Tactical capacity management under capacity flexibility

In many production systems a certain level of flexibility in the production capacity is either inherent or can be acquired. In that case, system costs may be decreased by managing the capacity and inventory in a joint fashion. In this paper we consider such a make-to-stock production environment with flexible capacity subject to periodic review under non-stationary stochastic demand, where we allow for positive fixed costs both for initiating production and for acquiring external capacity. Our focus is on tactical-level capacity management which refers to the determination of in-house production capacity while the operational-level integrated capacity and inventory management is executed in an optimal manner. We first develop a simple model to represent this relatively complicated problem. Then we elaborate on the characteristics of the general problem and provide the solution to some special cases. Finally, we develop several useful managerial insights as to the optimal capacity level, the effect of operating at a suboptimal capacity level and the value of utilizing flexible capacity.