Business (9609) | Capacity utilisation and outsourcing

Operations Management: Capacity Utilisation and Outsourcing (4.3)

Hello Business student! Welcome to a really important area of Operations Management. This chapter is all about making sure a business uses its resources efficiently (Capacity Utilisation) and deciding whether to do tasks internally or pay someone else to do them (Outsourcing).

Why is this important? Operations managers must constantly balance output volume, costs, and quality. Getting capacity and outsourcing decisions wrong can be incredibly expensive and can destroy a business’s reputation. Let’s dive in!

1. Significance and Measurement of Capacity Utilisation (4.3.1)

What is Capacity?

Capacity is the maximum total output a business can produce in a given period (e.g., per week, per year) using its current resources (machinery, staff, buildings).

Think of it like this: If you have a water bottle that holds 500ml, its maximum capacity is 500ml. A factory with 10 machines, each making 100 units per day, has a capacity of 1,000 units per day.

Measuring Capacity Utilisation

Capacity Utilisation (CU) measures the actual output as a percentage of the maximum possible output.

This is a vital performance indicator because it shows how effectively the business is using its fixed assets (like machinery and buildings). A higher CU generally means lower unit costs, which leads to higher profit margins.

The Formula:

\[ \text{Capacity Utilisation} (\%) = \frac{\text{Current Output}}{\text{Maximum Output (Capacity)}} \times 100 \]

Example: If a car factory can produce 200 cars a week (Maximum Output) but only produced 150 cars this week (Current Output):

\[ \text{CU} = \frac{150}{200} \times 100 = 75\% \]

Impact of Operating Under Maximum Capacity (Low CU)

Operating below the optimal level (often below 80% or 90%) means a business has spare capacity. While 100% CU sounds ideal, it is rarely achievable or desirable (as discussed below).

Problems of Low Capacity Utilisation (Under-Capacity):

• High Unit Costs: Fixed costs are spread over fewer units, making each product more expensive to produce. This hurts competitiveness.
• Demotivated Staff: If workers are idle or underemployed, morale can drop, leading to boredom and low productivity.
• Wastage of Resources: Machinery and factory space are expensive resources lying unused, representing wasted investment.
• Perception of Failure: For service industries, empty tables in a restaurant or empty seats on a plane suggest the business is unpopular or struggling.

Impact of Operating Over Maximum Capacity (Strain and Pressure)

While 100% is the mathematical maximum, businesses often operate under intense pressure when CU is consistently high (e.g., 95% or more).

Problems of Operating at High/Stretched Capacity:

• Increased Stress on Employees: Workers may have to work excessive overtime, leading to fatigue, high labour turnover, and decreased long-term productivity.
• Reduced Quality: Rushing production or running machines constantly increases the risk of mistakes, accidents, and breakdowns. Quality control processes may be skipped.
• Loss of Flexibility: The business cannot respond to sudden increases in demand (unexpected orders) or machine breakdowns, leading to missed sales opportunities.
• Poor Customer Service: Delivery times lengthen, and the business may be unable to quickly handle complaints or special requests.

Did you know? The optimum capacity level is usually slightly below 100%, allowing for scheduled maintenance, staff breaks, and sudden peaks in demand. For many manufacturers, this optimum is around 85%-90%.

Methods of Improving Capacity Utilisation

Managers generally aim to match capacity closely to demand. If CU is too low, the business must either increase demand (output) or reduce its capacity.

A. To Increase Output/Demand:

1. Increase Sales/Marketing: Focus promotional efforts to boost orders, especially during off-peak times (e.g., running ‘early bird’ discounts).
2. Subcontracting (Partial Outsourcing): If a short-term increase in demand occurs, use another firm to temporarily manufacture some components or products.
3. Overtime/Temporary Staff: Ask existing workers to work longer hours, or hire temporary staff to manage peaks.
4. Diversification: Use the spare capacity to manufacture new products or offer new services, filling the empty time.

B. To Reduce Capacity:

1. Rationalisation: Close down unprofitable sites, sell off excess machinery, or merge departments.
2. Redundancy: Reduce the workforce (labour capacity) to better match current output levels, reducing overall fixed labour costs.
3. Sell Fixed Assets: Dispose of unused buildings or equipment.

2. Outsourcing (4.3.2)

What is Outsourcing?

Outsourcing occurs when a business arranges for activities, functions, or processes that were previously done internally (in-house) to be carried out by external, independent providers (third parties).

This is different from simply buying raw materials. Outsourcing involves hiring an external company to perform a specific *service* or *function* (e.g., payroll processing, IT support, or customer call centres).

Analogy: Instead of hiring a full-time cook (in-house), you decide to use a catering company (outsourcing) for all your office lunches.

The Impact of Outsourcing on a Business (Evaluation Focus)

Outsourcing involves complex decisions that affect nearly all areas of the business. You must weigh the potential benefits against the serious risks.

A. Positive Impacts (Benefits)

1. Cost Reduction and Efficiency

• Lower Labour Costs: Outsourcing to companies in countries with lower wages (offshoring) drastically reduces costs.
• Reduced Capital Investment: The business does not need to invest in expensive machinery, buildings, or software for non-core tasks (e.g., no need to buy a fleet of delivery vans if transport is outsourced).
• Fixed Costs become Variable Costs: Salaries (fixed costs) turn into payments to the outsourced firm (variable costs), giving the business more flexibility in a downturn.

2. Increased Focus and Quality

• Focus on Core Competencies: Managers can concentrate their time and effort on what the business does best (its core product or service), improving competitive advantage.
• Access to Expertise: External providers are specialists in their field (e.g., accounting or IT security) and often possess higher quality standards and technology than the firm could afford internally.

3. Flexibility and Capacity Management

• Easier Capacity Adjustment: If demand suddenly increases, the business can quickly increase orders with the external provider without needing to hire and train new permanent staff.

B. Negative Impacts (Drawbacks/Risks)

1. Loss of Control and Quality Issues

• Dependence: The business relies heavily on the external provider. If the provider fails, the entire supply chain can be disrupted.
• Loss of Control over Quality: While the external firm is specialized, the business loses direct control over how the task is performed, potentially leading to quality compromises if the external firm cuts corners.
• Communication Problems: Differences in culture, time zones (especially in offshoring), and language can lead to misunderstandings and delays.

2. Stakeholder and Reputation Risk

• Job Losses: Outsourcing often results in large-scale redundancies for internal staff, leading to low morale, high severance costs, and negative public relations.
• Confidentiality Risks: Handing over sensitive data (e.g., customer details or new product designs) to an outside firm can pose security and confidentiality threats.
• Ethical Concerns: If the external provider operates in a country with poor labour standards, the outsourcing firm's reputation can be damaged (e.g., 'sweatshop' allegations).

Factors Influencing the Outsourcing Decision

The decision to outsource requires careful analysis. Key factors include:

• Cost vs. Quality: Will the cost savings outweigh the potential decline in quality control?
• Core Competency: Is the function truly non-core? Outsourcing a core activity (the business's main source of competitive advantage) is highly risky.
• Reliability: How reliable and trustworthy is the external provider?
• Legislation/Contracts: Are the contractual terms clear regarding standards, delivery times, and penalties for failure?