Production Flexibility This shows how flexibility in the allocation of production capacity can increase value Value comes from “over design” of capacity It is due to uncertainty in both Overall level of demand Relative demand of different products Example inspired by Jan van Mieghem, development help from João Claro

The Example Two – Stage Manufacturing Process The question: how do we allocate capacity to the facilities? SUV Assembly Sedan Assembly Product Finishing SUVs Sedans

Basic Data $40 million fixed cost Variable cost for each facility $300 / unit for SUV $200 / unit for sedans $800 / unit for shared finishing Gross Margins for each product $ 4000 / SUV $ 3000 / Sedan For simplicity, all in present dollars

1. Design based on best forecast Assume forecast is 30,000 of each vehicles Design is then 30 / 30 /60 30,000 for SUVs 30,000 for Sedans 60,000 for Finishing System value = Revenues – costs = [30(4) + 30 (30)] – 40 –[30(.3) + 30(.2)] =107 Million

2. Best forecast +/- 15% Calculations based on deterministic forecast of course unrealistic We need to recognize uncertainty For example +/- 15% overall

2. Results for +/- 15% Uncertainty Value calculated is less than with unrealistic certainty. Why? No gains for high scenario because of production constraints For low scenario: Revenue loss = 5(4 +3) = 35 Million This occurs 25% of time Net loss in expected value 8.75 Overall Expected Value = 98.75 Million

3. Asymmetric Variation in Products Suppose, as often happens, that demand for products is negatively correlated (if demand for 1 goes up, demand for other goes down) Why would this happen? In bad times consumers buy less and cheaper Overall number of units down Proportion skewed toward cheaper vehicles Conversely, in expansive times

3. Assumed Asymmetry Total demand up or down by 15% as before But demand for SUV’s very sensitive SUV shift partially counter-balanced by demand for sedans

3. Effect on Production Counter intuitively, units sold drops during expansion period! Sales of SUVs limited by capacity constraint Demand for sedans drops!

3. Effect on Profits Negative correlation in demand increases losses compared to situation without this effect Expected value now 88.25

4. Cutting Capacity An intuitive reflex might be to cut size since expected sales less than capacity What does this do? Not much good! Gap persists

4. Effect of Cutting Capacity Net effect of cutting size of a profitable business is to cut profits Expected Profits drop to 78.8 Not a good plan

5. Flexibility to Allocate Capacity Idea: expand capacity of SUV and Sedan facilities without expanding finishing plant This is an unbalanced design: SUV and Sedan together will never operate at capacity (in this case, less than 60/70 ~ 86%) Why is this good? Allows tracking demand

5. Value of Flexibility Increases profits Expected Value = 94.5 > 88.25 Net Value of flexibility = 6.25 Million

5. VARG Comparisons Asymmetric demand, with and w/o flexibility Policy “reduces downside, increases upside” Flexible Design Base Case

5. Benefit-Cost of Flexibility = Cost of Extra Capacity = 5(0.3) + 5(0.2) = 2.5 million Benefit – Cost of Flexibility (remember, total value = net + cost) = [6.25 + 2.5] / 2.5 = 3.5

Take-aways from presentation Flexible Capacity Allocation can be valuable -- when demand for products (services) is negatively correlated Solution is counter-intuitive Not a “balanced” design Flexibility consists of having extra capacity to absorb changes