Manufacturing Flexibility Under Uncertain Demand by a Real Options Approach

Abstract

Evaluation of the optimal investment in plant modification (facility renovation and/or equipment replacement) is becoming significantly important in forecasting profits for soft drink business. The sales of soft drink have a typical seasonality; higher in summer and lower in winter. This chapter proposes a decision-making method for the optimal investment in plant expansion by treating uncertainty of potential demand, based on the real options approach (ROA) and the seasonal autoregressive integrated moving average (SARIMA) . For example, the demand for soft drink in the summer can be often too high for production capacity. This chapter examines following two methods based on option theory, first one is Bermudan call options to flexibly coordinate the number of part-time workers for increase in recruitments in summer and simultaneously a decrease in winter. The second method is the American call option used to expand equipment capacity to meet not only summer demand but also long-term upside demand even at a high sunk cost. We also compare these options in binomial lattice through Monte Carlo simulation . There may be dividend like effects of seasonal demand variation on the exercise of American call options and some signaling threshold demand level just before rising wave period can be a trigger criterion for flexible investment decision if enough lead time is available.