Vol. 23, No. 5, May 2014, pp. 861–876 DOI 10.1111/poms.

12082
ISSN 1059-1478|EISSN 1937-5956|14|2305|0861 © 2013 Production and Operations Management Society

Flexible Capacity Investments and Product Mix:

Optimal Decisions and Value of Postponement
Options
Panos Kouvelis
Olin Business School, Washington University, St. Louis, Missouri 63130-4899, USA, kouvelis@wustl.edu

Zhongjun Tian
School of International Business Administration, Shanghai University of Finance and Economics, Shanghai 200433, China,
tian.zhongjun@mail.shufe.edu.cn

n this article, we study a firm’s interdependent decisions in investing in flexible capacity, capacity allocation to individ-
I ual products, and eventual production quantities and pricing in meeting uncertain demand. We propose a three-stage
sequential decision model to analyze the firm’s decisions, with the firm being a value maximizer owned by risk-averse
investors. At the beginning of the time horizon, the firm sets the flexible capacity level using an aggregate demand
forecast on the envelope of products its flexible resources can accommodate. The aggregate demand forecast evolves as a
Geometric Brownian Motion process. The potential market share of each product is determined by the Multinomial Logit
model. At a later time and before the end of the time horizon, the firm makes a capacity commitment decision on the
allocation of the flexible capacity to each product. Finally, at the end of the time horizon, the firm observes the demand
and makes the production quantity and pricing decisions for end products. We obtain the optimal solutions at each
decision stage and investigate their optimal properties. Our numerical study investigates the value of the postponed
capacity commitment option in supplying uncertain operation environments.
Key words: flexible capacity; capacity investment; product mix; real options; postponement
History: Received: September 2010; Accepted: February 2013 by Suresh Sethi, after 3 revisions.

Product platforms and associated flexible capacity

1. Introduction
Investing in capacity of flexible resources used to
meet the needs of a wide envelope of products is a
common operational strategy for firms operating in
environments with substantial demand and product
mix uncertainty. For example, in the pharmaceutical
industry, in order to meet strict Food and Drug
Administration (FDA) regulations, firms have to
invest 3–5 years ahead of the actual market demand,
and in the presence of uncertainty on the mix of prod-
ucts to be offered, and the size of the potential appli-
cation market. Investing in capacity of flexible
facilities is the heavily advocated strategy by pharma-
ceutical firms as documented in the authoritative
treatment of process strategies in the pharmaceutical
and other industries by Pisano (1997). In the automo-
tive industry, use of flexible assembly facilities able to
accommodate a wide range of products that are
derived from well-defined product platforms is often
the way to effectively manage demand risks at the
individual product level for a hard-to-specify product
mix when capacity investment decisions are made.
861
strategies in the automotive and other discrete manu-
facturing industries are discussed in Meyer and
Lehnerd (1997), Fisher et al. (1995), and Robertson
and Ulrich (1998).
Capacity investments in the above mentioned
industrial settings share a common sequence of inter-
dependent decisions made over time in the presence
of uncertainty both in demand and in the mix of prod-
ucts to be eventually produced by the flexible facility.
Let us describe the common pattern of such decisions
in more detail. First, early capacity decisions for flexi-
ble resources are made. At that time the only available
information is on the boundaries of the product enve-
lope that will be accommodated (e.g., the broad range
of technical processes and therapeutic use applica-
tions for pharmaceutical products, e.g., development
of cell-regulating proteins with potential application
to treatment of burn wounds) and a forecast for
aggregate level demand for products within such a
product envelope. As another example, Volkswagen
(VW) builds capacity for flexible lines using a broad
definition of vehicle platforms they accommodate.

862 Production and Operations Management 23(5), pp. 861–876, © 2013 Production and Operations Management Society
Volkswagen defines its platforms as having common-
alities across products on the cockpit, drive unit, front
and rear axle, fuel tank, and floor group, with the VW
A-platform covering more than 20 or so potential
vehicles (VW Golf and its variations, VW Bora, VW
Beetle, Audi A3, Audi TT and its variations, Skoda
Octavia, etc.). Flexible capacity decisions are made
with a farsighted aggregate forecast across all these
vehicles.
At a later point in time, the firm commits some of
the flexible capacity to the production of each product
based on the result of R&D and on more accurate
forecasts for their demand. For example, R&D may be
highly successful or less so. Referring to our pharma-
ceutical example above, corresponding to a given
level of R&D success, each product is exogenously
endowed with a quality level, which reflects its attrac-
tiveness to the potential customers. Product platform
planning over time and results from ongoing market
research allow automotive companies to specify the
products out of the common platform to be offered in
the market. Capacity is allocated to these products
after a better understanding is gained of the demand
of the segments each product is better positioned to
serve. Finally, close to the market demand realization,
the firm makes detailed production and pricing deci-
sions in an effort to match supply with demand of
individual products subject to constraints from
already made capacity decisions.
The presence of the embedded real options for post-
poned capacity commitment and allocation, final pro-
duction, and pricing heavily influence the valuation
and magnitude of investment in flexible resources.
We argue in detail in section 2 that the presence and
combined influence of these real options have either
been ignored (especially the postponed capacity com-
mitment option) or ineffectively captured (failure to
effectively value the underlying real options) in the
existing literature on flexible capacity investments.
Our study presents a comprehensive valuation and
capacity investment framework for flexible resources
capturing the interconnected nature of flexible capac-
ity investments and commitments decision in the
presence of demand uncertainty.
We propose a three-stage sequential decision model
to analyze the firm’s decisions of initial flexible capac-
ity investment, capacity allocation to individual prod-
ucts, production quantities, and pricing. These
decisions are made at three distinct time points,
but they are heavily interdependent either through
the presence of later executed real options or through
the early decisions constraining the full capture of the
value of these options. For expository convenience,
we present the case of two products in a product fam-
ily derived from a common product platform accom-
modated by the flexible capacity. However, it is
Kouvelis and Tian: Flexible Capacity Investments and Product Mix
straightforward, and in a later section (see end of sec-
tion 5) we describe how to extend our model to the
multiple product case.
Our work contributes to the literature in three
ways. First of all, we develop a model for flexible
capacity valuation and investments in the presence of
uncertainty in both demand and product mix with
aggregate demand forecast continuously evolving
over the decision horizon and with the capacity com-
mitments postponed to a later time than the flexible
capacity investment. Our model fully reflects the
intertwined nature of flexible capacity valuation and
execution (capacity commitment, production, and
pricing) decisions. While previous literature on capac-
