Making Right Capacity Investment Decision Under Demand Uncertainty

Capacity choice is a long-term decision and usually made before firms have a good idea of demand. Production and pricing decisions can be made before or after the actual demand curve is known. Whether or not a firm can exploit demand information to better adjust output depends on the capability of its infrastructure. For example, any production system entails a lead time. Subcontracting production (say, overseas) requires a long lead time, whereas in-house production can be done much more quickly. Consequently, with subcontracted production, it is likely that a firm makes production decisions before observing the actual demand. Alternately, for a given production technology, a firm can choose to invest in an infrastructure to obtain information earlier in time. Regardless of the approach, a firm develops a capability to postpone production decisions.

More generally, the initial capacity investment can be considered as an option that can be exercised afterwards to produce or customize a desired product. Although firms may have some idea of pricing in mind when they make the investment decisions, they often revise prices after observing demand. Examples of postponed production abound; in addition to the classical examples of Hewlett Packard and IBM’s vanilla boxes, many others involve General Motors, Reebok, Polaroid, and others. The specifics of each case vary but in each there is some notion of an initial investment and investment after customization.

The interplay between the timings of demand revelation and the technology that a firm possesses gives rise to two types of firms:

  1. Flexible firm - has the ability to postpone production until the actual demand curve is observed.

  2. An inflexible firm - has to decide production before observing the demand.

Industry structure and the nature of demand shock critically affect firms’ flexibility choices, when the decisions are made endogenously. If it is assumed that price decision and knowledge come afterwards than:

  1. A flexible firm has the ability to do production and price postponement

  2. An inflexible firm resorts only to price postponement with clearance

An intermediate situation can be a partially flexible firm with the capability to postpone delivery of products into market by holding back a fraction of produced units. Effectively, a partially flexible firm cannot postpone production, but is able to do price postponement with holdback. Such an intermediate case allows one to model the different types of postponement capabilities. Partial flexibility may be less costly to implement than full flexibility; for example, it may entail developing a distribution network capable to hold back products in a particular market.

Benefits of flexibility in a competitive setting would be:

  1. Ability to postpone production - benefits firms from market volatility.

  2. Endurance against demand shock—has strong influence on the value of flexibility to postpone production.

Whereas, inflexible firms with price-only postponement capability are impacted by demand variability. Thus, inflexible firms with demand shocks face both strategic and destructive effects of competition.

However, for firms with demand shock, flexibility to postpone production eliminates the adverse impact of “destructive competition.” Flexibility plays an important role in mitigating the destructive effect of competition. Finally, flexibility allows firms to keep prices within a smaller bounded range. Flexibility allows a firm to increase investment in capacity and earn a higher profit while benefiting customers by keeping the price in a narrower range.

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