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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

nor the most intelligent. All rights reserved. but the one most responsive to change.³It is not the strongest of the species that survive. WU Wien. 7 February 2012 .´ Charles Darwin PAGE 2 Copyright 2011.

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

All rights reserved. .Valuation methods need to be evaluated for their applicability in turbulent times Valuation Methods 1 Traditional valuation methods  Discounted cash flow analysis  Scenario analysis Dynamic valuation methods  Real options approach  Simulation methods 2 3 7 February 2012 2 PAGE 4 Copyright 2011. WU Wien.

All rights reserved.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) PAGE 5 Copyright 2011. WU Wien. 7 February 2012 .

technicians and senior management in Switzerland) 7 February 2012 Copyright 2011.Where should the new plant be located? Location Benefits EXAMPLE + Labor cost advantage í Limited ability to customize products í High distance from HQ: challenges with implementation of new production processes and technology Source: de Treville & Trigeorgis (2010) PAGE 6 + 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. WU Wien. . All rights reserved.

g. therefore plant capacity is set at this level) . All rights reserved.DCF assumes a predetermined artificial plan is followed. demand falls Response: NONE 0 1 2 3 JV opportunity emerges Response: NONE  Traditional valuation methods are not designed to cope with conditions of volatility and uncertainty (static. WU Wien.g. average consumption is 300 units. regardless of how events unfold Limitations of DCF Recession. 7 February 2012 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. decide against flexibility)  SC decisions taken under these circumstances are inadequate for turbulent times Source: Luehrman (1998) PAGE 7 Copyright 2011. seek lowest cost solution. oil price in 2020 at 200 USD / barrel)  The ³flaw of averages´: plans based on the assumption that average conditions will occur are usually wrong (e.

g. WU Wien. 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 asset¶s value under uncertainty Source: Luehrman (1998) PAGE 8 Copyright 2011.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. 7 February 2012 . All rights reserved. 3 2 1 0 1 2 New competitor enters market Response: PROACTIVE 2 3 3 range of possible outcomes JV opportunity emerges Response: PROACTIVE Recession. e.

WU Wien. All rights reserved. . ROV showed the benefits of the Swiss location Value of Flexibility EXAMPLE DCF 0 1 2 3  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) 7 February 2012 ROV 2 0 1 1 2 2 3 3 3 Source: de Treville & Trigeorgis (2010) PAGE 9 Copyright 2011.Given the uncertainty of this venture.

What is the value of flexibility in supply chains? A lot ± if uncertainty is high .

the very exercise of working through options systematically. WU Wien. 7 February 2012 .To include the full value of flexibility. All rights reserved. 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. valuation methods that consider flexible options need to be chosen Conclusio  To include the full value of flexibility into supply chain decisions. 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. begins to change the way management thinks PAGE 11 Copyright 2011.

7 February 2012 . All rights reserved. WU Wien.PAGE 12 Copyright 2011.