ity investments has looked at the production and
pricing postponement, it has not accounted for the
product mix uncertainty and the possibility of capac-
ity commitment postponement. Second, our solution
to the sequential decision model provides useful valu-
ation and capacity investment formulas to guide
conceptually the complex capacity allocation and pro-
duction decisions over time. Finally, our study
provides managerial insights on factors affecting the
value and magnitude of flexible capacity investments
and commitment postponement strategies, character-
istics of environments appropriate for such invest-
ments, and the value of executing such strategies in
the presence of demand uncertainty.
The remainder of this article is organized as
follows: In the next section, we provide a review of
existing literature. In section 3, we propose the three-
stage sequential decision model. In section 4, we
investigate the capacity commitment, production, and
pricing decisions, while in section 5 we deal with the
initial capacity investment decision. For each decision
stage problem we present optimal solutions and their
associated properties. In section 6, we study numeri-
cally the value of the postponed capacity commitment
option. We summarize our insights and conclusions
in section 7. All proofs are provided in the Supporting
Information Appendix.
2. Literature Review
There is an immense amount of literature on the valu-
ation of manufacturing flexibility. One of the early
and seminal papers in valuing flexibility with the use
of options is Sethi and Sethi (1990). They present a
scheme of flexibility classification and review some
early references from the economics literature. Papers
closer to our work value flexible resources in the pres-
ence of embedded real options, especially with
respect to product mix, capacity allocation, and pro-
duction. Bengtsson (2001) provides an extensive
review of the literature on manufacturing flexibility
and relevant embedded real options from the
Kouvelis and Tian: Flexible Capacity Investments and Product Mix
Production and Operations Management 23(5), pp. 861–876, © 2013 Production and Operations Management Society
perspective of industrial engineering/production
management. In a later study, Bengtsson and Olhager
(2002) use real options to evaluate product mix flexi-
bility. Bengtsson and Olhager (2002) is an excellent
exposition of real option applications in evaluating
product mix flexibility (defined as the ability to switch
production among different products). However, in
most of these studies, capacity constraints are not
considered. Exceptions are the works of Andreou
(1990), Triantis and Hodder (1990), and Bengtsson
and Olhager (2002), which we discuss in more detail.
In the Andreou (1990) model, a manufacturing system
consists of two dedicated capacities, each of which
produces one of two differentiated products, and one
flexible capacity, which can produce both products.
Andreou assumes uncertain demand and variable
profit, which are statistically independent. His results
show that the flexible capacity is not utilized unless at
least one of the dedicated capacities is constrained
and is used to produce the product giving higher
profit if both of the two dedicated capacities are con-
strained. In the Triantis and Hodder (1990) model, a
flexible capacity can be costlessly switched to produce
different combinations of a product mix over time.
They assume downward sloping demand curves and
possibly increasing marginal production cost. The life
cycle of the production system is divided into periods
of equal duration, and the production decisions are
made at the beginning of each period, but the deci-
sions in one period do not affect the value of the pro-
duction in subsequent periods. In both Andreou
(1990) and Triantis and Hodder (1990), the two-
product case can be analytically solved by partition-
ing the two-dimensional demand space into different
regions corresponding to different demand realiza-
tion. Nevertheless, for the multiple product case as in
Bengtsson and Olhager (2002) and in the general
model of Triantis and Hodder (1990), numerical
approaches such as Monte Carlo simulation have to
be used to estimate the value of a flexible system. The
emphasis of all of the above work is on demonstrating
the value of product mix flexibility due to the embed-
ded switch options and less on setting optimal flexible
capacity levels in the presence of embedded post-
ponement options on capacity commitment, produc-
tion quantities, and pricing, which is the focus of our
work.
There is a substantial operations literature on prod-
uct mix flexibility outside of real option modeling
frameworks (see Chod and Rudi 2005, Fine and
Freund 1990, van Mieghem 1998, and references
therein), but all of that work ignores the interconnected
nature of early flexible capacity decisions and the abil-
ity to postpone capacity commitment, production, and
pricing decisions. The recent work by Chod et al.
(2012) on the interconnected nature of cost, mix, and
863
time flexibility is the most related to our work. They
develop a three-stage model of a two-product firm that
makes capacity, production, and pricing decisions at
each of the three stages. The product-specified capacity
levels are set at the first stage, but capacity can be
exchanged between products at a cost at the second
stage based on the updated demand information. The
production and pricing decisions are made at the third
stage when the demand is observed. They identify
three types of flexibility: mix (production switch
among products), volume (production quantity adjust-
ment), and time (postponed production decisions) flex-
ibility, corresponding to the firm’s ability to respond to
the dynamically evolving market conditions. They
present a continuous measure for each of these flexibil-
ities and then focus on their relationships and their
impacts on firm value and corporate diversification.
Our work differs from theirs in multiple aspects: First,
we split the aggregate demand into individual product
demands via the Multinomial Logit (MNL) model, the
optimal prices are not market-clearing prices, and
there always exists some market share uncovered. In
the Chod et al. (2012) paper, it is assumed that in each
of the two markets the firm is a monopolist facing an
iso-elastic demand curve, which guarantees the mar-
ket-clearing price being optimal. Second, our model
can be easily extended to the multiple product case
with all the analytic results preserved, while in their
study the obtained analytic results are heavily driven
and limited by the two-dimensional representation
and segmentation of the demand space. The explicit
focus of their work is on conceptual insights on the
relationships between different flexibility types and
less on offering a decision modeling framework for
flexible capacity investments in multi-product firms,
which is the distinct focus of ours. Finally, from a valu-
ation perspective, our firm is owned by risk-averse
investors, and the Intertemporal Capital Asset Pricing
Model (ICAPM; see Merton 1973) is used for valuation
purposes, while risk neutrality is assumed in Chod
et al. (2012).
We note that, from a methodological perspective,
our work relies heavily and has built upon the real
options valuation literature and more specifically on
related valuation and investment work in capacity
and inventory applications. For the basic foundations
of such literature and all early references to it, we
refer the reader to the seminal text by Dixit and
Pindyck (1994) and references therein. The early influ-
ential work on the use of real options to study the
impact of risk on capacity planning models, mostly
for single-product firms and without any embedded
switching and/or postponement options, is Birge
(2000). Looking at inventory decisions of single-
selling-season products as American options and
quantifying the benefits of postponing the ordering

