19

Capacity Planning:
A Case Study From
Cigarette Production
by P. N. Finlay*
It is conventional for a manufacturing company to equip itself to cope with a demand greater than that considered most likely to arise. Often the costs associated
with excess capacity are not high, and so little energy is expended on determining
least-cost solutions and options close to them.
Increases in machinery costs in the mid 1970s necessitated one cigarette manufacturer to rethink its policy towards machinery purchase; in particular that governing
the size of its machinery contingency allowance the machinery to hold over and
above that required to meet the most likely forecast of demand. This paper describes
the background to the refraining of this policy on machinery acquisition, including
an analysis of the structure of demand for cigarettes and ways of achieving an appropriate level of supply.
The machinery contingency allowance for one specific case of great importance to
the company is worked out in detail. This detailed exposition is then used to help
derive a formula and reference table that enabled robust least-cost solutions to be
determined covering all feasible values of the significant parameters.
Introduction
Within the cigarette manufacturing industry, the 1970s were a time of heavy capital
investment. Sophisticated machinery was available but at a price that required a
more carefully thought out acquisition policy than had been necessary in the past.
When this study was undertaken, the production department of one cigarette
manufacturer worked to a machine purchasing policy that provided a capacity 20
per cent greater than was needed to meet the "most likely" forecast of annual demand. This machinery contingency allowance of 20 per cent arose from the addition
of an extra ten per cent capacity to cover for errors in annual forecasts and a further
ten per cent capacity to cover for seasonal variations in demand. Owing to the steeply rising cost of machines the production manager felt that this policy ought to be
reviewed and he approached the company's management services department for
assistance. (This paper describes the subsequent study which dates from 1975. Consequently the policies presented in this paper may not necessarily be those currently
used).
The company produced many brands of cigarette. The vast majority were King
Sized (84mm long) but with 95mm and 100mm also made in quantity. The predominant pack was a 20s hinge-lid, and packs of 10s were also manufactured. The
*Department of Management Studies, Loughborough University of Technology.

20

IJOPM 3,1

making of the cigarettes themselves and their subsequent packing were the main
operations in the manufacturing process and the machinery becoming available in
the mid 70s included combined maker/packer units.
Although the principles established in the study would be valid for many years,
the production department wished the numerical calculations to concentrate on
financial year 1977/78 as this would be the first year in which the effects of any new
policy could be reflected in machines installed. The emphasis was to be on King Sized 20s cigarettes.
The paper begins by explaining how a generalised equation governing the errors
in forecasts and variations in demand for the company's cigarettes was derived, and
follows this by examining the ways in which the company could match supply and
demand. The least-cost method (and methods around this) were derived for the
specific case of meeting the demand for king sized cigarettes for the financial year
1977/78, including the most appropriate level of contingency allowance. Finally a
generalised model is developed and used to suggest a suitable machinery contingency
allowance for 95mm cigarettes.
Errors in Forecasts and Variations in Demand
From a general understanding of the company's markets, it was recognised that demand could be considered as made up of three elements a year-on-year trend, a
seasonal variation and a random, unexplainable fluctuation. The next section
describes how values for these three elements were derived.
Errors in the Forecast of the Annual Demand
The company's marketing intelligence department supplied the research team with
its estimate of the most-likely annual figures over the next five years, together with
high and low estimates. The high figure, which was about ten per cent greater than
the most likely estimate, was considered to have a one in ten chance of being surpassed. Using this information and assuming both that the error in estimation
would change linearly with demand and that it was distributed normally with no
systematic error, (as was thought to be the case by the marketing intelligence department) the probability that an annual estimate would differ from the best estimate by
more than a given percentage could be determined. The results of the determination
are given in Table I. For financial year 1977/78 the most likely average demand was
estimated to be 12,876 million cigarettes.
Seasonal Variation in Demand
To separate the seasonal and random components from the trend in the total demand, a 12 month moving average was derived for the years 1969 through 1975 and
taken as being the year-on-year trend. The residual data were analysed to see if any
significant changes were apparent in the seasonal variation. The conclusion was that
the size of the extra summer demand was remaining constant and not changing as
the average annual demand changed and that any other changes in the seasonal
pattern were likely to be inconsequential.
Following this result, the average amount by which each month's demand was
over or under the trend line was determined, and a smoothed curve drawn through

