies. For example, by illustrating your ability to build capacity and manage risk, procurement officers from a grocery store may choose to source product from your area, where capacity is high, over another region, where capacity is lower. This allows the grocery store to manage their supply chain risk more effectively.

However, in order for this strategy to be successful, you must have the ability to build capacity and follow-through with the intended strategy you lay out. Otherwise, you will lose the goodwill that fostered any short-term successes.

Wait-and-see strategy

The wait-and-see strategy involves lagging behind demand and using short-term options such as temporary workers, renting land and barns, purchasing feed, to deal with any shortfalls. The aim of this strategy is to expand capacity in smaller increments, such as renovating existing facilities rather than building new ones. For example, renting land may be an effective option to avoid large capital expenditures, especially for field-crop farmers looking to expand. The risk lies in losing access to rented land, in this case, illustrating the importance of written agreements.

By following demand, the risk of overexpansion based on overly optimistic demand forecasts, obsolete technology or inaccurate assumptions are significantly reduced.

However, this strategy has its own risks. If you decide to adopt this approach, you may be pre-empted by a competitor or competing jurisdiction, or may not be able to respond to sudden and unexpected high levels of demand or contract opportunities without pushing your system above capacity.

This strategy is better suited to businesses that are focused on the short-term. As a savvy farm business owner/operator, you will have to select the most appropriate strategy for your business needs.

There are innumerable strategies on the spectrum between these two strategies, such as the "follow-the-leader" strategy, which suggests expanding capacity in conjunction with your competitors or like-producing businesses. If you do this effectively, no business gains a competitive advantage, though volume of production and economies of scale can be beneficial to your business. However, if something goes awry with the leader, you will suffer a similar fate, which means that everyone has to deal with overcapacity issues. While your influence on the market may be small, the impact on your operations may be significant.

Long-Term Capacity Decisions

As you prepare to make decisions on your long-term capacity and how to proceed, there are four general steps that can be used to guide you in your decision-making:

1. Estimate future capacity requirements.
   Determine where your future capacity needs will be and how your operation relates to that today. Remember, capacity requirements can be expressed as either output or input measures.
2. Identify gaps by comparing requirements with available capacity.
   A capacity gap refers to the difference between projected requirements and current capacity. If multiple operations and several resource inputs are involved, making a long-term capacity decision can become very complex. For example, if you decide to only expand the capacity of certain operations, your overall capacity may be increased.
3. Develop alternative plans for reducing the gaps.
   Once you have estimated your capacity requirements and identified gaps, you should develop plans to cope with any projected gaps.
4. Evaluate each alternative, both qualitatively and quantitatively, and make a final choice.
   The final step involves evaluating each alternative both qualitatively and quantitatively. Qualitatively, does this fit into your overall farm strategy? You may want to use a "what-if" brainstorming session to further assess each alternative's implications before making a final choice.

Quantitatively, you must estimate the change in cash flow, not just potential output or profit, for each alternative over the forecast time horizon compared to the base case.

Where do I Start?

Capacity is a big concept to understand, let alone operationalize. The first step is to understand your system: is it better for you to use input or output measures? Determine which of these methods works best for your business. After this, brainstorm your process of growing and selling your product - write this down and determine your utilization rate for the various processes to learn where you can make profitable change.

Resources

OMAFRA Factsheet: Preparing Business Plans, ontario.ca/agbusiness

Slack, Nigel, Stuart Chambers, and Robert Johnston. 2007. Operations Management. 5th ed. New York: Prentice Hall/Financial Times.

Greasley, Andrew. 2009. Operations Management. 2nd ed. Chichester, England: John Wiley & Sons.

Krajewski, Lee, Larry Ritzman, and Manoj Malhotra. 2010. Operations Management: processes and supply chains. 9th ed. New Jersey: Prentice Hall.

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What is capacity cushion quizlet?

Which one of the following operating levels is best with respect to capacity?

Which of the following situation is to be considered as best operating level?

Is to find the capacity level of resources that best supports a firm's competitive strategy?