110923 mit forum vienna - value of flexibility v1.0

8/3/2019 110923 MIT Forum Vienna - Value of Flexibility v1.0

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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


Traditional valuation methods Discounted cash flow analysis

Scenario analysis1

Dynamic valuation methods

Real options approach Simulation methods2

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3


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How do valuation methods account for

flexible supply chain decisions?

Supply Chain Network Design at Flexcell


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


+ 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



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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)

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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


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

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3

2

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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


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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)


0

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3

2

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3

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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



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110923 mit forum vienna - value of flexibility v1.0

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