Question

Discuss each of the four strategies for long-term capacity expansion. Include the benefits and risks of each. Which is best, and why?

Answer 1

1. One large capacity increase: -

The advantage of one large capacity increase is that the fixed costs of construction and operating system setup needs to be incurred only once, enabling the firm to allocate these costs over one large project. However, if aggregate demand exhibits steady growth, the facility will be underutilized.

2. Small capacity increases that match demand:

When capacity is above the demand curve, the firm has excess capacity; when it is below, there is a shortage of capacity to meet demand. In this situation, there will be short periods of over and under resource utilization. This is often called a capacity straddle strategy.

3. Small capacity increases that lead demand:

Since there is always excess capacity, safetycapacity to meet unexpected demand from large orders or new customers is provided. Thissafety capacity also enables the firm to give good customer service since backorders will rarely occur. Of course, this strategy is expensive. This is often called a capacity lead strategy.

4. Small capacity increases that lag demand:

This results in constant capacity shortages. It requires less investment and provides for high capacity utilization and thus a higher rate ofreturn on investment. However, it may also reduce long-term profitability through overtime, subcontracting and productivity losses that occur as the firm scrambles to satisfydemand. In the long run, such a policy can lead to a permanent loss of market position. This is often called a capacity lag strategy.