Capacity Planning

21

these points. The corresponding table of results (rounded to the nearest five million
cigarettes) is shown in Table II.
Table I. Probability of Annual Forecasts in the Demand for 84mm Cigarettes
being in Error by the Stated Percentages
% by which 'most likely'
estimate is surpased

Probability of this %
being surpased

2
4
6
8
10
12
14
16
18
20

40
30
22
15
10
6
4
2
1
0.5

Table II. Seasonal Variation of Demand for 84mm Cigarettes

(Monthly Difference from the Long-Term Trend)
Month
January
February
March
April
May
June
July
August
September
October
November
December

Difference from trend line

(Million Cigarettes)
-100
-110
- 5
40
65
80
65
50
30
- 5
- 35
- 75

Random Fluctuations in Demand

The random fluctuations in demand were analysed for the period 1969 to 1975. It
was concluded that they did not vary with the season of the year but that they did
vary with the average level of demand. The deviations around the mean were very
close to being normally distributed with the standard deviation of the random fluctuation in a. month's demand (S) being linearly related to the average monthly demand (D) by the equation:
S = 0.10 * D
Using the expected annual figures for financial year 1977/78 provided by the
marketing intelligence department, the above equation and assuming normality,
Table III was constructed.

22

IJOPM 3,1

Table III. Size of Fluctuation (in million cigarettes) which is Exceeded on the
Stated Percentage of Occasions
(Expected A>erage Monthly Sales of 1073 million cigarettes for Financial Year 1977/78)
% Probable

Fluctuation (rounded)

50
40
30
20
10
5
1

0
20
45
70
105
140
195

Before moving on to discuss the possible ways of matching supply and demand, it is
worth noting that in theory, errors in estimating machine efficiencies could be just as
important as errors in forecasting demand. However, in practice, errors in estimates
of efficiency would only have been consequential if they had been comparable to, or
greater than, the errors in the forecasts. From an analysis of machine operating
data, this was found unlikely ever to be so; the errors in forecasting annual demand
were expected to remain at least twice those associated with machine efficiencies.
Possible Ways of Matching Supply and Demand
With a demand whose general level could only be forecast imprecisely and which
varied from month to month in the manner described above, it was not easy to
match optimally the supply of goods to it. Nine possibilities appeared to be available
to help achieve the desired match, and these will now be discussed in turn.
Throughout this section the costs referred to will be those incurred over and above
the costs associated with normal working if the demand for cigarettes could be
forecast without error and if no seasonal variation or random fluctuations existed.
Prices relevent to August 1975 will be used throughout.
Supply the Excess Demand in the Next Month
Deferment of an order from one month to the next was obviously an attractive
measure since, unless sales were lost by doing it, it cost nothing. However, it would
not be much of an option to cover for inaccuracies in the forecasts of annual demand; its prime use would be as an expedient to cope with short-term shortages in
productive capacity.
Work Overtime
The maximum quantity per month currently achievable by overtime working appeared to be about 30 million cigarettes. The extra cost of making a thousand
cigarettes in overtime rather than in normal working hours was about 4p.
Install Extra Machines
Each maker/packer would be able to make approximately 25 million cigarettes a
month. Taking a 15 year discounting period as a rough guide to the lifetime of the

Capacity Planning

23

machine, and using the current discount rate of 11 per cent, the average yearly cost
of a machine would be roughly 27,000.
Using the data in Table I, the link is shown between installing extra machines and
the likely size of the demand that cannot by met. The results set out in Table IV.
Table IV. Consequences of Extra Planned Production Capacity to Cover
for Forecasting Errors for FY 1977/78
% Extra Capacity
allowed for

