1. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 1 of 23 Richard de Neufville Professor of Systems Engineering and of Civil and Environmental Engineering MIT Real Options in Supply Chain Management

2. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 2 of 23 Objectives of this presentation l To stress the role of flexibility in design and management of supply chains –It provides the means to adjust to the consequences of inevitable risks l To define Options, as means to create flexibility –Build upon their use in financial context –Focus is on application to the design and then effective management of the system over time l Take-away: “options thinking” is crucial

3. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 3 of 23 Outline l Motivation by Example –Managers need flexibility to respond to unexpected l This simple concept implies a deep change in way we think about design of these systems –From: designing to specified circumstances –To: planning for a range of possibilities l Options is the formal way of defining and analyzing flexibility –Builds upon options analysis as used in finance

4. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 4 of 23 Managers need flexibility l They frequently may encounter disruptive situations that demand, or would benefit from, out- of-ordinary responses l Recent Examples: –Key supplier cannot deliver (fire in a chip plant) –Normal links broken (West Coast shipping strike) –Product demand surges (hit fashion or holiday item) l Ability to respond quickly can be critical –Nokia responded fast to chip plant fire, Motorola couldn’t => Nokia was able to expand market share significantly

5. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 5 of 23 Flexibility => Insurance, Opportunity l One way to view flexibility is as “insurance”, the capability to avoid bad outcomes l Another: readiness to capitalize on opportunities l [ these are like ‘puts’ and ‘calls’ – see later] l Either way, flexibility requires prior preparation –Backup suppliers or alternative designs –Commitments by manufacturers for extra capacity –Capacity to re-deploy supply chain

6. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 6 of 23 Flexibility thinking => Mental Shift l Building flexibility into system requires a mental shift in framing of supply chain l Problem viewed as managing risk over range of circumstances, not as traditional view of optimizing performance for given specifications l We face a higher order problem, building on our capability to optimize for particular situations

7. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 7 of 23 Traditional Practice l Typically focuses on design to specifications l This is a complex optimization process l These specs decided outside the optimization process (for example, by market analyses) Cost Capacity Best design to specification

8. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 8 of 23 Actual System Performance is Risky l Why is this? l Because market and other conditions uncertain l Example: Profitability depends on market size Profit Loss Market demand Design spec

9. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 9 of 23 Design involves a distribution of risk l Outcomes vary in probability l Consequences of outcomes x probabililty => pdf (probability distribution function) ProfitLoss Probability distribution

10. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 10 of 23 Design Opportunity l To vary the distribution of probability distribution to increase, maximize value l Key means of doing this: flexibility that permits adaptation of design to circumstances ProfitLoss Probability distribution Shift

11. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 11 of 23 New pdf Original pdf ProfitLoss Consequences of Flexibility (1) l Accentuate the positive -- take advantage of opportunities (also known as “call options”)

12. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 12 of 23 Consequences of Flexibility (2) l Minimize the negative -- avoid big losses (as with insurance) (also known as “put” options) ProfitLoss Original pdf New pdf

13. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 13 of 23 Stress on Flexibility l Represents a real change in concept of design and management of systems over time l Why is this? l Because: instead of designing to a spec, we design for a range of possible levels of performance Cost Performance Design to specification Design for expansion

14. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 14 of 23 Flexibility Adds Value l Flexible systems allow managers to –Recover from disruptions –Take advantage of opportunities l Flexibility can reduce total costs –Costs less to adapt to variability and change l Example: Fire in chip plant –Ability to redesign product with alternative chips permitted Nokia to reduce cost of interruption and, in this case, to take advantage of weakness of competitor

15. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 15 of 23 Flexibility Costs l Money –Inventories, investment in design, computer systems –Extra Space for Expansion l Complexity –Management systems more complex l Time –Design and Planning Efforts take time

16. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 16 of 23 Central Issue l What Flexibility should we incorporate in System? l The question is in effect: What elements of flexibility are more valuable than their cost? l How do we value flexibility? l This is the central topic of options analysis

17. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 17 of 23 “Options” = Formal Notion of Flexibility l An Option is a formal way of defining flexibility l Options valuation well developed for financial markets l Field of “real” options applies theory to real projects –Future decisions have features similar to financial options –Financial options valuation can be extended to projects

18. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 18 of 23 What is an Option? l A right, but not an obligation… –Asymmetric returns; exercise only if advantageous –Acquired at some cost l to take some action… –to switch fuels, drop project, buy or sell something, etc, etc, l now, or in the future... –May be indefinite, as for dual fuel burner –Often for a limited time after which option expires l for a pre-determined price. –Cost of action separate from cost of option (down time for switching burners different from cost of dual fuel burner)

19. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 19 of 23 Example Financial Option l Example: An Option to buy 100 shares of ATT at 15 through Jan. 2003 l Option is a right. It allows, doesn’t force owner to... l … buy shares at a specified price l … for a specific time (through January) l “Strike” price is set in advance (at $15 in this case) l Note: on November 15, 2002, quoted prices were: –1 share of ATT = $ 13.8 –option on 1 share = $ 0.50

20. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 20 of 23 Asymmetry of Option l Owner of Option Likely to exercise right to buy stock if its price > strike price or $S > $15 –owner then makes profit = $(S - 15) –these profits may be unlimited l Owner not required to exercise option –Loss limited to cost of buying option (example: $0.50/share) –losses are limited l Once you own this option, Value is not symmetric –In this case: All gain, No pain l Note: Other options might be all pain, no gain...

21. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 21 of 23 Example: “Real” Option l “Real” Options concerns things, as distinct from “financial” options embodied in contracts l Example: The spare tire on your car is an option that gives you the right l... to change the tire l … the right in this case has unlimited time l... “cost” of exercising option = effort to change tire l Note Similarity to Financial Option –You will change tire only if you need to –You do not have to do a thing about it

22. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 22 of 23 Supply Chain “Real” Options l “Real” Options for Supply Chain Management can come in many shapes l Examples: –Maintenance of alternative supplier, perhaps at higher cost, to enable use as needed –Inventories motivated by disruptive events –Investment in platforms for products to reduce vulnerability to specific components –Contracts with manufacturers to insure priority supply l These are topics of current research

23. Options for Supply Chain Management Massachusetts Institute of Technology Richard de Neufville  Dec. 5, 2002Slide 23 of 23 Summary l Flexibility has value, because of risk l Supply chain design should incorporate flexibility l Issue is: How do we incorporate value flexibility? l Options embody formal concept of flexibility l “Options Thinking” key l Topic of current research