Real options at the interface of finance and operations: exploiting embedded supply-chain real options to gain competitiveness

Abstract

Exploiting embedded supply-chain real options creates powerful opportunities for competitive manufacturing in high-cost environments. Rather than seeking competitiveness through standardization as is common to lean production, real-options reasoning explores opportunities to use supply-chain variability as a strategic weapon. We present an illustrative case study of a Swiss manufacturer of cable extrusion equipment supported by a formal real-options model that aids in valuing the embedded options that make up supply-chain flexibility: postponement, contraction, expansion, switching, and abandonment. Real-options reasoning provides a plausible retrospective rationale for the case firm's use of supply-chain flexibility that provided protection against competition from low cost, but less responsive competitors. Their intuitive real-options reasoning facilitated incorporating fuller information concerning volatility, flexibility, and control into choosing what products to make, in what quantity, and with work allocated to which supplier. The case study also highlights how competing through exploiting embedded real options requires a different managerial skill set than does competing through cost reduction. Skills such as customer communication, supplier management, and ability to ensure a smooth flow of production join the ability to reduce and control lead times as key sources of competitive advantage.

Keywords:

• real options
• supply-chain strategy
• supply-chain risk

JEL Classification :

• D24
• L64

Acknowledgements

We are indebted toward Maillefer Extrusion for allowing this case study to be published. We are particularly grateful to Mr Pentti Hätälä and Mr Georges Duruz for sharing their experiences and enriching the discussions. We are also grateful to an anonymous referee, whose detailed comments substantially improved the paper.

Notes

A real-options perspective offers the alternative of adjusting probabilities for risk to allow discounting the resulting risk-adjusted cash flows at the risk-free rate.

Note that the last equality in Equation (6) holds only when D is positive, which should be the case for demand.