Likely Demand
not met (million
cigarettes) pa

Approx Extra
M/C cost
000 pa

4
8
12
16
20

195
80
27
7
2

46
93
139
186
232

The diminishing returns from increasing the per cent of extra capacity can be seen
very starkly from this table. For instance, an increase of capacity from 12 per cent to
16 per cent would enable an extra 20 million cigarettes to be made at an increased
cost of 47,000 an extra cost of about 2.3 per thousand cigarettes.
To get an idea of the cost of covering the seasonal variations by purchasing
machinery for this purpose alone, it is instructive to consider the successive purchase
of three machines. Given the pattern of this demand, (Table II) the first machine
would be called upon to manufacture 150 million cigarettes per anum (25 million
cigarettes in each of six months) at a cost of about 18p per thousand cigarettes,
whilst the second machine would be called upon to manufacture about 120 million
cigarettes per annum at a cost of about 22p per thousand cigarettes. The third
machine would be called upon to manufacture about 55 million cigarettes per anum
at a cost of about 50p per thousand cigarettes, whilst the fourth machine would be
called upon to manufacture about 5 million cigarettes per annum at a cost of 540p
per thousand cigarettes.
Stockpile Goods
Currently any cigarettes stored in the UK would be duty paid and thus represent
about 16 per thousand cigarettes in money tied up. At an interest rate of 11 per cent
the stockpiling of a thousand cigarettes would cost about 1.76. Since this was
greater than the costs associated with installing extra machinery, cigarettes were not
stockpiled in the UK.
On 1 January 1978, the UK was intending to move to an end-product taxation
system. Under it, it was expected that the timing of the levying of the duty would
also change to harmonise with methods adopted in other EEC countries. This would
enable goods to be stored duty free until the time of sale or, in the case of exported
goods, for UK duty never to be paid at all. Thus after 1977 stockpiling of goods in
the UK would become feasible.

24

IJOPM 3,1

The study was mainly concerned with the period after 1977 and so the concentration
was on the costs associated with the period after tax harmonisation. These costs
were of two types the cost of money tied up in stocks, and storage and handling
costs. The costs of money tied up that should enter this analysis were those that
could have been deferred had stockpiling not taken place. Because of the different
production and sales timings associated with a stockpile to cover the seasonal variation and that to cover for random fluctuations, the costs of money tied up were different at an 11 per cent interest rate, the annual costs averaged about 9p per thousand cigarettes and 20p per thousand cigarettes respectively.
A rough figure of 2p per thousand cigarettes was used to arrive at handling
charges and rental of warehousing. Stock durations in store were estimated as two
months for the buffer stock against random fluctuations and three months for the
seasonal stockpiles.
Alter the Pattern of Demand
Altering the pattern of demand through discounts or other incentives was only a
short term expedient it could not help problems brought about by errors in the
forecasts of annual demand. Because other methods appeared to offer a more
satisfactory answer to short term changes in demand, this possibility was not pursued further.
Use an Outside Manufacturer
It was planned to subcontract the manufacture of certain cigarettes' in the near
future; the charge for this would be 1.30 per thousand cigarettes.
Do not Supply the Goods
The company had established a list of the markets that would not be supplied if the
demand for cigarettes were greater than the supply. The contribution from the first
market on this list was about 2.50 per thousand cigarettes and, since this was a
large market, it could be taken that it would be this amount that would be foregone
if demand could not be met.
Increase the Short-term Machine Performance
An assessment of the "operating performance" for making and packing machinery
suggested that no improvement in efficiency during the peak summer period could
be achieved within the currently adopted overhaul/cleaning/training procedures.
Changes to these procedures could possibly enable efficiences to be increased in the
short-term, but since it was likely that the longer term disadvantages of such changes
would outweigh any short term benefits, this possibility was not considered further.
Buy Change-Parts
An apparently attractive way of coping with shortages in productive capacity for
one type of product when there was slack capacity for another, was to have changeparts available so that machines could be converted. Several features made this proposition less attractive when considered in detail however. Firstly, whilst conversion
of a making machine was straightforward, that of a packer took about three to four