864 Production and Operations Management 23(5), pp. 861–876, © 2013 Production and Operations Management Society
decision to an a priori set time closer to the start of the
selling season has been presented in a working paper
by Gaur et al. (2010). They also assume risk-averse
investors and adopt the ICAPM model, but their anal-
ysis involves a single product and as a result does not
consider embedded real options in capacity commit-
ment as part of flexible capacity valuation.
3. The Model
3.1. Timing and Sequence of Events
Time is denoted by t, t 2 [0,T], where t = 0 is the
beginning and t = T is the end of the horizon. The
demand information evolves through the entire hori-
zon, while a series of operational decisions are made
at three distinct time points. The stochastic process of
the aggregate demand forecast is denoted by Dt ,
0 ≤ t ≤ T. It will be explained in detail in the end of
section 3.2 that Dt represents the number of the poten-
tial customers.
At time t = 0, based on the initial demand forecast
D0 , the firm invests in a flexible capacity which is to
be used to produce two substitute products. Assume
constant unit investment cost and denote it by
c0 2 Rþ . Denote the initial capacity investment level
by K0 2 Rþ . The total investment cost is then c0 K0 .
At some time s 2 [0,T], the demand information is
updated and the result of R&D is revealed. The R&D
success level determines the quality of the product the
firm designs and builds, with the quality index mod-
eled as a composite measure of the multi-attribute fea-
tures of a product reflecting its appeal and value to
the customers. Higher scores imply that the portfolio
of product features is more highly valued by custom-
ers. Let ai denote the quality level of product i, i = 1,2,
and a ¼ ða1 ; a2 Þ the vector of the quality levels.
The volume of the capacity to be used to produce
each product is determined according to the quality
levels a and the new demand forecast Ds . s is called
the commitment time. To keep our model simple, we
assume that s is pre-determined and not a decision
variable. The only constraint for s is that the remain
time, T  s, meets the requirement of production
lead-time. If s is an endogenous decision variable, it
can be optimally set through numerical tools.
Let xi denote the success level of the R&D process
of product i, i = 1,2. For simplicity, we consider the
two-level case, i.e., the R&D process may succeed at
either a low or a high level. But our model can be eas-
ily extended to the multiple level case. Define x as the
result of the R&D processes, and Ω its domain. Then,
x  ðx1 ; x2 Þ 2 X ¼ fðL; LÞ; ðL; HÞ; ðH; LÞ; ðH; HÞg:
Let pi ðxi Þ denote the probability by which the R&D
of product i ends up with success level xi , xi ¼ L; H,
Kouvelis and Tian: Flexible Capacity Investments and Product Mix
i = 1,2. Also, let Pr(x) denote the probability of
x ¼ ðx1 ; x2 Þ. For simplicity and tractability, we
assume that the R&D results are independent of the
demand process.
Meanwhile, let K ¼ ðK1 ; K2 Þ denote the capacity
vector, where Ki is the capacity committed to product
i, i = 1,2. We assume that the firm has the option to
commit to only part of the initial capacity in case the
demand forecast is low. So, K1 þ K2  K0 . For ease of
description, we define
K1 þ K2 K1
K  K1 þ K2 ; f  ;g :
K0 K2
We call f the capacity commitment rate, g the capac-
ity allocation ratio, and (f,g) the capacity commitment
(allocation) scheme. The reason for defining f and g is
that in some situations it is convenient to study (f,g)
instead of ðK1 ; K2 Þ. For given f, g, and K0 , we have
g 1
K ¼ fK0 ; K1 ¼ fK0 ; K2 ¼ fK0 :
1þg 1þg
At time s, when the flexible capacity is committed
to specific products, some additional capacity recon-
figuration costs is incurred. We refer to such a recon-
figuration cost as the “capacity commitment cost” (or,
for simplicity hereafter, a “commitment cost”). Since
the commitment costs are a part of the capacity cost
postponed to time s, they are proportional to the vol-
ume of the total capacity committed. The commitment
cost depends on the commitment time s and is non-
decreasing in s. Denote the unit commitment cost by
cs 2 Rþ . Then the total commitment cost is cs K.
At time t = T, our demand forecast process Dt stops
evolving and the aggregate demand DT is broken
down to the demand of individual products. The pro-
duction is finished and the prices are announced
instantaneously. As a result of the price announce-
ment, the aggregate demand is directed to individual
products according to market shares determined by
the quality levels and prices.
We shall note that time T is not only the end of the
time horizon in our model but also the start of the sell-
ing season. As there is no model dynamics once the
selling season begins, we compress the entire season
into an instantaneous selling event at time T. Specifi-
cally, all customers arrive at time T simultaneously,
and each arrived customer makes her decision to buy
either one of the two products or none of them, based
on her own valuation. The valuation of all customers
determines the market shares of the products.
Let r 2 R2þ denote the price vector, Q 2 R2þ the
vector of the production quantities, and Q 2 Rþ the
total production quantity, that is, Q ¼ Q1 þ Q2 .
Without loss of generality, the resource consumption
rates are assumed to be equal. So, Qi  Ki , i = 1,2,
Kouvelis and Tian: Flexible Capacity Investments and Product Mix
Production and Operations Management 23(5), pp. 861–876, © 2013 Production and Operations Management Society
Figure 1 Timeline of Sequence of Decisions
and Qi ¼ Ki if capacity i is fully utilized. Assume a
constant unit production cost and denote P it by
ci ; i ¼ 1; 2. Then the total production cost is 2i¼1 ci Qi .
Let c ¼ ðc1 ; c2 Þ, denote the vector of the production
costs. All results hereinafter hold for convex increas-
ing costs c0 , cs , and c.
A timeline describing the sequence of decisions is
given in Figure 1.
3.2. Demand Models
We make the following assumption on the aggregate
demand process.
ASSUMPTION 1. The stochastic process of the aggregate
demand forecast Dt is a Geometric Brownian Motion
(GBM) defined by
dDt
¼ adt þ rdz; t 2 ½0; T;
Dt
where a is the drift, r > 0 is the variance, and dz is the
increment of the Wiener process.
GBM is used to model stock prices in the Black–
Scholes model and is widely used in modeling stock
price behavior. In real options literature, it is also
common to assume GBM for the evolution of the
underlying asset. For example, Dixit and Pindyck
(1994) discuss a variety of applications of real option
models for investment decisions under demand
uncertainty, with the assumption of a GBM demand
process. The GBM process implies that the Markovian
property holds, and for any value of t 2 [0,T], the
aggregate demand Dt is log-normally distributed. The
process may be either biased (a 6¼ 0) or unbiased
(a = 0). A positive (resp. negative) a means that the
demand forecast increases (resp. decreases) exponen-
tially at an average rate of a. A positive r is assumed
to exclude the trivial case of a deterministic demand
process. Meanwhile, a positive r implies increasing
forecast uncertainty. That is, the volatility of the
demand forecast increases in the length of the forecast
period. In our model, the volatility of Dt for given D0 ,
that is, Var[Dt jD0 , increases in t for all t 2 (0,T], while
for any t 2 (0,T), Var[DT jDt  increases in the length of
865
the remaining period, i.e., T  t, or, equivalently,
Var[DT jDt  decreases in the length of the elapsed time,
that is, t.
ASSUMPTION 2. The market share of product i, i = 0,1,2,
or, equivalently, the probability with which a random
customer chooses product i, is determined by the Multi-
nomial Logit (MNL) model:
eðai ri Þ=l
Pi ¼ P2 ; i ¼ 1; 2; ð1Þ
j¼1 eðaj rj Þ=l þ eu0 =l
eu0 =l
P 0 ¼ P2 ðaj rj Þ=l
; ð2Þ
j¼1 e þ eu0 =l
where u0 is the utility of the outside choice (including
other substitute products from the competitors and the
no-purchase choice) and l is a constant.
The MNL model is a special case of the attraction
model, with eðai ri Þ=l denoting the attractiveness of
product i, i = 1,2, and eu0 =l the attractiveness of the out-
side choice (see Leeflang et al. 2000). An implicit
assumption of the MNL model is that the customer
utilities follow a Type I Gumbel distribution. Accord-
ing to the MNL model, for product i with quality ai
and price ri , ui  ai  ri is the nominal utility, which
is determined by the observable characteristics of the
product and, so, is the same for all customers. But an
individual customer’s actual utility derived from prod-
uct i is Ui  ui þ ei , where ei is a Gumbel (extreme
value of Type I) random variable with distribution
Pðei  xÞ ¼ expð  expð  ðx=l þ 0:5772ÞÞÞ with mean
zero and variance ðlpÞ2 =6, where l is the standard
deviation (up to a positive factor) reflecting taste het-
erogeneity among consumers (Anderson et al. 1992,
p. 138). The MNL model assumes that the e’s are
independently and identically distributed, and, thus,
the actual utility of each product differs from cus-
tomer to customer. Let U0 ¼ u0 denote the nominal
utility of the outside choice. A utility maximizing
customer always chooses the product with the largest
utility. Define Pi ¼ PðUi ¼ maxfUj : j ¼ 0; 1; 2gÞ as
the probability that product i has the maximum

