When creating a set of financial projections for a manufacturing business, part of the review process is to ensure that the business has sufficient production capacity and resources to manufacture the products needed to achieve the sales forecast and required inventory levels included in the plan.
Production capacity or manufacturing capacity refers to the maximum number of units of production a business is capable of making with its available resources such as machinery, buildings, and production labor.
The process for reviewing production capacity in financial projections involves three separate steps.
Step 1. Production Budget: The first step is to decide on the level of production needed to satisfy sales demand and required inventory levels. This is more fully discussed in our Production Budget Plan and Inventory Management tutorial, and our Production Budget Calculator is available to help calculate the number of units the business needs to make.
Step 2. Production Capacity Requirements: Next the business needs to decide how much production capacity is necessary to meet the production budget plan and ensure that the business plan and financial projections incorporate sufficient resources in terms of machinery, production facilities, and labor to provide this production capacity.
Step 3. Capital Investment: Finally, the production capacity calculated in Step 2 has cost implications. The financial projections must include the necessary expenses to pay for the required labor and operating costs, and also include the necessary capital investment to purchase machinery and build the production facilities required to satisfy the production needs.
Production Capacity Planning Calculation Example
The example below shows a typical production capacity review process. Assume that the business developed draft financial projections using the financial projections template, and has estimated its sales levels and required inventory levels.
Step 1: Production Budget
Suppose as the first stage of its business plan and financial projections the business has calculated an annual production budget of 24,000 units based on forecast sales demand and required inventory levels.
Step 2: Production Capacity Requirements
The business plans to operate one shift of 7.5 hours a day for 250 days of the year. The peak capacity in terms of production hours is therefore 1,875 hours (7.5 x 250)
If the products to be manufactured take 0.5 hours of machine time to produce, then the peak capacity for one machine in terms of units of production, is calculated as follows.
Peak capacity (units) = Peak hours / Unit production time Peak capacity (units) = 1,875 / 0.5 Peak capacity (units) = 3,750 units
Unfortunately the production facility will not be operating at 100% efficiency, there will be breakdowns, maintenance requirements, set up time etc. To allow for this an estimate of the operational efficiency needs to be included in the calculations.
Suppose the business operates at 80% efficiency, the effective capacity is calculated as follows.
Effective capacity = Peak capacity x Efficiency Effective capacity = 3,750 x 80% Effective capacity = 3,000 units
So running one 7.5 hour shift for 250 days a year with one machine operating at 80% efficiency , the business can produce 3,000 units.
Knowing we have a production budget of 24,000 units and each machine has a capacity to make 3,000 units we can now estimate the number of machines required by the business to produce sufficient product to satisfy sales demand and required inventory levels.
Machines required = Production budget / Effective machine capacity Machines required = 24,000 / 3,000 = 8
To satisfy the forecast demand in the financial projections the business will need 8 machines.
The requirement for 8 machines now dictates among other things how much space the business needs for its production facilities. If each machine requires say 60 sq ft in which to operate, then the minimum production facility has to be 480 sq ft (8 x 60).
Likewise the requirement for 8 machines also dictates the number of production staff required.
If each machine requires 2 people to operate, then the minimum labor hours needed is calculated as follows.
Labor hours = Machines x People x Peak capacity hours Labor hours = 8 x 2 x 1,875 Labor hours = 30,000 hours
Together with materials, the cost of this labor forms part of the cost of the product included in the gross margin calculations.
Step 3: Capital Investment
To calculate the required capital investment in machinery and production facilities it is now simply a matter of attributing a cost to each machine, and a construction cost per sq ft to building the production facilities.
Suppose in the above example, the cost of each machine is 2,000 and the cost to build production facilities is 250 per sq ft, then an estimate of the required capital investment can be calculated as follows.
Machinery capital investment = Number of machines x Machine cost Machinery capital investment = 8 x 5,000 = 40,000 Production facility capital investment = Area x Cost per sq ft Production facility capital investment = 480 x 250 = 120,000 Total capital investment = 40,000 + 120,000 = 160,000
In summary, based on the draft financial projections, the business shows a requirement for a production budget of 24,000 units a year. One way to achieve this is to operate 8 machines for one shift of 7.5 hours for 250 days a year. The capital investment required to achieve this is 160,000 comprising 40,000 in machinery and equipment and 120,000 to build production facilities.
Now suppose the business does not want to or cannot afford to operate 8 machines in a facility costing 160,000. An alternative solution might be to operate a second production shift.
Suppose the business operates two shifts the first of 7.5 hours as before, and a second evening shift of 4.5 hours.
Using the same calculations as above, the capital investment required is calculated as follows.
Peak capacity (hours) = (7.5 + 4.5) x 250 = 3,000 hours Peak capacity (units) = 3,000/0.5 = 6,000 units Effective capacity = 80% x 6,000 = 4,800 units Machines required = 24,000 / 4,800 = 5 machines Production facilities required = 5 x 60 = 300 sq ft Labor required = 5 x 2 x 3,000 = 30,000 (as before) Machinery investment = 5 x 5,000 = 25,000 Production facilities investment = 300 x 250 = 75,000 Total capital investment = 25,000 + 75,000 = 100,000
The business operating two shifts can now produce the required number of units (24,000) with a capital investment of 100,000 comprising 25,000 in 5 machines and 75,000 in production facilities.
It should be noted that although the number of labor hours to produce 24,000 units is the same as before (30,000), the additional evening shift may result in overtime rates being paid thereby increasing the labor cost and reducing the gross margin of the product.
Of course as an further alternative the business might chose to rent the machinery and production facilities, in which case they must ensure that instead of capital investment, the operating expenses are increased to allow for the rental costs.
Following this process, it can be seen that there are many ways for the business to provide the production capacity to manufacture the products needed to satisfy sales demand and required inventory levels.
Whichever route is chosen, the business must now ensure that the draft financial projections incorporate the necessary capital investment, labor costs and other expenses to provide for this production capacity.
In the financial projections template, the capital investment would be included in the cash flow on the line headed ‘Amount paid for long-term assets’. In addition, the necessary funding, either by way of debt or equity, would need to be included to finance this capital investment in machinery and production facilities.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.