Capacity Planning

25

weeks, so that only "long term" conversion would be feasible. Secondly only
limited conversions were possible only those between 84mm 10s packers to 84mm
20s packers and vice-versa, and from 100mm 767 to 84mm 767. Thirdly for purposes
of contingency planning it was necessary to be confident that the unforeseen demand for one type of product would not be positively correlated with that for
another to which machinery conversion was possible. For example, proposals to buy
change-parts to convert a 10s packer to a 20s packer would be ineffective if unforeseen increases in the demand for 10s were associated with unforeseen increases in the
demand for 20s.
Summary of the Use of Options
In summary it can be stated that the only feasible options of consequence were as

follows:

(1) To cover errors in forecasts of annual demand work overtime; install more
machinery; use an outside manufacturer; do not supply goods; buy changeparts.
(2) To cope with the seasonal variation work overtime; stockpile cigarettes.
(3) To cope with random fluctuations defer orders; work overtime; stockpile
cigarettes.
The best combination of these options will now be considered.
Contingency Allowances for 84mm Machinery for Financial Year 1977/78
Coping with Errors in Forecasting
When determining the optimum contingency allowance for machinery the first consideration was to get into a position to cope with possible underestimating of the
average annual demand, since if this were not done there was no way of coping with
the seasonal or random fluctuations.
The figures below sum up the consequences of having various levels of "extra"
capacity that is capacity over and above that necessary to produce at the level of
most likely demand considering only the need to cover for errors in forecasting.
Any shortfall in capacity was assumed to be taken care of by using an outside
manufacturer, who charged 1.30 per thousand cigarettes (Figure 1) or by not supplying orders, which lost a contribution of 2.50 a thousand cigarettes (Figure 2).
The ability to produce 30 million cigarettes per month in overtime is assumed.

26

IJOPM 3,1

The least-cost machinery contingency allowance would be one of roughly ten per
cent with 27 million cigarettes per year to be made in overtime and 21 million
cigarettes per year to be obtained from an alternative source.
Coping with the Seasonal Variation
Once steps had been taken to cope with the annual average, then it would always be
possible to make and stockpile goods in the winter months to cover for the greater
demand in the summer, (see Table II) since by definition the rise in the demand for
goods in the summer was exactly counterbalanced by the fall in the demand for
goods in the winter. If however, more productive capacity were available than was in
fact needed to cover a smooth annual demand (because demand was lower than the
most likely forecast figure) sufficient capacity might be available to cover most and
possibly all the summer peak without having to stockpile goods at all. The maximum
number of cigarettes that might have had to be stockpiled would have been 330
million, and this would be needed only if the productive capacity were at that needed
to cover a hypothetical, fluctuation-free annual demand.
Coping with the Random Fluctuations
The same broad considerations applied to the treatment of random fluctuations in
demand. There was a difference however, in that some overtime working or deferment of orders was allowed. The average maximum buffer stock contemplated to
cover for the random fluctuations was 150 million cigarettes, but because of the
liklihood that some spare capacity would be available, the probability of needing
this much buffer stock would be low.
Tens and 20s Packers
The discussion so far has treated all 84mm cigarette products as identical. In fact
about ten per cent of the King Size cigarettes were packed into 10s. One market currently took over 80 per cent of all 10s manufacture. Thus the size of any contingency
allowance rested on one market, and one that might be subject to the imposition of
fairly arbitrary rules. Currently there was some over-capacity and thus no new
packers were needed in the near future. Because it would be very unlikely that

Capacity Planning

27

demand for 10s and 20s would both be much higher than expected at the same time,
if a situation were developing in which the productive capacity for one pack became
stretched, whilst that for the other became under-utilised, change parts ought to be
bought, at a cost of 15,000 per machine. Heavy conversion costs would have had to
be borne if a change-over were implemented, and production department requested
that this capability be kept in reserve and not used in contingency planning.
Summary for 84mm Machinery
All costs associated with different levels of contingency allowance for 84mm cigarettes in FY1977/78 (excluding those of change-parts) are summarised in Table V for the
case when an outside manufacturer is used to manufacture the shortfall. The costs
associated with losing orders are given in Table VI. The least-cost machinery contingency allowance was one of about ten per cent. Stockpiling of cigarettes in rented
accommodation was recommended to help cope with the seasonal variations and
random fluctuations in demand.
Table V. Consequences of Planning for Various Levels of Extra Capacity
for 84mm Machinery (FY1977/78) when Outside Manufacturer Used
2
1
3
4
5
Likely Likely aver- Overtime Cost of
Extra
capacity
average age short- cost when
using
allowed shortfall fall with making up outside
(% of most
up to 30mn. to 30mn. manufaclikely)
made in a month
ture
overtime
4
6
8
10
12
14
16
18
20