866 Production and Operations Management 23(5), pp. 861–876, © 2013 Production and Operations Management Society
utility. A standard result of the MNL model gives
Equations (1) and (2). (Detailed derivation can be
found in Anderson et al. 1992, pp. 39–40.)
The Gumbel distribution seems a strong assump-
tion. However, it leads to the simple formulation of
customer choice probabilities in the MNL model,
which is very important to analytical studies in cus-
tomer choice modeling. Moreover, empirical tests
confirm that the MNL model is good at estimating the
market shares of substitute products and thus has
been widely used in the marketing literature (see, e.g.,
Anderson et al. 1992). In recent years it has found
noticeable application in the operations literature
(see, e.g., van Ryzin and Mahajan 1999).
From Equations (1) and (2), given the quality level
vector a and the values of u0 and l, the probability Pi
is affected by the price vector r only. Moreover, the
second derivatives of Pi to ri , i = 1,2, are negative, and
the cross derivatives of Pi to rj , i 6¼ j, are positive, and
thus the market share of one product is strictly
decreasing in its own price and strictly increasing
in the price of the other product. Such monotone
properties properly reflect the demand substitution
effect in our model.
Because ei ’s are random variables, the Pi ’s given by
Equation (1) are indeed the expected market shares.
However, since all customers arrive and make deci-
sion simultaneously, Pi also represents the proportion
of the customers willing to buy product i. Meanwhile,
since the entire selling season is compressed into an
instantaneous selling event at time T, Pi can be treated
as deterministic without loss of optimality. Also, we
assume that customers do not switch to the other
product if their first choice is out of stock, that is,
demand substitution is assortment based but not
stock-out based. Consequently, Pi DT is the total
amount of customers directed to product i, i = 1,2,
while P0 DT is the amount of customers who choose
the outside choice.
Therefore, for any t 2 [0,T), Dt is actually the popu-
lation of the potential customers of the two products
and other substitute products in the same family from
the competitors, which is aggregated into the outside
choice in the MNL model. Such a population may
include anyone who shows serious interest in certain
products in the family. A potential customer may
have a rough range of the acceptable price for each
product, but the final decision depends on both the
quality levels and the announced prices.
3.3. The Three-Stage Decisions
From the above analysis, the firm makes four deci-
sions: flexible capacity investment, capacity alloca-
tion, production and pricing, sequentially at three
time points t = 0,s,T, based on the result of R&D, the
demand forecast, and the MNL attraction model.
Kouvelis and Tian: Flexible Capacity Investments and Product Mix
These three-stage decisions are described here in
detail in reverse order.
At the third stage (t = T), when the demand DT is
observed, for given K, the firm determines the opti-
mal production quantities Q and the optimal prices
r to maximize the profit. The optimization problem is
X
2
max pT ðQ; r; xÞ ¼ ðri Si  ci Qi Þ;
Q;r2R2þ ;Q  K i¼1
where Si ¼ minfQi ; Pi DT g is the sales level of prod-
uct i, i = 1,2.
At the second stage (t = s), conditional on the realiza-
tion of x (the results of R&D, which determine the qual-
ity levels) and the updated demand forecast Ds , for
given K0 the firm selects the optimal capacity to commit
K . To find K , we must know the current value of the
claim of the future profit pT ðQ ; r ; xÞ, which is uncer-
tain at any time t < T. We use V(K;x,t), or V(x,t) for
short, to denote the value of this future risky profit at
time t, t 2 [s,T]. To value the claim on the future risky
profit with the consideration of risk aversion, we use
the ICAPM in Merton (1973). If the firm is owned
by risk-neutral investors, we simply have
Vðx; tÞ ¼ ecðT  tÞ Et ½pT ðQ ; r ; xÞ, where Et is the
expectation taken with respect to the demand DT fore-
casted at time t and c denotes the riskless rate of return.
Following the standard assumption of ICAPM, the
firm is a risk neutral value maximizer but owned by
risk-averse investors, and thus a risk premium is
requested by the investors as compensation. Let
 ¼ ðam  cÞ=rm denote the market price of risk,
where am is the expected rate of return on a portfolio
of all assets in the economy (the market portfolio,
denoted by M), and r2m is the variance of the rate of
return on the market portfolio. Also, let qDm denote
the correlation coefficient between the aggregate
demand forecast and the whole market portfolio M.
Then, rqDm is the risk premium which serves as the
adjustment to the expected rate of return for system-
atic risk. Here we assume that the systematic risk of
the portfolio V(x,t) is identical to that of the demand
forecast Dt . Strictly speaking, these two risks may not
be equal, as the former is caused by both mix and vol-
ume uncertainty but the latter is caused by volume
uncertainty only. However, the R&D processes are
assumed to be independent of the evolution of the
demand. Furthermore, the aggregate demand
observed at time T is directed to an individual prod-
uct according to an optimal ratio that is determined
by the results of the R&D processes. Therefore, the
effect of product mix uncertainty can be separated
from that of the volume uncertainty. Thus, the sys-
tematic risk of the portfolio V(x,t) can be adjusted
according to the distribution of the outcomes of the
R&D processes to include the mix uncertainty. Never-
Kouvelis and Tian: Flexible Capacity Investments and Product Mix
Production and Operations Management 23(5), pp. 861–876, © 2013 Production and Operations Management Society
theless, the adjustment is a complex issue in practice.
Since our model stays at a rather abstract level offer-
ing insights rather than be used as a decision support
tool, we abstract this issue from our model.
Suppose V(x,t) is traded; for an investor to will-
ingly hold this claim in a portfolio, its expected rate of
return must be equal to as  c þ rqDm , where as is
actually the expected rate of return on a financial asset
with the same financial risk as the committed capac-
ity’s exposure to demand. We note that as is not nec-
essarily equal to a, the drift of the demand process.
For these two rates to be equal, the aggregate demand
must be expected to increase at the risk-adjusted rate
of return as , which is not necessarily the case in equi-
librium. (Interested readers are referred to McDonald
and Siegel 1985 for more about the difference between
a and as .) Define the convenience yield
d  as  a ¼ c  a þ rqDm :
Using Ito’s lemma, we know that V(x,t) must sat-
isfy the PDE given below, which is also derived by
McDonald and Siegel (1985) for the valuation of
firms with an option with shut down and by Constan-
tinides (1978) for valuing a call option on a “non-
traded” asset:
1 2 2 @2V @V @V
r Dt þ ðc  dÞDt þ  cV ¼ 0;
2 @Dt 2 @Dt @t
subject to the boundary condition
Vðx; TÞ ¼ pT ðQ ; r ; xÞ:
The commitment decision is to choose K to maxi-
mize the value of the committed capacity at time s.
The optimization problem is
max ps ðK; xÞ ¼ Vðx; sÞ  cs K:
K2R2þ ; K1 þK2  K0
At the first stage (t = 0), based on the initial
demand information D0 , the firm decides the optimal
initial capacity volume K0 . To make the investment
decision, we must know the current value of the claim
of the future profit ps ðK ; xÞ for any x 2 Ω, which is
uncertain at any time t < s. The analysis is similar to
that in the second stage. We use FðK0 ; tÞ, or F(t) for
short, to denote the value of this future risky profit at
time t, t 2 [0,s]. Also by Ito’s lemma, F(t) must satisfy
the PDE (3) with V replaced by F, subject to the new
boundary condition
X prices satisfy Pi DT  Ki for i = 1,2.
FðsÞ ¼ ½PrðxÞps ðK ; xÞ:
x2X
The investment decision is to set to maximize K0
the firm’s value at time t = 0. The optimization
problem is
867
max p0 ðK0 Þ ¼ Fð0Þ  c0 K0 :
K0 2Rþ
4. The Commitment, Production, and
Pricing Decisions
In this section, we investigate the capacity commit-
ment decision in the second stage and the joint deci-
sions of production and pricing in the third stage. We
incorporate the study of these decisions made in two
different stages because part of the commitment deci-
sion is closely related to the third-stage decisions.
Recall that a capacity commitment scheme consists of
the capacity commitment rate f and the capacity allo-
cation ratio g. We claim that the optimal capacity allo-
cation ratio g is independent of the demand forecast
Ds and the demand evolution after time s and can be
determined together with the optimal production
quantities and prices in the third-stage analysis.
4.1. The Third-Stage Analysis
At this stage, the firm observes the demand DT and
makes the production and pricing decisions simulta-
neously to maximize the time T profit pT ðQ; r; xÞ ¼
P2
i¼1 ðri Si  ci Qi Þ, where Si ¼ minfQi ; Pi DT g is the
sales level of product i, i = 1,2. Recall that according
to the MNL model, for a given price vector r, the mar-
ð3Þ ket share of product i is Pi , and then for a given
demand DT , the individual demand is Pi DT . Thus, for
a given product mix and aggregate demand, the firm
decides the optimal market share for each product by
optimally pricing the products and the optimal pro-
duction quantities to cover the individual demands
determined by the aggregate demand and the optimal
market shares.
Since the firm sets both the prices and the produc-
tion quantities simultaneously, it is sub-optimal to
have any of the optimal market share uncovered
and/or to leave any excessive inventory, and, hence,
for each product the firm shall always produce to the
individual demand level specified by the aggregate
demand and the optimal market share and bring all
inventory to the market, that is, Si ¼ Qi ¼ Pi DT ,
i = 1,2. Nevertheless, it would be impossible for the
firm to set Qi ¼ Pi DT if the optimal prices give
Pi DT [ Ki , as the production is constrained by the
capacity Ki . Therefore, we need to show that the opti-
mal prices always imply Pi DT  Ki , i = 1,2.
PROPERTY 1. For any aggregate demand DT , the optimal
Therefore, the optimal sales level is Si ¼ Qi ¼
Pi DT ,
and, hence, without loss of optimality, we con-
sider only the situation of Si ¼ Qi ¼ Pi DT , i = 1,2.
Consequently, the individual product profit is
 Kouvelis and Tian: Flexible Capacity Investments and Product Mix
868 Production and Operations Management 23(5), pp. 861–876, © 2013 Production and Operations Management Society

