Sourcing flexibility with uncertain costs

Abstract

This paper proposes a real-options model in which a client firm can reversibly choose the mode of supply between outsourcing and in-house production. The state variable of the model is defined as the difference between the current operational cost and the alternative one, and is assumed to evolve according to an arithmetic Brownian motion. The model is simple and flexible, and can encompass different situations. The effect of reversibly choosing the mode of supply (or full sourcing flexibility) is far from negligible: our numerical illustrations suggest that it substantially increases the option values over the situation with partial flexibility (about 15%–20% for a typical parameter configuration); the expected times until shifting also change substantially. Moreover, it is shown that: (i) an increase of volatility has an asymmetrical effect on shifting the supplying mode; (ii) the real-option associated with full sourcing flexibility reduces the impact of the sunk expenditure on firms’ decisions, favouring the shift in any supplying mode.

Keywords:

• Real-options
• outsourcing
• backsourcing
• arithmetic Brownian motion
• optimal stopping

Acknowledgments

The author gratefully acknowledges the journal Editor, the anonymous referees, and Vicente Salas, for the detailed comments and suggestions made on the paper.

Disclosure statement

No potential conflict of interest was reported by the author.

Additional information

Funding

The author gratefully thanks the financial support from the research project ECO2017-86305-C4-3-R MINECO (Ministerio de Economía y Competitividad - Fondos FEDER).