195
128
80
48
27
15
7
4
2

106
65
38
21
11
6
3
1
0

4
2
2
1
1
0
0
0
0

138
85
50
28
15
7
3
2
1

7
6
8
9
Machine Total costs Costs to Overal cost
costs
to cover cover for of conforecasting random and tingency
seasonal allowance
errors
variation
46
70
93
116
139
163
186
209
232

188
157
145
145
155
170
189
211
231

23
19
15
11
8
6
4
3
2

211
176
160
156
163
176
193
214
233

All costs and quantities refer to a period of a year

All costs are in 000's
All quantities of cigarettes are in millions

The cost savings consequent upon operating this contingency allowance rather than
one of 20 per cent depends on the method adopted for coping with excess demand. If
an outside manufacturer were used and he charged 1.30 per thousand cigarettes,
the cost savings would be 77,000 per annum. The corresponding savings if orders
were lost would be 52,000 per annum.

28

IJOPM 3,1

Table VI. Consequences of Planning for Various Levels of Extra Capacity

for 84mm Machinery (FY1977/78) when Orders Lost
1
2
4
3
5
6
7
8
9
Extra
Likely Likely aver- Overtime Value of Machine Total cost Costs to Total cost
capacity
cost
average age shortlost orders
costs
to cover cover for
of
allowed (% shortfall fall with
to company
forecasting random and[contingency
of most in capacity overtime
seasonal allowance
errors
likely
used
variation
demand)
4
6
8
10
12
14
16
18
20

195
128
80
48
27
15
7
4
2

106
65
38
21
11
6
3
1
0

4
2
2
1
1
0
0
0
0

266
164
96
53
28
14
7
3
1

46
70
93
116
139
163
186
209
232

316
236
191
170
168
184
193
212
231

23
19
15
11
8
6
4
3
2

339
255
206
181
176
190
197
215
233

All costs and quantities refer to a period of a year

All costs are in 000's
All quantities of cigarettes are in millions

Contingency Allowance Formula

Whilst the calculations shown above concentrated on the specific area of greatest concern to the company's production department, a formula was also required that would
allow the least-cost contingency allowance to be calculated under other conditions.
The detailed calculations summarised in Tables V and VI indicated that the dominant
factor in the determination of the least-cost machinery contingency allowance was the
error in the forecast of annual demand, and that the costs associated with covering for
the seasonal variation and for the random fluctuations were rather inconsequential.
Table V and Figures 1 and 2 show that the cost curves have broad minima and thus
slight moves away from a true minimum were not likely to be significant. These two
features of the cost curves enabled a formula to suffice, whose "demand side" was based solely on the error in the forecast of annual demand. Also the shallowness of the
minimum, together with the large number of machines involved meant that the integer
nature of the machinery could be ignored.
The factors that might change and influence the machinery contingency allowance
were:
(1) the effective annual cost of maker/packer machines
(2) the low or extra cost incurred per thousand cigarettes when the company could
not produce the cigarettes itself.
(3) the quantity of cigarettes that could be produced in overtime.
(4) the size of the most-likely annual demand.
(5) the precision of forecasting annual demand over the time horizon given. (The effects of alterations in this time horizon were not explicitly investigated but Table
VIII gives some guidance).

Capacity Planning

29

In what follows, the capacity over and above that required to match the most-likely
demand is termed the supply contingency allowance and is made up of overtime
working and the machinery contingency allowance.