ri Si  ci Qi ¼ ðri  ci ÞPi DT . We call ri  ci the profit ~0 ¼ l ; ~T ¼ K K

P D ; Pc0 ¼ 1  : ð10Þ
margin of product i and define ~
m 1P~0 DT
X
2
me  ðri  ci ÞPi ð4Þ LEMMA 1. For any initial capacity volume K0 and
i¼1 capacity commitment rate f,

as the expected profit margin from one unit aggregate (i) the optimal capacity allocation ratio is g ¼ h, with
demand at time T. h specified in Equation (9);
Then the third-stage problem can be re-formulated (ii) with any optimal solution to the third-stage Prob-
as lem P3, the capacity constraints are neither binding
if DT  D ~ T , with D~ T specified in Equation (10),
ðP3Þ max pT ðr; xÞ ¼ me DT ; ð5Þ and both binding otherwise;
r2R2þ
(iii) for DT  D ~ T , the optimal profit margins are equal
s:t: Pi DT  Ki ; i ¼ 1; 2: ð6Þ and the common profit margin m ~ is specified in
Equation (7); for DT [ D ~ T , the optimal profit mar-
Thus, for any aggregate demand DT , the third-stage gins are also equal and the common profit margin
problem is to maximize me DT , subject to the con- mc is specified in Equation (8).
straints in Equation (6). On the one hand, for small
DT , for example, DT  minfK1 ; K2 g, none of the con- Lemma 1(iii) extends the equal profit margin prop-
straints can be binding (as Pi \ 1 and Pi DT \ erty of joint inventory and pricing models with MNL
DT  Ki ) and the optimal solution to Problem P3 is models to the constrained model with early capacity
just the price vector maximizing me , as in the uncon- commitment. Because of the capacity constraints, the
strained version problem. It will be shown (in the profit margin is no longer a constant for all DT . For
DT  D ~ T , no capacity is constrained and the margin m ~ is
proof of Lemma 1) that the optimal prices are given ~ T , from Equation (8) it can be seen
by ri ¼ m~ þ ci , i = 1,2, where m
~ is the common mar- constant. For DT [ D
gin shared by all products and is the unique solution to that the margin mc is strictly concave increasing in DT .
According to Lemma 1, so long as the initial capac-
~ 0 Þ=l
X
2 ity is optimally allocated at time s, there are only two
~  1Þeðmþu
ðm=l ¼ eðaj cj Þ=l : ð7Þ scenarios to consider at time T: low demand
j¼1 (DT  D ~ T ) and high demand (DT [ D ~ T ). The optimal
prices and production quantities in each scenario are
On the other hand, as DT increases, eventually both given in Theorem 1.
constraints in Equation (6) become binding, and the
optimal solution to Problem P3 can be obtained by THEOREM 1. Suppose that the total volume of the com-
solving the joint equations of Pi DT ¼ Ki , i = 1,2. For a mitted capacity is K and the capacity allocation ratio is
set of arbitrarily allocated capacity levels (K1 ; K2 ), optimally set at g ¼ h, with h specified in Equation (9).
there exists an interval of DT in which the optimal
prices force only one of the constraints to be binding. (i) The optimal prices are
Nevertheless, it will be shown (in the proof of Lemma 
~ ~ T,
1) that, so long as the initial capacity is optimally allo- ri ¼ m þ ci ;
 if DT  D i ¼ 1; 2;
cated between the two products at time s, such a one mc þ ci ; otherwise,
constraint binding case does not appear at time T.
with m~ determined by Equation (7) and mc given in
That is, with an optimal capacity allocation ratio g ,
~ T such that none of the con- Equation (8).
there exists a threshold D
~ T and both of the con- (ii) The optimal production quantities are
straints is binding for DT \ D
straints are binding for DT  D ~ T . To facilitate the 
~ T,
Qi ¼ ð1  m~ Þhi DT ;
l
~ T and some  if DT  D i ¼ 1; 2;
presentation of Lemma 1 we define D hi K; otherwise,
other terms. (Detailed derivation and a description of
these definitions can be found in the proof of Lemma with hi specified in Equation (9).
1 in the Supporting Information Appendix.) (iii) The optimal profit is

X
2
~ ~ T,
mc ¼ l ln eðaj cj Þ=l þ l lnðDT =K  1Þ  u0 ; ð8Þ pT ðQ ; r ; xÞ ¼ ðm  lÞDT ; if DT  D
mc K; otherwise.
j¼1

eða1 c1 Þ=l eðai ci Þ=l

h¼ ; hi ¼ P2 ða c Þ=l ; i ¼ 1; 2; ð9Þ From Theorem 1(ii), the optimal production quanti-
eða2 c2 Þ=l j¼1 e
j j ~ T and remain
ties increase linearly in DT for DT  D
Kouvelis and Tian: Flexible Capacity Investments and Product Mix
Production and Operations Management 23(5), pp. 861–876, © 2013 Production and Operations Management Society
constant for DT [ D ~ T . Meanwhile, Theorem 1(iii)
implies the following property.
PROPERTY 2. pT ðQ ; r ; xÞ is continuous, differentiable,
and concave increasing in DT in the entire domain of DT .
4.2. The Second-Stage Analysis
Based on the result of R&D and the updated demand
forecast, the firm makes a capacity commitment and
allocation decision at time s. As g ¼ h is shown in
Lemma 1, the firm needs only to decide the optimal
total capacity to commit K , or, equivalently, the opti-
mal capacity commitment rate f . So, the remaining
problem is to find f that maximizes ps ðK; xÞ ¼
Vðx; sÞ  cs K. We note that hereinafter the capacity
variable is the one-dimensional K 2 Rþ rather than
the vector K 2 R2þ .
With the value of pT ðQ ; r ; xÞ given in Theorem 1
we can solve the PDE (3) with the terminal condition
Vðx; TÞ ¼ pT ðQ ; r ; xÞ and get an expression of V(x,
t) for any time t 2 [s,T]. As Equation (3) is the
Black–Scholes–Merton PDE, V(x,t) can be obtained
by the risk-neutral pricing method in the option pric-
ing literature (see, e.g., Shreve 2004, pp. 237–240). Let
~ denote the expectation under the risk-neutral mea-
E commitment cost is linearly increasing in K, the
sure. Then, the risk-adjusted discounted expectation
of the value of the committed capacity at any time
t 2 [s,T] is Vðx; tÞ ¼ e  cðT  tÞ E½p ~
~ T ðQ ; r ; xÞ, where E
is taken with respect to a standard normal random
variable y. For any demand forecast Dt , s ≤ t ≤ T, y
corresponds to a random variable of the demand to
be observed at time T defined by
pffiffiffiffiffiffi
DT ðyÞ ¼ Dt er Ttyþðcd2r ÞðTtÞ :
1 2
ð11Þ
We define two boundaries d2 and d1 below. We note
that d2 is the threshold under which the capacity is
~T
binding. It is obtained by substituting DT ðyÞ ¼ D
~
into Equation (11), as DT is the threshold of DT
beyond which the capacity is constrained:
~ T Þ þ ðc  d  1 r2 ÞðT  tÞ
lnðDt =D
d2 ¼ pffiffiffiffiffiffiffiffiffiffiffi 2 ; ð12Þ
r Tt
pffiffiffiffiffiffiffiffiffiffiffi
d1 ¼ d2 þ r T  t :
Substituting DT ðyÞ into Equation (8) gives the profit
margin and the corresponding no-purchase probabil-
ity for y  d2 :
X
2  
ðaj cj Þ=l DT ðyÞ
mc ðyÞ ¼ lln e þlln 1 u0 ;
j¼1
K
K the capacity is fully utilized and the margin mc ðyÞ
Pc0 ðyÞ ¼ 1  : ð15Þ
DT ðyÞ
869
Let /, Φ, and U denote the probability density func-
tion (pdf), the cumulative distribution function (cdf)
and the complementary cumulative distribution func-
tion (ccdf) of the standard normal distribution, respec-
tively. The following lemma gives the value of the
optimally committed capacity. By optimally committed
we mean that the capacity allocation ratio is g ¼ h.
LEMMA 2. For any time t with demand forecast Dt ,
s ≤ t ≤ T, the value of an optimally committed capacity
with total volume K is given by
 1Þ
~  lÞDt edðTtÞ Uðd
Vðx; tÞ ¼ ðm
Z d2
1
þ pffiffiffiffiffiffi KecðTtÞ mc ðyÞe2y dy:
1 2
ð16Þ
2p 1
The first term of V(x,t) represents the risk-adjusted
discounted (from T to t) expectation of the terminal
value over all y  d2 , that is, all DT for which the
capacity is not fully utilized, while the second term is
the expectation over all y  d2 , that is, all DT for
which the capacity is fully utilized.
For any Ds forecasted at time s, the firm maximizes
ps ðK; xÞ and V(x,s) given by Equation (16). As the
change of V(x,s) in K determines the optimal volume
to commit. From Equations (12)–(16), any change of K
affects V(x,s) through the boundaries d1 and d2 and
the optimal profit margin mc ðyÞ. To study these
effects, we define
l
fc ðyÞ ¼ mc ðyÞ  : ð17Þ
Pc0 ðyÞ
The following theorem gives the optimal capacity
to commit at time s.
THEOREM 2. V(x,t) is strictly concave increasing in K.
The optimal volume of capacity to commit to is
K ¼ minfK; ^ K0 g and the optimal capacity commitment

rate is f ¼ minfK=K ^ 0 ; 1g, where K^ is the unique solu-
tion of the following equation with t = s in d2 and fc ðyÞ.
Z d2
1 y2
ð13Þ pffiffiffiffiffiffi ecðTsÞ fc ðyÞe 2 dy ¼ cs : ð18Þ
2p 1
The intuition behind Equation (18) is that at the
optimal capacity commitment rate the expected
marginal capacity value is equal to the marginal
cost cs . Committing one additional unit capacity at
ð14Þ time s incurs cost cs , but increases ps only when
the capacity is constrained at time T, that is, y \ d2 .
So the integral is from ∞ to d2 . For any y \ d2 ,
is the profit gain from the marginal capacity.
 Kouvelis and Tian: Flexible Capacity Investments and Product Mix
870 Production and Operations Management 23(5), pp. 861–876, © 2013 Production and Operations Management Society

