Component Replacement Under Uncertainty - A Switching Option Perspective

Abstract

We develop a novel, workable switching option model approach to component redesign and replacement projects that are divisible into sequential phases. The component manufacturer has the option to retain the current product position and abandon the project, or switch to a redesigned product position. Additional uncertainty remains as to whether the redesigned product can meet the newly set production efficiency criteria. Depending on the viability of a prototype, the firm can finally decide whether or not to move to final production. Our framework incorporates a potentially valuable option which aims to reduce the cost of the project. It is generally applicable to fields where investments in components’ replacement have to be correctly timed due to large costs and uncertainties about the outcome. We illustrate this by means of a case study application in aeronautical engineering using real data, where we show via a sensitivity analysis based on the key variables that the flexibility of component switching offered via options during the development of the project can be significantly valuable.