Figure 3 depicts the probability density function of cigarette demand greater than
"the most likely". If the supply contingency allowance (equivalent overtime plus
machinery contingency allowance) were set at W, then the quantity of cigarettes that
the company could not produce itself would be the area under the pdf to the right of
W. If W were increased by one unit (one million cigarettes per anum) the marginal
gain to the company of being able to produce these cigarettes itself (to be called the
marginal gain) would correspond to the shaded area shown.
In Figure 4 are sketched the costs incurred through increasing the company's own
supply capability above that required to meet the most-likely demand. The initial
portion corresponds to overtime working; the portion to the right of WO to the purchase of extra machines. In all practical cases the contingency allowance required
would be greater than WO and so it was the marginal cost of machinery (equal to the
cost of acquiring an extra productive capacity of one million cigarettes per annum)

30

IJOPM 3,1

that needed to be considered.

The costs and benefits that were to be considered were those relative to the basecase when the supply capacity was just sufficient to meet the most-likely demand. At
this base-case the company would expect to lose some contribution in half the years.
If the company decided to have a supply contingency allowance of X per cent (on
top of a capacity equal to the most-likely demand) then the lost contribution to the
company would fall but at a cost in terms of machinery purchased.
Letting C = the extra cost or loss to the company from it not producing cigarettes
during normal working or in overtime ( per thousand cigarettes)
Q = the quantity of cigarettes produced by one maker/packer machine
per year (one million cigarettes per year)
S = the least cost supply contingency quantity (i.e. that when marginal
loss = marginal cost) (million cigarettes per year)
T = the effective annual cost of one maker/packer ( per year)
A = sf(D)dD from Figure 3: the mean value of the demand not met by
the company itself (million cigarettes per year)
M = most likely annual demand (million cigarettes)
Reduction in lost contribution = 1000*C*A
Cost in machinery purchase =
In determining the least-cost supply contingency allowance, what were being
brought into balance were the marginal fall in lost contribution (marginal gain) and
the marginal cost; in other words the least-cost supply contingency allowance will be
that which ensures that
marginal gain = marginal cost
(1)
thus we have
or - 1000*CM*

(2)

or, for reasons that will become apparent below

(3)
The right hand side of equation (3) includes the ratio of the cost of buying an addi
tional supply capability of one million cigarettes per year (770 to the loss to the
company of not making one million cigarettes itself (C). It was this ratio rather than
the two individual terms that was important, since the least-cost supply contingency
allowance would not change if this ratio stayed the same.
The "look-up" table Table VII enabled the least-cost supply contingency
allowance to be found for any reasonable values of M, T, Q and C. This table was
only valid when the annual forecast of demand was such that there was a ten per cent
chance that the actual demand would be at least ten per cent greater than the mostlikely forecast. (The general case to cover for any precision in the annual forecast,
will be given later.)

Capacity Planning

31

Table VII.
Least-cost supply
contingency allowance
(% of most-likely
requirements)

(Thousand
cigarettes per year)

4
6
8
10
12
14
16
18
20
22
24

39,000
28,000
20,000
13,000
8,000
4,700
2,600
1,400
750
350
150

Value

Treatment of a variation in the quantity of cigarettes that could be produced in overtime was easy, so long as the distinction between the use of overtime and the planning with overtime was kept in mind. In use, overtime would only be resorted to after
all machines had been brought into use during normal working time. When planning
however, it is valid to assume that overtime would be available, and it was the appropriate level of machinery required to cope with demand greater than the supply
available in normal and overtime working that was of concern. Thus when determining the machinery contingency allowance, it was permitted to determine first the
supply contingency allowance and then subtract the contingency allowance
equivalent to the overtime worked, in order to obtain the machinery contingency
allowance. (If from Table VII a supply contingency allowance of 12 per cent were indicated and the overtime production were equivalent to a three per cent contingency
allowance, (roughly the situation for 84mm cigarettes in 1977/78 when the cost of
the company not making the cigarettes themselves was 1.3 per thousand cigarettes)
then the machinery contingency allowance would be nine per cent).
The marketing intelligence department supplied a most likely annual forecast and
also a high forecast which it considered to have a one in ten chance of being surpassed. We needed to take into account changes that might be made in the precision of
forecasting.
If the error in the forecasting were halved, the absolute value of the supply contingency allowance would also be halved. Since the most-likely demand had not been
altered, the least-cost supply contingency allowance expressed as a per cent of the
productive capacity able to match the most-likely demand would also be halved.
Thus if p = the per cent difference between the high and most-likely forecasts
(when there is a ten per cent probability that demand will be greater
than the high forecast)
Vp = the per cent least-cost supply contingency allowance when the per
cent difference between the high and most-likely forecasts in p
V10 = the per cent least-cost supply contingency allowance for p = 10