Meanwhile, mc ðyÞ is strictly decreasing in K (by Prop- ^

where Vðx; sÞ is given by Equation (16) with t = s
erty 6 in the Supporting Information Appendix). As and K ¼ K, ^ and Vc ðx; sÞ is from the same formula
the decrease of mc ðyÞ reduces the profit from every with t = s and K ¼ K0 .
unit of utilized capacity, there is a profit loss of Now the risk-adjusted discounted expectation of
K@mc ðyÞ=@K ¼  l=Pc0 ðyÞ. (The derivative of mc ðyÞ to the value of the uncommittedP capacity at any time
K is given in the proof of Property 6.) Therefore, the t 2 [0,s] is FðtÞ ¼ ecðstÞ x2X ðPrðxÞE½p ~ s ðK ; xÞÞ. In
net profit gain is fc ðyÞ. Taking the expectation of fc ðyÞ F(t), for any demand forecast Dt at time t, 0 ≤ t ≤ s,
over y \ d2 at time T and then discounting it back to the demand forecast to be expected at time s is a ran-
time s, we have the expected marginal capacity value dom variable defined by
given by the LHS of Equation (18). pffiffiffiffiffiffi
Ds ðzÞ ¼ Dt er stzþðcd2r ÞðstÞ ;
1 2
One observation from Equation (18) is that, for ð19Þ
given parameters of time, quality, and demand pro-
cess, the unconstrained optimal capacity to commit K ^ where z is another standard normal random variable
depends on both cs and Ds (through d2 and fc ðyÞ). which is independent of y, and E ~ is taken with
Applying the Implicit Function Theorem to ps ðK ; xÞ respect to z.
gives the following properties. ^ s into Equation (19) gives
Substituting Ds ðzÞ ¼ D
the boundary
PROPERTY 3. K ^ is strictly decreasing in cs . Moreover,
^ ^ s Þ þ ðc  d  1 r2 Þðs  tÞ
lnðDt =D
K ¼ 0 if and only if cs ¼ 1. b2 ¼ pffiffiffiffiffiffiffiffiffiffi 2 : ð20Þ
r st
The second part of Property 3 implies that, as long
as the commitment cost cs is finite, the firm will not According to Equations (19) and (20), the initial
abandon all capacity and quit the business. This is capacity K0 is fully committed if and only if z  b2 .
due to the MNL demand model, which guarantees Thus, the value of the uncommitted capacity is given
nonzero market share and positive profit at time T. by the following lemma.

PROPERTY 4. K ^ is strictly increasing in Ds . Let D ^s LEMMA 3. For any time t with demand forecast Dt ,
denote the minimum demand forecast for which full com- 0 ≤ t ≤ s, the value of an uncommitted capacity with vol-
^ s is strictly increas-
mitment is optimal (i.e., f ¼ 1). D ume K0 is given by
ing in K0 . 
1 cðstÞ X
FðtÞ ¼ pffiffiffiffiffiffi e PrðxÞ
Intuitively, if there is no capacity constraint at time 2p x2X
s, the firm tends to commit more capacity when Z 1
^ is strictly increasing in  ^
ðVðx; ^ 12z2 dz
sÞ  cs KÞe ð21Þ
higher Ds is forecasted. So K
b2
Ds . Meanwhile, more initial capacity implies higher Z b2 
threshold of full commitment. So D ^ s is strictly increas- 12z2
þ ðVc ðx; sÞ  cs K0 Þe dz :
ing in K0 . 1

5. The Initial Capacity Investment We note that in the first integral, for any z  b2 , K^ is
^
determined by Equation (18) first, and then Vðx; sÞ is
Decision ^
calculated by Equation (16) with K ¼ K.
In solving the first-stage problem, D^ s plays the same
Now we look for the optimal investment level. For
~
role as DT does in the second-stage problem. As D ^ s is
any z  b2 , substituting Equation (19) into Equations

the minimum demand forecast for which K ¼ K0 (11)–(12) (with t = s) gives
holds, we have K ¼ K\K ^ ^
0 for all Ds \ Ds and pffiffiffiffiffiffiffi pffiffiffiffiffiffi
 ^
K ¼ K0 for all Ds [ Ds . As for the threshold D ^ s,
DT ðy; zÞ ¼ Dt erð Tsyþ stzÞþðcd2r ÞðTtÞ ;
1 2
ð22Þ
 ^
K ¼ K ¼ K0 , which implies that Equation (18) holds
^ and K0 in d2 and fc ðyÞ in the LHS. Hence, the pffiffiffiffiffiffiffiffiffiffi
with D ~ T Þ þ ðc  d  1 r2 ÞðT  tÞ  r s  tz
lnðDt =D
value of D ^ s can be obtained by solving Equation (18) d2 ðzÞ ¼ pffiffiffiffiffiffiffiffiffiffiffiffi
2
;
with K ¼ K0 , while Ds is treated as a random vari- r Ts
able. For any x 2 Ω, the time s value of the committed ð23Þ
capacity is
where DT ðy; zÞ is the time T position of the current
 demand forecast Dt , and d2 ðzÞ is the threshold by
^
Vðx; ^
sÞ  cs K; ^ s,
if Ds  D which the capacity is constrained at time T. We note
ps ðK ; xÞ ¼
Vc ðx; sÞ  cs K0 ; otherwise, that the threshold D ~ T in Equation (23) is given by
Kouvelis and Tian: Flexible Capacity Investments and Product Mix
Production and Operations Management 23(5), pp. 861–876, © 2013 Production and Operations Management Society 871

Equation (10) with K ¼ K0 , as d2 is defined only for Finally, we note that all the models and results of
z  b2 , for which K ¼ K0 always holds. sections 3–5 can be easily extended to the multiple
Then, substituting Equation (22) into Equation (8), product case. Let n, n > 2, denote the number P of prod-
we have the following definitions for z  b2 and ucts in the assortment. Redefine f ¼ ð ni¼1 Ki Þ=K0
y  d2 ðzÞ: and gij ¼ Ki =Kj . Now we have r 2 Rnþ in Problem P3
  and the FOC’s are n-dimensional. Also redefine
X
2
DT ðy; zÞ ða c Þ=l

mc ðy; zÞ ¼ l ln e ðaj cj Þ=l

þ l ln
j¼1
K0
K0
Pc0 ðy; zÞ ¼ 1  ; ð25Þ
DT ðy; zÞ
l
fc ðy; zÞ ¼ mc ðy; zÞ  : ð26Þ
Pc0 ðy; zÞ
We also note that K0 instead of K appears in mc ðy; zÞ
and Pc0 ðy; zÞ, as they are defined only for z  b2 . With
the above re-defined parameters and variables, we
have the following theorem on the optimal invest-
ment level.
THEOREM 3. F(t) is strictly concave increasing in K0 .
The optimal initial capacity volume K0 is the unique
solution of the following equation with t = 0 in b2 , d2 ðzÞ
and fc ðy; zÞ (We note that all b2 , d2 ðzÞ, and fc are x-
dependent),
" Z b2 Z d2 ðzÞ # exogenous or endogenous prices, has been well stud-
1 cT X y2 þz2
e PrðxÞ fc ðy; zÞe 2 dydz
2p x2XX 1 1
¼ ecs cs ½PrðxÞUðb2 Þ þ c0 : ð27Þ
x2X
Essentially, similar to Equation (18) in Theorem
2, Equation (27) requires that the expected marginal
value of the initial capacity be equal to the mar-
ginal cost. Nevertheless, because of the possible
partial commitment, an additional unit of initial
capacity increases p0 when the capacity is not only
fully committed at time s but also fully utilized at
time T, that is, z  b2 and y  d2 ðzÞ. So the
expected marginal value is given by the summation
of the double integral in the LHS. On the other
hand, the marginal cost is the initial investment
cost c0 plus the expected capacity commitment cost,
which
P is incurred with cumulated probability
x2X ½PrðxÞUðb 2 Þ and is discounted from time s to
0. Intuitively, the higher the cost, the less will be
invested. Also, the higher the forecasted demand,
the more will be invested. So we have the follow-
ing property.
PROPERTY 5. K0 is strictly increasing in D0 and strictly
decreasing in both c0 and cs . Moreover, K0 ¼ 0 if and
only if c0 ¼ 1 and/or cs ¼ 1.
 1  u0 ; hij ¼ eðaij cij Þ=l . From the FOC’s we have gij ¼ hij for all i,
e
j = 1,…,n. Then, all the results follow as in the two-
ð24Þ product case.
In the multiple product case, the MNL model may
suffer from the independent irrelevant alternatives
(IIA) property, which implies that the choice probabil-
ities of any two variants are independent of the set
that contains them. Generally, the larger the assort-
ment size, the higher possibility by which the IIA
property is violated. One way to avoid the IIA restric-
tion is applying the nested multinomial logit (NMNL)
model (see Anderson et al. 1992). Now the form of gij
is more complicated than that of the two-product
case, but it is still independent of DT . Consequently,
the optimal commitment ratio is demand indepen-
dent. Then, the three-stage problems can be solved in
the same way as in the two-product case.
6. Numerical Study
Since the postponed production option, with either
ied, we focus our study on the postponed capacity
commitment option. Recall that the capacity commit-
ment decision consists of two parts: the capacity com-
mitment rate f and the capacity allocation ratio g.
According to the analysis in the previous sections, the
optimal allocation ratio g is solely determined by the
R&D results, whereas the optimal rate f depends on
both the R&D results and the demand forecast Ds .
Therefore, we investigate the effect of the two types of
uncertainty considered in this study, namely, the
aggregate demand forecast and the R&D success
level, on the value of the commitment option. In par-
ticular, we are interested in the interaction of these
two effects. The following parameters are assumed to
be constant unless otherwise declared.
1. a = 0.05, r = 0.2, and qDm ¼ 0:1; that is, a posi-
tive drift of the demand forecast and a positive
correlation coefficient between the demand
forecast and the whole market portfolio are
considered.
2. ai ðLÞ ¼ 5, ai ðHÞ ¼ 10, and pi ðLÞ ¼ pi ðHÞ ¼ 0:5,
i = 1,2; that is, the two products own the same
level of quality if both are developed into the
same success level, and for both products the
R&D results are equally distributed.
3. c0 ¼ cs ¼ 0:5, ci ðLÞ ¼ 2:5, ci ðHÞ ¼ 5, i = 1,2;
that is, the total capacity cost, including the

