Real Options in Supply Chain Management

A real option is “a right – without an obligation – to invest resources (e.g., labor, money, time) toward a course of action at a future point in time” (McCarter et al., 2011). SCM applications of real options are scarce. In their illustrating HBR article, It may be cheaper to manufacture at home, de Treville and Trigeorgis (2010) argue that supply chain managers “typically rely on the discounted cash flow (DCF) model to help them value the alternatives”. However, this model undervalues flexibility and, thus, supply chain managers “may end up with supply chains that are lean and low cost under normal circumstances – but extremely expensive if the unexpected occurs”. The authors demonstrate that it is better to rely on the real options model. Applying this model enables supply chain managers “to put dollar figures on flexibility in the supply chain and on the ability to manage production problems directly rather than from afar”.

de Treville, S. & Trigeorgis, L. (2010). It may be cheaper to manufacture at home. Harvard Business Review, 88 (10), 84-87