Rethinking Lead Time Reduction Investment: A Real Options Perspective

Abstract

Although it is generally agreed that companies are better off with shorter manufacturing lead times, investment in lead time reduction is often difficult to justify using traditional project valuation techniques such as net present value (NPV). In this article, we suggest that evaluating investment in lead time reduction from a real options perspective facilitates quantification of the value of manufacturing flexibility brought about by lead time reduction, particularly the value of the option to time production commitment based on better demand information. This flexibility is significant when demand is volatile. We also present examples to demonstrate how options inherent in lead time reduction can have synergistic effects with related investments, such that a combination of such investments may have positive value even when the NPV of the individual investments is negative.