32

IJOPM 3,1

Then, working from the "base-case" figures given in Table VII that relate to
P = 10%

vp =V10*

(Thus if, using Table VII, a least-cost supply contingency allowance of 16 per cent
had been suggested and p = 20 per cent, then the appropriate least-cost supply contingency allowance would be one of 32 per cent
The effects of changes in all the relevant factors on the supply contingency
allowance can be determined from Table VIII and on the machinery contingency
allowance by a little further calculation. The two examples will make this clear. In
Example 1, the machinery contingency allowance for 84mm cigarettes in FY 1977/78
is recalculated using the look-up table; in example 2 the case for 95mm cigarettes for
the same time period is derived. Note that in using Table VIII, the assumption made
for it to be strictly applicable is that a single machine will only make a small contribution to the machinery contingency allowance.
Table VIII. Determination of the Least-Cost Contingency Allowance
Least-Cost Supply Contingency Allowance
(as % of the most-likely requirement)
P =

Value of
TM
100QC

5%

10%

20%

30%

40%

(thousand cigarettes
per year)

2
3
4
5
6
7
8
9
10
11
12

4
6
8
10
12
14
16
18
20
22
24

8
12
16
20
24
28
32
36
40
44
48

12
18
24
30
36
42
48
54
60
66
72

16
24
32
40
48
56
64
72
80
88
96

39,000
28,000
20,000
13,000
8,000
4,700
2,600
1,400
750
350
150

Example1:Machinery contingency allowance for 84mm cigarettes for FY1977/78,

when the company plans to use an outside manufacturer to supply the cigarettes that
the company cannot make itself,
T
C
P
Q
M

= 27,000
= 1.30 per thousand cigarettes
= 10%
= 300 million cigarettes per year
= 12876 million cigarettes per year

Thus TM/100QC = 8914. From Table VIII with p = 10%, the least-cost supply

Capacity Planning

33

contingency allowance could be one of about 12 per cent. Since 360 million cigarettes per year can be made in overtime, and this is equivalent to an approximately
three per cent contingency allowance, then the least-cost machinery contingency
allowance would be one of nine per cent. (For presentational purposes called
"roughly ten per cent").
Example 2: Machinery contingency allowance for 95mm cigarettes for FY1977/78,
when the demand not capable of being met by the company itself is left unsatisfied.
T = 27,000
C = 2.50 per thousand cigarettes
P = 20%
Q = 300 million cigarettes per year
M = 2300 million cigarettes per year.
Thus TM/100GC = 828. From Table VIII with P = 20 per cent, the least-cost supply contingency allowance would be one of 40 per cent. Since for FY1977/78all overtime production was planned to be allocated to 84mm cigarettes, this equals the
least-cost machinery contingency allowance.
Conclusion
This study might be considered as an "old-fashioned" application of operational
research a problem was posed to an analyst, who went away and with little interaction between manager and analyst devised a least-cost solution. However it was
a successful application in spite of Ackoff's strictures[1] concerning such studies.
There were two main reasons for this. As is evident from the study's description, the,
problem was not so conceptually difficult that the thinking that went into the solution could not be transmitted to management at a presentation: the proposed leastcost contingency allowance solutions were roughly half as expensive as those currently used and this change hinged on the different treatment of probabilities. Acceptance was also helped greatly by concentrating on one specific important instance
and producing a solution for this a solution that could be tested against experience and in which interest was high; and then introducing robustness into the
solution by showing graphically how costs changed as departures were made from
the least-cost solution. Finally the use of a look-up table to allow least-cost solutions
to be determined for all feasible values of the important parameters. Thus the move
was from the specific to the general, in contrast to the methods normally used in
operational research.
Reference
1. Ackoff, R. L., "Optimization + Objectivity = Opt out", European Journal of Operational
Research, Vol. 1 No. 1, 1977, pp. 1-7.