What is the Value of Flexibility for Supply Chains?

MIT Forum for Supply Chain Innovation Vienna, 21 September 2011 Prof. Dr. Sebastian Kummer Christian Hammer

It is not the strongest of the species that survive, nor the most intelligent, but the one most responsive to change.
Charles Darwin

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7 February 2012

How do you

? ?

convince your senior management that investing into a flexible supply chain does make sense financially?

Valuation methods need to be evaluated for their applicability in turbulent times

Valuation Methods

Traditional valuation methods  Discounted cash flow analysis  Scenario analysis Dynamic valuation methods  Real options approach  Simulation methods

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How do valuation methods account for flexible supply chain decisions?

Supply Chain Network Design at Flexcell
EXAMPLE

Flexcell is a Swiss university spin-off producing innovative solar panels and chargers In 2000 had to make a decision on where to locate the main manufacturing plant: Switzerland, Germany or China?
Source: de Treville & Trigeorgis (2010)
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Where should the new plant be located?

Location Benefits
EXAMPLE

+ Labor cost advantage Limited ability to customize products High distance from HQ: challenges with implementation of new production processes and technology
Source: de Treville & Trigeorgis (2010)
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+ Near enough to permit reasonable amount of customization + Lower manufacturing costs by 15% compared to Switzerland

+ Flexibility in timing production commitments + Ability to directly manage problems (head scientists, technicians and senior management in Switzerland)
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DCF assumes a predetermined artificial plan is followed, regardless of how events unfold
Limitations of DCF
Recession, demand falls Response: NONE

JV opportunity emerges Response: NONE

 Traditional valuation methods are not designed to cope with conditions of volatility and uncertainty (static, seek lowest cost solution, decide against flexibility)  SC decisions taken under these circumstances are inadequate for turbulent times
Source: Luehrman (1998)
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range of possible outcomes

New competitor enters market Response: NONE

The benefits of flexible response are ignored by DCF:  DCF assumes a static system (not capable of considering the effect of a flexible option)  Single point forecasts for key variables (e.g. oil price in 2020 at 200 USD / barrel)  The flaw of averages: plans based on the assumption that average conditions will occur are usually wrong (e.g. average consumption is 300 units, therefore plant capacity is set at this level)

Decisions that keep most options open are preferable to those that shut options down
Real Options Thinking Real options valuation (ROV) is a fundamentally different way of evaluating supply chain options  A way to value flexibility monetary value of an option, e.g.

3 2 1 0 1 2 New competitor enters market Response: PROACTIVE 2 3

range of possible outcomes

JV opportunity emerges Response: PROACTIVE

Recession, demand falls Response: PROACTIVE

 Real options assume that management is active and can modify decisions as necessary

 In financial terms, a supply chain strategy is much more like a series of options than a series of static cash flows  ROV leads to a more accurate representation of the assets value under uncertainty
Source: Luehrman (1998)
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Given the uncertainty of this venture, ROV showed the benefits of the Swiss location
Value of Flexibility
EXAMPLE

DCF

 DCF approach is in favor for the German plant  NPV comparison shows significantly lower fixed manufacturing costs  Flexibility value is not accounted for  Flexibility is given through delayed production and investment commitments (time is used to gather critical information about demand)  Real options valuation is used to put a EUR-figure on flexibility benefits of Swiss plant (postponement option)  Management showed that also in financial terms the Swiss location is preferable (value of the option was much higher than 15% unit cost savings)
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ROV
2 0 1 1 2 2

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Source: de Treville & Trigeorgis (2010)

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What is the value of flexibility in supply chains?

A lot if uncertainty is high

To include the full value of flexibility, valuation methods that consider flexible options need to be chosen
Conclusio

 To include the full value of flexibility into supply chain decisions, valuation methods that consider flexible options need to be chosen  Traditional DCF method assumes a static and predetermined path  Lacking the capability of being able to appraise the value of flexibility leads to suboptimal decision making  ROV accounts for the value of flexibility, as it incorporates dynamic decision making into the valuation model  ROV is often criticized for its complexity and limiting assumptions, but real option logic offers benefits for decision making in turbulent times  Perhaps the greatest benefit of the real option approach is real option thinking; the very exercise of working through options systematically, begins to change the way management thinks

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Copyright 2011. WU Wien. All rights reserved.

7 February 2012