872 Production and Operations Management 23(5), pp. 861–876, © 2013 Production and Operations Management Society
initial investment cost and the deferred
commitment cost, is normalized to 1 and half
of it can be delayed to time s; the high quality
product is produced at higher production cost,
but yet is more profitable, as ai ðHÞ  ci ðHÞ [
ai ðLÞ  ci ðLÞ.
4. T = 6 and s = 5.5; that is, a 6-years-long time
horizon, which is quite normal in pharmaceuti-
cal and automotive industries, is considered,
and the commitment time is set at t = 5.5 to
allow a minimum 6-month leadtime for pro-
duction at time t = 6.
Financial data being used in our study include (i)
the risk-free interest rate c = 0.03, which is the sec-
ondary market rate of the 3-month Treasure Bill
(TB3MS) since 1993 according to the database of the
Federal Reserve Bank of St. Louis, and (ii) the market
price of risk k = 0.25, as according to the CRSP
of WRDS database, the long run market return am
is about 7% and the standard deviation rm is around
16% in the US stock market in the last 20
years since 1993, and so the market price of risk is
k = (0.07  0.03)/0.16 = 0.25.
We also have the following normalization:
D0 ¼ 100, u0 ¼ 0, and l = 1.
Our benchmark is a variation of our model in which
there exists no postponed capacity commitment
option, that is, the invested capacity must be allocated
to individual products at the beginning. While the
R&D results are still uncertain until time s, there is no
Figure 2 Effect of Demand Uncertainty on Firm Profitability and Optimal Capacity Investment
(a) ρDm = 0.2
* *
π0 K
0 %
200
100
100
50
0 0
0 0.5 σ 0
(d) ρDm = − 0.2
*
π K*
0 0
200
100
100
50
0 0
0 0.5 σ 0
Our model
Kouvelis and Tian: Flexible Capacity Investments and Product Mix
opportunity of capacity commitment and allocation.
Meanwhile, the production and pricing decisions are
still postponed to time T. Apparently, the optimal
firm value in our model is higher than that in this
benchmark model, and the difference represents the
value of the commitment option.
6.1. The Effect of Demand Uncertainty
Figure 2 shows how the optimal firm value p0 ,
which reflects the firm profitability, and the optimal
capacity investment level K0 change in r, the vari-
ance of the stochastic process of the aggregate
demand forecast Dt . Figures 2(a)–2(c) correspond
to the case of positive correlation coefficient and
Figures 2(d)–2(f) the negative case. From Figure
2(a) and 2(d) we see that for both positive and neg-
ative qDm , and in both our model and the bench-
mark model, the firm profitability is monotonically
decreasing as r increases (with the exception only
of negative qDm and small r in the benchmark
case). While this result is completely different from
the monotone increasing price of a simple call
option without dividend payment (Black and
Scholes 1973), it is partially consistent with the
existing results in the real option literature. For
example, McDonald and Siegel (1985) notice that
the value of projects with high positive (resp. zero
or negative) correlation with the market decreases
(resp. increases) in the volatility of the stochastic
price process. Their results are explained by the
(b) ρDm = 0.2 (c) ρDm = 0.2
100
50
σ 0 σ
0.5 0 0.5
(e) ρDm = − 0.2 (f) ρDm = − 0.2
%
100
50
0 σ
0.5 σ 0 0.5
Benchmark Δπ*0/π*0(B) ΔK*0/K*0(B)
Kouvelis and Tian: Flexible Capacity Investments and Product Mix
Production and Operations Management 23(5), pp. 861–876, © 2013 Production and Operations Management Society
derivative of the value with respect to the volatility
(the price variance). The decrease trend in Figure 2
can be explained by such a derivative analysis as
well. Essentially, the capacity constraint, which is
not an issue in McDonald and Siegel (1985), plays a
key role now. The analysis is much involved and is
thus presented in the Supporting Information
Appendix. However, the intuition behind the nega-
tive influence of the capacity constraint is straightfor-
ward: As the demand volatility increases, the firm
cannot fully capture the upside benefit due to the
capacity constraint but suffers all the negative effects
of the downside. Such asymmetric impacts are also
seen in Equation (21), in which the first term reflects
the downside effect and the second term shows the
negative effect of the capacity constraint.
In both Figures 2(a) and 2(d), consistent with the
decrease of the p0 ’s is the decrease of their
difference, that is, Dp0 ¼ p0  p0 ðBÞ, where p0 ðBÞ
stands for the optimal expected firm value in the
benchmark model. By the construction of the bench-
mark model, this difference reflects the value of the
commitment option. We note that in the extreme
case of r = 0, there is no demand forecast uncer-
tainty, and thus the value of the commitment option
is totally attributed to the R&D uncertainty. The
decrease trend of Dp0 reveals that, for a given uncer-
tain level of the R&D processes, the absolute effect
of increasing demand uncertainty is negative. Nev-
ertheless, as shown in Figure 2(c), the higher the
volatility, the larger the relative value of the com-
mitment option. By relative value we mean the
absolute value, that is, Dp0 ¼ p0  p0 ðBÞ, divided
by p0 ðBÞ. Therefore, in the relative sense, the
commitment option is more attractive in a highly
volatile demand environment.
Figures 2(b) and 2(e) show the change of the opti-
mal capacity investment levels. We note that in both
graphs and in both models, the change of K0 is not
monotone. For small r, the firm responds to the
increase of r by increasing the investment levels
accordingly. However, increasing K0 is not the only
choice in response to the increase of demand volatil-
ity. In fact, for large r, the firm relies on the pricing
option to capture the upside benefit from the highly
volatile demand (by controlling the actual demand to
be equal to the capacity level). Thus, K0 changes in the
increase–decrease pattern. Meanwhile, we note that
in both graphs the optimal investment level in our
model is always higher than that in the benchmark
model. This implies that to gain the benefit from the
postponed commitment option, the firm has to oper-
ate at a higher investment level. Moreover, from
Figures 2(c) and 2(f) we see that the relative change of
K0 , i.e., DK0 =K0 ðBÞ, where DK0 ¼ K0  K0 ðBÞ and
K0 ðBÞ stands for the optimal investment level in the
873
benchmark model, increases faster than the relative
value of the commitment option.
Finally, comparing Figures 2(c) and 2(f), we see that
both the relative value of the commitment option and
the relative change of the optimal capacity investment
level are rather robust in qDm .
6.2. The Effect of R&D Uncertainty
To examine the effect of the R&D uncertainty we
consider two extreme scenarios. In one scenario the
success levels of the two R&D processes are perfectly
positively correlated, that is, p1 ðLÞ ¼ p2 ðLÞ and
p1 ðHÞ ¼ p2 ðHÞ, while in the other scenario they are
perfectly negatively correlated, that is, p1 ðLÞ ¼ p2 ðHÞ
and p1 ðHÞ ¼ p2 ðLÞ. We let p1 ðHÞ range from 0 to 1 to
see how the firm profitability and the optimal capac-
ity investment level change accordingly. In the first
scenario, as both p1 ðHÞ and p2 ðHÞ increase simulta-
neously, the investment becomes more profitable, and
thus the firm enjoys the rapid increase of p0 , as shown
in Figure 3(a). The second scenario is a bit compli-
cated. Because of the perfect negative correlation
between p1 ðHÞ and p2 ðHÞ, if we move from the mid-
point of p1 ðHÞ ¼ p2 ðHÞ ¼ 0:5 toward the right, p1 ðHÞ
increases and p2 ðHÞ decreases at the same speed.
Similarly, if we move from the midpoint toward the
left, p2 ðHÞ increases and p1 ðHÞ decreases at the same
speed. Thus, the curve of p0 must be symmetric.
Figure 3(d) shows that in both models the firm profit-
ability increases from the middle toward the ends.
Such symmetric behavior can be explained by the
improvement of the certainty of the R&D results. We
shall note that in this scenario, p1 ðHÞ þ p2 ðHÞ ¼ 1
holds for any p1 ðHÞ. At the midpoint, we have
p1 ðHÞ ¼ p2 ðHÞ ¼ 0:5, and thus it is equally possible
for both R&D processes to succeed at a high level. As
p1 ðHÞ increases from 0.5 to 1, it becomes more likely
that the R&D of product 1 will succeed at a high level.
Meanwhile, the R&D of product 2 is more likely to
succeed at a low level. At the right end, such R&D
results are certain (with a probability of 1). Appar-
ently, the firm benefits from the improvement of the
certainty of the R&D results and, thus, p0 increases
as p1 ðHÞ moves from the midpoint to the right end.
The same argument applies to the interval of
p1 ðHÞ 2 ½0; 0:5.
Since there is no R&D uncertainty at both ends
(with either pi ðHÞ ¼ 0 or pi ðHÞ ¼ 1, i = 1,2), the
value of the commitment option is totally due to the
demand forecast uncertainty. From Figures 3(a) and
3(d) we see that, for given demand volatility, the
effect of increasing the R&D uncertainty is positive,
that is, the value of the commitment option increases
as the uncertainty of the R&D results increases. This
is in contrast to the result of the last subsection, where
we find that the value of the commitment option
 Kouvelis and Tian: Flexible Capacity Investments and Product Mix
874 Production and Operations Management 23(5), pp. 861–876, © 2013 Production and Operations Management Society

