Volume flexibility and capacity investment under demand uncertainty

Verena Hagspiel, Kuno Huisman, Peter Kort

Research output: Contribution to journalArticleScientificpeer-review

Abstract

The paper considers optimal capacity investment decisions under uncertainty taking a real options approach. Concerning the production decision, we study a flexible and an inflexible scenario. The flexible firm can costlessly adjust production over time with the capacity level as the upper bound, while the inflexible firm fixes production at capacity level from the moment of investment onwards. We find that the flexible firm invests in higher capacity than the inflexible firm, where the capacity difference increases with uncertainty. For the flexible firm the initial capacity utilization rate can be quite low, especially when investment costs are concave and the economic environment is uncertain. As to the timing of the investment there are two contrary effects. First, the flexible firm has an incentive to invest earlier, because flexibility raises the project value. Second, the flexible firm has an incentive to invest later, because costs are larger due to the higher capacity level. The latter effect dominates in highly uncertain economic environments. Our model being dynamic enables us to derive the at first sight counterintuitive result that an increase in capacity holding cost raises the capacity level the firm invests in.
Original languageEnglish
Pages (from-to)95-108
JournalInternational Journal of Production Economics
Volume178
Early online date13 May 2016
DOIs
Publication statusPublished - Aug 2016

Fingerprint

Costs
Economics
Dynamic models
Uncertainty
Demand uncertainty
Volume flexibility
Capacity investment
Economic environment
Incentives
Real options
Investment decision
Scenarios
Upper bound
Optimal capacity
Utilization rate
Capacity utilization
Decision under uncertainty

Keywords

  • investment analysis
  • flexible manufacturing
  • real options
  • capacity choice

Cite this

@article{ce2a90487ed04acc9f9d1ab434a23dc1,
title = "Volume flexibility and capacity investment under demand uncertainty",
abstract = "The paper considers optimal capacity investment decisions under uncertainty taking a real options approach. Concerning the production decision, we study a flexible and an inflexible scenario. The flexible firm can costlessly adjust production over time with the capacity level as the upper bound, while the inflexible firm fixes production at capacity level from the moment of investment onwards. We find that the flexible firm invests in higher capacity than the inflexible firm, where the capacity difference increases with uncertainty. For the flexible firm the initial capacity utilization rate can be quite low, especially when investment costs are concave and the economic environment is uncertain. As to the timing of the investment there are two contrary effects. First, the flexible firm has an incentive to invest earlier, because flexibility raises the project value. Second, the flexible firm has an incentive to invest later, because costs are larger due to the higher capacity level. The latter effect dominates in highly uncertain economic environments. Our model being dynamic enables us to derive the at first sight counterintuitive result that an increase in capacity holding cost raises the capacity level the firm invests in.",
keywords = "investment analysis, flexible manufacturing, real options, capacity choice",
author = "Verena Hagspiel and Kuno Huisman and Peter Kort",
year = "2016",
month = "8",
doi = "10.1016/j.ijpe.2016.05.007",
language = "English",
volume = "178",
pages = "95--108",
journal = "International Journal of Production Economics",
issn = "0925-5273",
publisher = "Elsevier Science BV",

}

Volume flexibility and capacity investment under demand uncertainty. / Hagspiel, Verena; Huisman, Kuno; Kort, Peter.

In: International Journal of Production Economics, Vol. 178, 08.2016, p. 95-108.

Research output: Contribution to journalArticleScientificpeer-review

TY - JOUR

T1 - Volume flexibility and capacity investment under demand uncertainty

AU - Hagspiel, Verena

AU - Huisman, Kuno

AU - Kort, Peter

PY - 2016/8

Y1 - 2016/8

N2 - The paper considers optimal capacity investment decisions under uncertainty taking a real options approach. Concerning the production decision, we study a flexible and an inflexible scenario. The flexible firm can costlessly adjust production over time with the capacity level as the upper bound, while the inflexible firm fixes production at capacity level from the moment of investment onwards. We find that the flexible firm invests in higher capacity than the inflexible firm, where the capacity difference increases with uncertainty. For the flexible firm the initial capacity utilization rate can be quite low, especially when investment costs are concave and the economic environment is uncertain. As to the timing of the investment there are two contrary effects. First, the flexible firm has an incentive to invest earlier, because flexibility raises the project value. Second, the flexible firm has an incentive to invest later, because costs are larger due to the higher capacity level. The latter effect dominates in highly uncertain economic environments. Our model being dynamic enables us to derive the at first sight counterintuitive result that an increase in capacity holding cost raises the capacity level the firm invests in.

AB - The paper considers optimal capacity investment decisions under uncertainty taking a real options approach. Concerning the production decision, we study a flexible and an inflexible scenario. The flexible firm can costlessly adjust production over time with the capacity level as the upper bound, while the inflexible firm fixes production at capacity level from the moment of investment onwards. We find that the flexible firm invests in higher capacity than the inflexible firm, where the capacity difference increases with uncertainty. For the flexible firm the initial capacity utilization rate can be quite low, especially when investment costs are concave and the economic environment is uncertain. As to the timing of the investment there are two contrary effects. First, the flexible firm has an incentive to invest earlier, because flexibility raises the project value. Second, the flexible firm has an incentive to invest later, because costs are larger due to the higher capacity level. The latter effect dominates in highly uncertain economic environments. Our model being dynamic enables us to derive the at first sight counterintuitive result that an increase in capacity holding cost raises the capacity level the firm invests in.

KW - investment analysis

KW - flexible manufacturing

KW - real options

KW - capacity choice

U2 - 10.1016/j.ijpe.2016.05.007

DO - 10.1016/j.ijpe.2016.05.007

M3 - Article

VL - 178

SP - 95

EP - 108

JO - International Journal of Production Economics

JF - International Journal of Production Economics

SN - 0925-5273

ER -