Optimal Investment in Product-Flexible Manufacturing Capacity

Abstract

This paper presents a model and an analysis of the cost-flexibility tradeoffs involved in investing in product-flexible manufacturing capacity. Flexible capacity provides a firm with the ability to respond to a wide variety of future demand outcomes, but at the expense of the increased cost of acquiring flexible manufacturing capacity, as compared with dedicated or nonflexible capacity. We formulate the product-flexible manufacturing capacity investment decision as a two-stage stochastic program. In the first stage, the firm must make its investment decision in manufacturing capacity, before the resolution of uncertainty in product demand. In the second stage, after demand for products are known, the firm implements its production decisions, constrained by the first-stage investments. The main contributions of this paper are threefold. First, we develop a model of the firm's flexible manufacturing investment decision that conceptually captures some of the key characteristics of this complex decision problem. Second, with the aid of the model, we characterize the necessary and sufficient conditions for a firm to invest in flexible capacity to protect efficiently against uncertainty in demand for all of its products. Third, we explore the sensitivity of the firm's optimal capacity investment decision to key problem components, namely to the cost of flexible and nonflexible production capacity, to the underlying distribution of product demand, and to the level of risk.