The Case for Capacity Management
Ultimately, we are all focused on The Goal; making money. The key question is, are we focusing on the right things to ensure we’re making money? I’d like to argue that, by and large, we are not. To manage money, we should model it, so we can see what is coming into and leaving the company, and how that affects how much money we have at any given moment. One of the most influential reasons money leaves an organization is paying for capacity it has purchased. Recall, capacity is what you buy in anticipation of demand or use. This includes space, labor, materials, equipment, and technology.
Capacity, then, should be the at the center of practically all financial and operational analyses. Whether you’re making money or you’re profitable will be influenced by how much capacity you have, how it’s used, and what was created and sold. When making improvements to processes via techniques such as lean and six-sigma, buying new IT solutions, or hiring consultants, you will find that the nature of the operational improvement will center on capacity, and the financial changes they enable are affected by capacity. Hence, managing capacity should be the center of our analyses, but it isn’t. Hourly labor capacity, for instance is often considered and modeled as direct labor in accounting analyses. Proof is found in the desire to focus on how it affects costs and profit as a variable cost even though its output is independent of what you paid to have it. We rarely look at space costs the same way we look at material, equipment, or labor costs even though, mathematically, and notionally from both operational and financial perspectives, they all behave the same as it relates to cash.
I would posit capacity is the most important and least understood aspect of business. As such, leaders make bad decisions with factors that are capacity related. Consider Toyota as a positive example. Arguably, the means Dr. Johnson referred to was primarily capacity management. By reducing changeover times, for instance, Toyota could manage machine capacity uptime as all as others managed around it by producing in large batches. This ultimately allowed Toyota to produce in much greater variety, in smaller batches, and in a much more cost-efficient manner than their competitors. Companies that were focused on results put their efforts into other areas that led to poor capacity management. For instance, instead of reducing setup time, they focused on buying faster equipment to reduce costs and maintain efficiency. If a machine is down due to changeovers, buy faster machines to make up for the downtime rather than eliminating that which causes downtime—lengthy changeovers. As Einstein said, a clever person solves a problem. A wise person avoids it.
Ultimately, our decision making is severely impaired with improperly modeled cost reduction analyses, make versus buy analyses, which lead to bogus value propositions, and investments in improvement opportunities and solutions such as IT projects that don’t realize the promised benefit.
To truly understand capacity, there are four ideas to understand about capacity:
1. The definition
2. It’s importance
3. The operating dynamics
4. The cash dynamics
The first two will be covered in this chapter. The operating dynamics of capacity will be covered in Chapter 7, while the cash dynamics will be the focus of Chapter 8.
Defining Capacity
In my book, Essentials of Capacity Management I defined capacity as what a company buys in anticipation of use or demand. If we think of capacity this way, it is what companies spend most of their money on. As mentioned earlier in the chapter, capacity includes space, labor, materials, equipment, and technology. Said differently, this is your office, factory, and warehouse locations that you are paying to lease or buy. It is all of the people who work for your firm. It does not only include the materials that go into products you make and sell, but the materials we consume in office work each day, and the inventory we have for operating equipment to minimize downtimes in case of a failure or repair. It includes the tools we used to perform work, such as MRI machines in healthcare, cranes and bulldozers in construction, planes in transportation, and stamping machines in fabrication. Finally, technology such as computers and servers, networks, and software, too, are types of capacity.
One way to think about capacity is to reconsider the local phone service example. We bought a month for $25 thinking we may or will need to use it sometime throughout the month. All capacity has the same attributes. We buy a certain amount, we consume some or all of what we bought, and this consumption leads to work output. Another key attribute is that what we buy and pay cash for doesn’t change with how we use it. We can calculate a cost per local call, for instance, but the $25 in cash we pay for local service remains the same whether we make calls or not. Similarly, neither the cash cost for salaries or rent change when consumed.
One important concept to understand as we define capacity is, it exists solely in the OC Domain. What you buy, how much you spend, what you do with it, and what it creates are native OC Domain attributes and data. The cash used to buy capacity affects the rate of cashOUT. What it creates that is sold forms the basis for the rate of cashIN. Hence, to understand capacity and to manage it effectively, the only way you can do so is to have an OC Domain model of capacity.
Understanding the Importance of Capacity
As mentioned previously, capacity is critically important to your business, and there are three reasons why I believe this is the case. First, capacity is likely your largest expenditure. When considering the entirety of what comprises capacity, that’s where your money is most likely going. Second, capacity is the basis for how most work is completed; the means. We buy capacity, we consume it, and create output. Whether making widgets in a factory using people, equipment, and materials we’ve purchased or performing surgery using people, space, and equipment, the capacity we buy is center to the completion of practically all work. This is where Toyota focused, which led to a significant competitive advantage. Finally, it creates the foundation for all financial data in both the OC Domain and the Accounting Domain. Being the largest expenditure, it has a greater effect on cashOUT than anything else in the business. This means any analyses that occur in the OC Domain and are focused on cash must consider capacity. In the Accounting Domain, costs are often calculated considering the cost of capacity and how it was consumed. For instance, calculating a cost per customer service call, you’d consider the wages of the employee (capacity) and the number of calls or length of the call (output). Most situations where an allocation or assignment must be used involves creating a cost for the output of capacity.
Since capacity is a very important aspect of a business, it is essential to understand what it is and how it works. This enables you to make decisions in the OC Domain to get the financial results you want in both domains; manage the means to achieve the results. The next two chapters will go into the operational dynamics of capacity and the financial dynamics of capacity. This will help create an understanding of how to manage capacity to achieve desired targets while avoiding accounting-centric pitfalls that happen when capacity dynamics are ignored.