Flexibility valuation of product family architecture: a real-option approach

Abstract

The rationale of a product family architecture (PFA) has been well recognized as an effective means to achieve mass customization. Investing into a PFA creates flexibility for the company to accommodate future customization requirements while taking a risk by increasing complexity in design and production. Thus an important issue of PFA is the economic justification of flexibility. This paper applies the real option theory to the valuation of PFA flexibility. A real option model is proposed, in which product family design within a PFA is referred to as an investment strategy being crafted by a series of options that are continuously exercised to achieve expected returns on investment. The real option approach surmounts traditional discounted cash flow analysis based valuation methods that tend to ignore the upside potentials to an investment from management flexibility.