ShmoopTube

00:00

and finance Allah shmoop How do capacity constraints work on

00:05

the bottom line All right people you're the CEO of

00:09

Little Poker is a company that makes shrimp forks You

00:12

just received an order for twenty thousand forks from a

00:15

shrimp fest in Gulf Port Mississippi Big order Big revenue

00:18

It should be time to pop the champagne and celebrate

00:21

but there's a problem You currently make forty eight thousand

00:24

forks per month and you only have capacity for fifty

00:27

thousand a month Which means that your facility working at

00:30

full speed has a limit or a constraint of fifty

00:33

thousand units that it can produce in any given month

00:36

Well we've run into a problem known as capacity constraints

00:39

You just don't have enough capacity now to fulfill the

00:42

Gulf port order in a timely fashion They want delivery

00:45

in two months and it would take you ten months

00:47

to make it the additional twenty thousand You need to

00:50

fill the order right So why not just increased capacity

00:53

Well it might not be that easy Whether you can

00:55

take the order or not depends on the specific reason

00:58

you have a cap on your production Well there are

01:00

different kinds of capacity constraints In your case Well you

01:03

don't have enough machines to make more than fifty thousand

01:06

a month If you want to expand production you'LL have

01:08

to buy some additional equipment It's very expensive solution to

01:11

the problem here Well they already be worth that additional

01:14

costs Buying those machines In other words is your bottom

01:17

line hurt or helped by an attempt to break through

01:20

your capacity constraint Well before we tackle that question directly

01:23

let's look at some other potential reasons that company's capacity

01:26

might be constrained Some situations are easier to fix than

01:29

others For instance the company might not have enough workers

01:32

will If that's the case they could just hire extra

01:34

people pay him a little bit of overtime to increase

01:36

production or they can pay a lot of overtime to

01:39

their current workers The only thing to look out for

01:41

with additional labor is whether the increased costs are going

01:44

to cut into their profit margins Bringing in additional workers

01:48

shouldn't matter The gross profit and gross margin figures already

01:52

include the cost of direct labor The new workers will

01:54

make more products The additional cost come with additional revenue

01:58

gross margins stay the same But using overtime workers that

02:02

you have to pay a lot of overtime to could

02:03

get too costly to be worth it Well since the

02:06

company would pay more per hour in the overtime shift

02:08

the gross margins for the products made during that time

02:11

would decrease On the other hand getting more use out

02:14

of the machinery and overhead means that the company is

02:16

able to leverage its operating expenses Mohr And that's a

02:18

good thing The overtime costs might hurt gross margins but

02:21

operating margins might not be impacted as much they might

02:25

even improved while based on the situation Right lot of

02:28

moving parts here another potential capacity constraints Not enough raw

02:32

materials like say you make caviar ice cream and your

02:35

supplier can't provide enough caviar to make more than ten

02:38

thousand gallons of ice cream a month That raw material

02:41

constraint limits your production will The solution here involves finding

02:44

an additional source of product or caviar The main worry

02:47

though in terms of the bottom line would be well

02:50

what if the prices for that extra caviar are really

02:53

high Getting additional raw materials might force you to tap

02:56

into a way more expensive means of obtaining them like

02:58

to get more caviar You might have to await into

03:00

expensive Russian black markets Make more than ten thousand gallons

03:04

of the caviar ice cream in the class per gallon

03:07

might actually increase We'LL all that expensive black market caviar

03:10

then you know really cuts into your profits Is it

03:12

worth it Is it worth it That's what you're asking

03:14

all the time here Or the mere fact that you

03:16

need more raw materials could drive prices higher like you're

03:19

now a big buyer a big commander of a limited

03:22

supply product More demand for the caviar consent Caviar prices

03:25

higher across the board Well if your raw materials cost

03:28

more it'LL cut into your gross margin of fact That

03:30

could make the additional production less profitable and that might

03:33

not be worth the effort Remember that's what we're asking

03:35

here Is it worth it Is it worth it Okay

03:37

back to little pokers In your case that capacity constraint

03:40

comes from limits to the output of your machinery You

03:43

have two time slapping machines These things here each one

03:47

can bust out twenty five thousand marks a month There's

03:49

nothing you can do to get them to produce Maur

03:52

If you want to increase capacity your only choice is

03:54

to buy additional machine Well the first question you have

03:57

to ask Can we fit anymore machines in the warehouse

04:00

singing here Well if the answer is no and you're

04:02

probably s out of luck if you're out of physical

04:05

space you may need then a new factory in warehouse

04:08

and laborers and all that That's an extremely expensive proposition

04:12

Buying a new factory would only make sense if you

04:14

force a long term demand well above your current capacity

04:17

If you believe that you could make and sell double

04:19

your current output for example well then maybe it be

04:22

worth it Well luckily for you you don't have to

04:24

make that choice Your chief engineer says she can move

04:27

things around toe add an additional machine She says she

04:30

can do it in such a way that you don't

04:31

have to interrupt current production to install the new machine

04:34

Right Well the big worries here one Will you have

04:36

enough sustained demand justify buying a new machine into How

04:40

will the cost of the new machine impact your real

04:43

bottom line Well the reason you're considering buying a new

04:45

machine because he received a special order from the Gulf

04:47

Port Shrimp fest Another time sliding machine cost two million

04:50

dollars If you spend that amount just to fill the

04:53

one order well then it's a money losing proposition and

04:56

or fit Say you buy the machine for two million

04:58

dollars and use it to make the additional twenty thousand

05:01

additional units It brings in ninety grand in revenue But

05:04

then the machine sits idle while you go back to

05:06

your normal production levels You lost more than one point

05:09

nine million dollars on that deal for buying that machine

05:11

that now holds coats very nicely Better to just turn

05:14

down that special order not worth it But if that

05:17

special order is a sign of long term demand for

05:19

Shrimp Fork thing is well it might be worth the

05:21

expansion You have your salespeople call around you bring in

05:24

some outside consultants who produced a lot of fancy pretty

05:26

looking charts you don't really understand but they tell you

05:29

bottom line they think there's enough demand to expand capacity

05:32

long term So you take the plunge you spend two

05:35

million dollars to buy the new machine And yes you

05:37

could have leased it for a month or two or

05:39

something like that and much higher prices But we won't

05:42

get you all complicated here That machine is enough to

05:44

increase your capacity to seventy five thousand Shrimp fork Thing

05:47

is a month You easily get the special order in

05:50

on time The customers so impressed they tell all the

05:53

other regional shrimp fest about your company You start to

05:56

get tons of orders Literally Infact you become the official

05:59

shrimp fork provider for the entire Gulf Coast Enough demand

06:02

for seventy five thousand forks a month Additional revenue of

06:05

one hundred twelve thousand five hundred dollars a month to

06:08

well you're gross Margins on the forks remain steady at

06:10

sixty five percent Meaning you bring in gross profit of

06:12

seventy three grand from that new product Well you were

06:15

able to sign a long term lease for the time

06:17

slapping machine that cost you fifty grand a month Yeah

06:20

So instead of buying in fall the capital twenty three

06:22

thousand one hundred twenty five dollars in new monthly profit

06:25

from the expansion Good for you The visitors to all

06:28

the Gulf Region Shrimp fest Get a shrimp eating experience

06:31

that's a really great and you add to your bottom 00:06:33.635 --> [endTime] line the only real losers here and the shrimp

Full Transcript