Figure 3 Effect of R&D Uncertainty on Firm Profitability and Optimal Capacity Investment
(a) p2(H) = p1(H) (b) p2(H) = p1(H) (c) p2(H) = p1(H)
*
π* K0 %
0

200 20
100

100 10
50

0 0 0
0 0.5 p (H) 0 0.5 p (H) 0 0.5 p1(H)
1 1

(d) p2(H) = p1(L) (e) p2(H) = p1(L) (f) p2(H) = p1(L)

*
π* K
0
%
0

200 20
100

100 10
50

0 0 0
0 0.5 p (H) 0 0.5 p (H) 0 0.5 p (H)
1 1 1
* * * *
Our model Benchmark Δπ0/π0(B) ΔK0/K0(B)

decreases in demand volatility for a given uncertainty
level of the R&D processes. But it is not a surprising
result. Intuitively, the higher the uncertainty of the
R&D results, the more opportunity for the firm to
enjoy the benefit from allocating the capacity accord-
ing to the R&D results. Moreover, Figures 3(c) and
3(f) confirm that the relative value of the commitment
option is also higher in a more uncertain R&D envi-
ronment.
As observed from Figure 2, Figures 3(b) and 3(e)
show that to gain the benefit from the postponed com-
mitment option, the firm has to operate at a higher
investment level in both scenarios. However, from
Figures 3(c) and 3(f) we can see that the relative
change of K0 is quite involved, especially in the sec-
ond scenario.
6.3. The Impact of the Commitment Time and the
Cost Deferment
In the rest of this section, we take a brief look at the
impact of the commitment time and the cost defer-
ment on the value of the postponed commitment
option. We consider four typical combinations of
p1 ðHÞ and p2 ðHÞ. Figure 4(a) shows the change of the
value of the commitment option when the commit-
ment time ranges from 0.5 to 5.5, while Figure 4(b)
shows the change of the value of the commitment
option when the deferrable cost increases from 10% to
90% of the total capacity cost. Recall that the total
capacity cost consists of the initial investment cost
and the deferred commitment cost and is normalized
to 1, that is, c0 þ cs ¼ 1. So, as cs increases from 0.1 to
0.9, c0 decreases from 0.9 to 0.1. From Figures 4(a) and

Figure 4 Impact of (a) Commitment Time and (b) Cost Deferment

(a) Δπ*0/π*0(B) (b) Δπ*0/π*0(B)

% %

20 20

10 10

0 0
0.5 3 τ 0.1 0.5 c
τ

p (H)=p (H)=0.5 p (H)=p (H)=0.1 p (H)=p (H)=0.9 p (H)=0.1, p (H)=0.9

1 2 1 2 1 2 1 2
Kouvelis and Tian: Flexible Capacity Investments and Product Mix
Production and Operations Management 23(5), pp. 861–876, © 2013 Production and Operations Management Society
4(b) we see that, even for short s and small cs , the
value of the postponed capacity commitment option
is significant.
To sum up, our numerical results show that the
value of the commitment option is decreasing in
demand volatility but increasing in R&D uncertainty,
whereas in the relative sense it is increasing in both
demand volatility and R&D uncertainty. Hence, the
commitment option is of great benefit, particularly to
firms operating in a volatile demand environment
and facing high R&D uncertainty, and can be adopted
widely as an important tool for hedging against the
demand volatility and the R&D uncertainty. Also, we
find that to gain the benefit from the commitment
option, the firm has to operate at a higher investment
level.
7. Conclusions
Investments in flexible capacity are often made well
ahead of the market demand as effective hedges
against uncertainties on the exact mix of products
produced and the overall demand to be met. In an
effort to better deploy such flexible capacity firms
postpone certain specialized capacity configuration
decisions and the allocation of capacity to individual
products for later when the exact mix of products to
be produced is specified and the demand forecast is
more accurate. Finally, closer to the selling season the
production and pricing decisions are made in
response to demand realization and subject to the
already made capacity decisions. Efforts to effectively
value flexible capacity investments and to decide on
the optimal magnitude of them are seriously chal-
lenged by the presence of the highly interconnected
embedded postponement options on capacity com-
mitment and subsequent production deployment and
pricing. We have presented a comprehensive model-
ing framework that accounts for the sequential nature
and embedded optionality of these decisions. It
allows us to value flexible capacity investments over
time as the product mix and the demand uncertainty
are gradually resolved and capacity allocation and
production and pricing decisions are progressively
made. We describe not only the optimality properties
of flexible capacity investments but also the way such
capacity can be best allocated and used.
We have been able to extend the equal profit margin
property of single period and single product uncon-
strained joint inventory and pricing models with
MNL demand to the complex setting of flexible capac-
ity investments with postponed product and capacity
commitment. Furthermore, we show that the optimal
capacity allocation is independent of the aggregate
demand and the prices, and it only depends on an
easy to specify a priori ratio that is a function of the
875
quality levels and the marginal production costs.
Finally, the production quantities and prices reflect
one of two aggregate demand scenarios (high or low).
For low demand, the capacities are not constrained
and the prices are fixed with an equal profit margin
on top of the product costs, while the production
quantities increase linearly as the demand increases.
Once the demand exceeds a specified threshold, the
individual product capacities are all constrained; thus
the production quantities stay fixed at a given level.
For this case, the prices keep increasing in a concave
fashion so that the demand directed to each product is
always equal to the available capacity.
Our results clearly show that flexible capacity deci-
sions in the presence of product mix and demand
uncertainty with embedded postponement options
cannot be intuitively understood through the logic of
simple call option or similar frameworks. Our frame-
work provides a clean way to value the embedded
postponement options on capacity allocation, produc-
tion, and pricing. While the often-used explanation
behind the value of such postponement options is the
time value of the deferment of relevant capacity and
production costs, our model points out, and can be
used to value, the first-order magnitude benefits of
exact product mix information and improved forecast
accuracy. Our modeling framework is, to the best of
our knowledge, the only one to fully value the com-
pounded nature of these intertwined postponement
options.
Acknowledgments
The authors thank the department editor Suresh Sethi, the
associate editor, and two anonymous referees for their help-
ful comments and suggestions that significantly improved
this article.
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Supporting Information
Additional Supporting Information may be found in the
online version of this article:
Appendix S1. Proofs