A real options approach to value manufacturing flexibilities with regime-switching product demand

This research is motivated by a real industry problem. A manufacturer produces two different types of products. The manufacturer has two alternatives to invest: fixed capacity systems, one for each type of product, or invest in a flexible system simultaneously producing both types of products. To this end, the value of flexibility has to be determined to justify the investment in the flexibility system. When valuing manufacturing flexibility to model demand uncertainty, most of the existing literature is built on the assumption that demand for a product will grow indefinitely. This assumption, however, ignores the reality that demand for a product often grows initially, then levels out, and finally falls off. To investigate how this nonstationarity in demand growth affects the value of flexibility, we consider a manufacturing system having three types of manufacturing flexibilities (expansion, contraction, and switching) and producing two types of products with correlated demands. Each type of product is assumed to have two demand regimes: a growth regime representing the demand increases initially and a decay regime representing the demand decreases subsequently. A lattice approach is developed to discretize the evolution of the correlated demands of both products and a dynamic programming-based model is used to value flexibilities. Results show that ignoring the two demand regimes undervalues contraction, switching, and total flexibilities; but overvalues expansion flexibility. It is very common that many sectors, such as automobile and semiconductor, produce products simultaneously. Hence, the findings may help decision-makers understand the inherent values of flexibilities under different demand shifting patterns.