Evaluation of setup time reduction alternatives using a real options approach

Obtaining sustainable competitive advantage in the face of the dynamics of market uncertainties requires an ability to adapt manufacturing strategies in a way that would allow a firm to harness market opportunities. Hence, manufacturing firms are constantly in search of technologies and strategies that would enable them to enhance their performance in order to effectively respond to market opportunities. The flexibility of the manufacturing system to adapt to the global competitive environment is a cost-effective strategy for improving the business performance of a manufacturing system. A substantial body of anecdotal evidence suggests that setup-time reduction improves manufacturing flexibility. Setup-time reduction is an important aspect of lean manufacturing because of its importance in reducing lead-time, batch sizes, and work-in-process levels, and offers manufacturers the flexibility necessary to respond effectively to demand uncertainty. Although the literature attests to the fact that investment in setuptime reduction is potentially worthwhile, the value of this investment is rarely evaluated. This research presents an application of real options analysis to the valuation of investments in setup-time reduction.; A practical application of the real options framework, using a discrete-event simulation to generate data for the underlying asset, is presented and the applicability of the real options methods is examined by comparing the results with a net present value analysis. The results of this study do not support the conclusion that real options analysis provides more value to investment analysis than the net present value approach. The suitability of investment analysis approach depends on the size of the investment cost relative to the expected benefits, the level of uncertainty and flexibility. This research contributes to the literature on the application of real options to the valuation of manufacturing process improvement by applying the Black-Scholes-Merton model to the valuation of setup-time reduction; hitherto, this has been the domain of discounted cash flow analysis. This research will not only enrich the application of real options theory, but it should bring this emerging theory closer to the heart of economic justification of manufacturing process improvement investments, and enhance the knowledge about the application of real options approach to capital investment valuation.