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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
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It is not the strongest of the speciesthat survive, nor the most intelligent, but
the one most responsive to change.
Charles Darwin
Copyright 2011. WU Wien. All rights reserved.PAGE 2 7 February 2012
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How do you
convinceyour senior
management
that investing
into a flexible
supply chain
does make
sense
financially?
????
?
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Valuation methods need to be evaluated for
their applicability in turbulent times
Valuation Methods
Copyright 2011. WU Wien. All rights reserved.PAGE 4 7 February 2012
Traditional valuation methods Discounted cash flow analysis
Scenario analysis1
Dynamic valuation methods
Real options approach Simulation methods2
2
3
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How do valuation methods account for
flexible supply chain decisions?
Supply Chain Network Design at Flexcell
Copyright 2011. WU Wien. All rights reserved.PAGE 5 7 February 2012
EXAMPLE
Flexcell is a Swiss universityspin-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)
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Where should the new plant be located?
Location Benefits
Copyright 2011. WU Wien. All rights reserved.PAGE 6 7 February 2012
+ Labor cost advantage
Limited ability to
customize products High distance from
HQ: challenges with
implementation of new
production processes
and technology
+ 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,
technicians and senior
management in
Switzerland)
EXAMPLE
Source: de Treville & Trigeorgis (2010)
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DCF assumes a predetermined artificial plan
is followed, regardless of how events unfold
The benefits of flexible response are
ignored by DCF:
DCF assumes a static system (not
capable of considering the effect of aflexible option)
Single point forecasts for key variables
(e.g. oil price in 2020 at 200 USD / barrel)
The flaw of averages: plans based on
the assumption that average conditions
will occur are usually wrong (e.g. averageconsumption is 300 units, therefore plant
capacity is set at this level)
Limitations ofDCF
Copyright 2011. WU Wien. All rights reserved.PAGE 7 7 February 2012Source: Luehrman (1998)
1 2 30
New competitor entersmarket
Response: NONE
Recession, demandfalls
Response: NONE
JV opportunity
emergesResponse: NONE
rangeofpossibleoutcomes
Traditional valuation methods are not designed to cope with conditions of volatility
and uncertainty (static, seek lowest cost solution, decide against flexibility)
SC decisions taken under these circumstances are inadequate for turbulent times
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Decisions that keep most options open are
preferable to those that shut options down
Real options valuation (ROV) is a
fundamentally different way of
evaluating supply chain options
A way to value flexibility monetary valueof an option, e.g.
Real options assume that management isactive and can modify decisions as
necessary
Real Options Thinking
Copyright 2011. WU Wien. All rights reserved.PAGE 8 7 February 2012
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 assets value under uncertainty
rangeofpossibleoutcomes
Source: Luehrman (1998)
0
2
3
2
2
3
3
1
1
JV opportunity emergesResponse: PROACTIVE
New competitor entersmarket
Response: PROACTIVE
Recession, demand fallsResponse: PROACTIVE
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Given the uncertainty of this venture, ROV
showed the benefits of the Swiss location
Value of Flexibility
Copyright 2011. WU Wien. All rights reserved.PAGE 9 7 February 2012
1 2 30
DCF approach is in favor for the German plant
NPV comparison shows significantly lower fixed
manufacturing costs Flexibility value is not accounted for
DCF
ROV
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)
Source: de Treville & Trigeorgis (2010)
0
2
3
2
2
3
3
1
1
EXAMPLE
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What is the value of flexibility in
supply chains?
A lot
if uncertainty is high
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To include the full value of flexibility,
valuation methods that consider flexible
options need to be chosen
To include the full value of flexibility into supply chain decisions, 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, 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;
the very exercise of working through options systematically, begins to change
the way management thinks
Conclusio
Copyright 2011. WU Wien. All rights reserved.PAGE 11 7 February 2012
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Copyright 2011. WU Wien. All rights reserved.PAGE 12 7 February 2012