Aggregate production process design in global manufacturing using a real options approach

Abstract

A main source of competitive advantage is derived from the cost efficiency offered by firms’ manufacturing and logistics operations. Consequently, firms typically globalise their operations whereby they may exploit the comparative advantages—defined as production functions—of the nations in which they are present. Production process design thus arises as a significant issue. The research presented in this paper targets two fundamental questions attached to production process design that multinational companies face, namely: (i) should plants that are located in different countries but producing similar products use similar production processes?; and (ii) given that the firm's policy is to use similar production processes, how should the production processes be designed? Among others, the paper shows, by way of a numerical illustration of a binational manufacturing network, that the option of choosing freely upon production process design for the respective facilities in certain cases adds little to firm value. In fact, the value of this option tends to zero as the volatility rate increases when the exchange rate is modelled as a geometric Brownian motion without drift rate, implying that firms should employ similar production processes throughout their manufacturing networks. That is, a market value approach stands up for the so-called copy-exactly approach to production process design in these settings. We furthermore show the effects of economies of scale on the optimal production process design.