Volume flexibility and capacity investment under demand uncertainty

Verena Hagspiel, Kuno Huisman, Peter Kort

Research output: Contribution to journalArticleScientificpeer-review

24 Citations (Scopus)

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

Keywords

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

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