Optimal Sourcing and Lead-Time Reduction under Evolutionary Demand Risk

Production and Operations Management, Forthcoming

32 Pages Posted: 3 Dec 2011 Last revised: 6 Jul 2015

See all articles by Suzanne de Treville

Suzanne de Treville

University of Lausanne - Faculty of Business and Economics; Swiss Finance Institute

Norman Schürhoff

University of Lausanne; Swiss Finance Institute; Centre for Economic Policy Research (CEPR)

Lenos Trigeorgis

University of Cyprus - Department of Public and Business Administration; King's College London; Massachusetts Institute of Technology (MIT) - Sloan School of Management

Benjamin Avanzi

UNSW Australia Business School, School of Risk and Actuarial Studies

Date Written: January 25, 2014

Abstract

We develop a real-options model for optimizing production and sourcing choices under evolutionary supply-chain risk. We model lead time as an endogenous decision and calculate the cost differential required to compensate for the risk exposure coming from lead time. The shape of the resulting cost-differential frontier reveals the term structure of supply-chain risk premiums and provides guidance as to the potential value of lead-time reduction. Under constant demand volatility, the break-even cost differential increases in volatility and lead time at a decreasing rate, making incremental less valuable than full lead-time reduction. Stochastic demand volatility increases the relative value of incremental lead-time reduction. When demand has a heavy right tail, the value of lead-time reduction depends on how extreme values of demand are incorporated into the forecasting process. The cost-differential frontier is invariant to discount rates, making the cost of capital irrelevant for choosing between lead times. We demonstrate the managerial implications of the model by applying it first to the classic Sport-Obermeyer case and then to a supplier-selection problem faced by a global manufacturer.

Keywords: lead-time reduction, forecast evolution, real options, supply-chain risk

Suggested Citation

de Treville, Suzanne and Schürhoff, Norman and Trigeorgis, Lenos and Avanzi, Benjamin, Optimal Sourcing and Lead-Time Reduction under Evolutionary Demand Risk (January 25, 2014). Production and Operations Management, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1967788 or http://dx.doi.org/10.2139/ssrn.1967788

Suzanne De Treville (Contact Author)

University of Lausanne - Faculty of Business and Economics ( email )

Anthropôle 3073
Lausanne, 1015
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Norman Schürhoff

University of Lausanne ( email )

Extranef 228
CH-1015 Lausanne
Switzerland
+41 (0)21 692 3447 (Phone)
+41 (0)21 692 3435 (Fax)

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Lenos Trigeorgis

University of Cyprus - