CHAPTER 7

Fundamentals of Capacity Dynamics

As mentioned in Chapter 6, capacity is one of the largest, most pervasive, and arguably most ignored aspects of an organization. The purpose of this chapter is to increase the awareness of the operational dynamics of capacity so that it can be managed more effectively. By operational dynamics, I mean how capacity functions within your organization. This is critical when thinking about, planning, and managing capacity; the means. How you use capacity and the demand for it can affect how much you need and, therefore, how much you buy. This, of course, affects cash_OUT when pay for what you buy.

Ideally, you will want appropriate supporting capacity metrics that describe how to use capacity and create output. These metrics should help you strike a balance between being efficient, effective, and productive. Being efficient allows you to create more output at a given level of input or the same output with less input. Making ten widgets in one hour is more efficient than making nine. However, efficiency isn’t enough, as the Big 3 found. Efficiency in the absence of being effective and productive can lead to poor managerial decisions and corporate results. Being effective and productive means you are using your capacity to do what is needed by your firm and the market, and no more. As defined in this book, effectivity and productivity have a component of aligning output with demand that efficiency does not have. Hence, focusing on efficiency alone can cause companies to buy or produce more than demand dictates, leading to poorer cash performance.

Every capacity type has the same operational attributes:

Let’s consider each in the context of improving organizational performance.

Buying Capacity

When you buy capacity, you buy a fixed amount of it for a price. For instance, when leasing space, you may pay $20,000 for 5,000 ft² for a month. With labor, you buy an hour, day, week, month, or year for a fixed price. With materials, you buy so many pieces, kilograms, liters, or meters of materials. Since the amount of capacity you buy is fixed, I sometimes refer to it as static capacity. I also synonymously use the term input capacity because they are inputs for creating work.

If you believe your costs are high and you want to know where money is going, look at the levels of input capacity you’re buying. There is a direct relationship between the input capacity you buy and cash_OUT, which is a function of when and how you pay for the input. When you are inefficient, ineffective, or unproductive with your capacity, you may need to buy more to meet demand. This information is not found, nor is it comprehensively available on the income statement. You may find some evidence in cash flow statements and the balance sheet, but the story is not as clear as if you just looked at the rate of cash leaving your firm because demand, the key element, is not a consideration in accounting reports.

Overproduction can lead to the need for excess capacity, as artificially high demand and subsequent output levels may require higher levels of capacity to process. The efficient use of capacity allows for more to get done with less input, hence, by using it wisely, you can get away with meeting demand with lower levels of capacity and, therefore, lower cash costs. The problem is, accounting can hide this excess labor or material capacity. It may show up, for instance, as a negative variance or may end up on the balance sheet as excess inventory. Excessive equipment purchases are hidden in depreciation values. This keeps you from seeing the immediate and periodic cash impact of decisions you make.

Overbuying capacity in the name of purchasing economies of scale, too, is an issue. Faced with lower unit price options, there is a tendency to focus on the deal rather than on the money being spent. Three for five dollars seems like a better deal than one for two dollars even when there is only demand for one or two. Emphases should be placed on both the demand for what you’re buying, and the cash spent.

There is a tendency with capacity to shift understanding, interpretation, and metrics to the Accounting Domain. For instance, if we lease 5,000 ft² of space for $20,000, you may be tempted to describe it as $4 per square foot. However, it is not $4 per square foot in the OC Domain. This is an Accounting Domain metric. In the OC Domain, you simply paid $20,000 for 5,000 ft². It is not broken down into smaller units, square feet in this case, because you were not buying by the square foot, you are buying a combined 5,000 ft². The $4 per square foot is a transformation of OC Domain data to create an Accounting Domain metric.

Consume Units of Capacity

Once we have the static capacity, the idea is to consume it with tasks or work. The factory worker builds widgets just like the construction worker executes building and improvement projects. Medical staff treat patients. This may be how we typically think of capacity, but it is limiting. The laborer is no different from a customer service rep, an HR manager, a finance director, or the CEO. You buy access and you consume them to perform work. Similarly, they are no different from the space you rent and consume, the computer processing and storage space you buy and consume, or the 10,000 pounds of steel you buy and convert to finished products.

As mentioned before, with input capacity, you pay for access to a certain number of capacity units and you consume what you bought. If you buy 10,000, pounds you consume pounds as you create output. If you buy eight hours, you consume hours as you perform work. If you buy 5,000 ft² of space, you consume square feet creating offices, performing operations and work, or storing items.

As you perform work, there is one truth. Think about the ball and the table. That intersection yields one answer no matter how you may want to represent it. Similarly, how much capacity the work consumed is, in retrospect, unambiguous. For instance, if you spent 30 minutes on a conference call, that you spent 30 minutes is unambiguous. Reporting what you did may include inaccuracies. For instance, if you’re required to keep track of, and document your time for reporting purposes, you may not report the 30 minutes accurately. However, the fact remains, you physically spent 30 minutes on the call whether you reported it accurately or not. This is important when understanding the use of capacity.

Output Capacity

When you buy 10,000 pounds of steel, that is input capacity; what you start with. Output capacity is what you can and do create with the input. For instance, if each product manufactured requires two pounds of steel, you can create 5,000 units, theoretically, from the steel you bought. That is the production output capacity of the steel in the context of making that particular product. Another product or combination of products can, and often will, create different levels of output capacity from the same amount of input. Because output levels can change, it is also referred to as dynamic capacity.

Output capacity, and the difference between output and input capacity, is very important to understand and manage because their interplay will decide how well your company performs both operationally and financially. Input capacity is what you buy and spend money on. Output capacity is what you can create from the input you bought. For instance, you hire a laborer for one day for $240. What you bought for the $240 is eight hours. That is input. Now you have her begin answering phones at a rate of five per hour. What you get from her, five calls per hour, is output. If the five phone calls consume an entire hour and that is the most she could possibly handle, that is her maximum output capacity. However, if she can handle more calls, the five is her realized output capacity and her maximum is a higher number.

When you focus on improvements such as buying new computers, software, equipment, you implement lean, or execute Six Sigma projects, the focus is typically on improving output and output capacity. In the same hour, call screening software may increase her output to eight calls from five. This is more output (8) at the same input level (one hour). There is a tendency to capture improvements like these as cost savings. However, input capacity, what you spent money on, has not changed. Hence, there are cost_NC savings, but not cost_C savings because you’re still on the same isocash curve and cash_OUT was not affected. The input capacity cost creates the cash basis for the isocash curve and output just moves you along the curve. Improving the output of input capacity just means you have increased efficiency, not saved money.

Mathematically, efficiency is just the ratio of output to input. For instance, you buy one gallon of gas. That is input. You drive 20 miles, output, and consume the gallon of gas. Your fuel efficiency is 20 miles for one gallon of gas or 20 miles per gallon. A more efficient car may travel 30 miles for each gallon. Fuel efficiency takes the output, distance traveled, and divides it by the input, one gallon. The same concept works with all other types of capacity. If our employees can increase the number of calls they can handle in a period of time, what we bought, time, has not changed, but the output has, and efficiency has improved as a result.

Let’s assume a gallon of gas costs $4. You can calculate a cost per mile of 20¢ when getting 20 miles per gallon. The cost per mile decreases to 13.3¢ as efficiency increases to 30 miles per gallon, but what you paid, $4 cash, did not change. Same numbers, different information. The cost per mile is cost_NC, and it decreases as efficiency increases. This isn’t a coincidence. The cost per mile is just the math inverse of efficiency.

Hence, increasing efficiency is the source of a lower cost per unit.

Consider the phone answering example. The input capacity we bought from a labor perspective was time. It is the denominator in the efficiency equation. The calls made comprise the numerator. For maximum output capacity, assume in one hour, she is able to make eight versus her usual five calls. You can see improvements in both efficiency and cost per hour by increasing output. If she makes $30 per hour, and through improvement her efficiency has increased to eight calls for $30 from five calls for the same $30. The cost per call will decrease to $3.75 from $5, again, with no change to cash.

The key, though, is whether there is demand for eight. If the improvement is made and there is no demand for eight calls, the improvement does not do a lot for you directly. Although she can make eight with her time, only five may be needed. The manifestation is that capacity is being made available that would have otherwise been consumed (Exhibit 7.1). This excess capacity can be used by other activities, eliminated, or left alone.

This suggests improvements such as lean and ERP solutions will not often improve cash directly with their proposed improvements. They target output and what you bought was input. To have a financial effect, you will have to shift to a lower isocash curve by changing what you buy. This is what focusing on the means bought for Toyota. They had a lower cost to meet demand, suggesting they operated on a lower cost curve relative to their competitors. The objective is to make decisions that affect cash_OUT. The changes necessary to reduce cash costs will not happen on their own. They require purposeful acts, enabled by improvements, that will cause the change (covered in Chapter 17). Understanding the cash dynamics will explain why.

Exhibit 7.1 By increasing efficiency, output levels can be met while consuming less capacity. This will free capacity to be available for other purposes

A Few Words on Time Sheets

My friend Ron Baker asked if my position on capacity suggests I’m an advocate for time sheets. One could conclude that given my interests in capacity consumption rates. However, I’m against their use. Here’s why.

I liken capacity utilization and management to looking at your property and its landscaping. If you stand across the street and look at your house, you can see whether there is a balance or not with the trees, shrubs, or decorative pieces you’re looking at. From here, you can plan your next steps; what else do you need to buy, where are you going to put it, or how are you going to use it. You may also observe something that is out of place or something you may need to look at in more detail as it relates to all other factors. You’re looking at the big picture and how things relate to one another, and then comparing them to what you consider desirable.

The question is, if you’re looking to manage the big picture in this scenario, would standing in the yard counting trees, shrubs, or blades of grass provide you with a better understanding of what you’re trying to manage? Would you understand how beautifully or effectively you’d designed your landscape? No. There seems to be a point below which detailed data fail to provide a better understanding of the whole system. As Stuart Kauffman, an author and leading thinker in the area of complexity noted, when studying living systems, which some argue businesses are, “[l]ife…[emerges] whole and has always remained whole. Life, in this view is not to be located in its parts, but in the collective emergent properties of the whole they create.”¹ He also states, “In all these cases, the order that emerges (from the living system), depends on robust and typical properties of the systems, than on the details of structure and function.”

When we start looking at parts of an 8-hour shift, we lose track of what we are supposed to be managing. It’s easy to get caught up expending resources to adjust individual blades of grass that seem out of place when viewed closely. However, in the bigger picture, they don’t distract from what you’re trying to accomplish and are hardly noticeable. What does knowing how much time someone spent in the bathroom or talking to a friend tell you about how productive they were overall? What’s important is the whole; given the level of capacity that exists, how much output was it able to create? Was it enough, too much, or not enough compared to demand? Was it considered valuable to the market? Those are the most important first questions. With the right tools and perspective, you can easily see whether you have problems with capacity levels, consumption, processes, or procedures, all from this simple question and subsequent analysis.

Managing by time sheets is akin to Johnson’s managing by results. The objective should be to consider the previous questions, identify high level issues, understand how work is done and to eliminate waste found when performing the work; manage and improve the means. If you do that, output improvement opportunities should be created. Keeping detailed track of time doesn’t fix anything. It doesn’t improve the process; it just reports “what was,” but only in a perfect world. The world of time sheets is far from perfect, however. Consider these factors why I believe time sheets should not be the focus to managerial activity.

The ultimate objective, as stated earlier, is to create output consuming the least amount of capacity. By stepping back and looking at the bigger picture of your system versus looking under a microscope, you will be able to see what is good and where improvement opportunities exist within your system. Again, this can happen without time sheets. If a report that should take hours takes days, there is a sign that something is wrong. Walking up to someone and asking her what caused the delay will likely, in a trustworthy working environment, create the information necessary to know the situation and address the situation. Answers such as, the computer was down, didn’t have the right information, the report was 9th on the priority list, or she forgot to do it may result, but you now know what happened. With the right approach, these are answers that can be identified, and addressed without a single time sheet being created or processed.

¹ Kauffman, S. 1996. At Home in the Universe: The Search for the Laws of Self-Organization and Complexity, 24. Cambridge, MA: Oxford University Press.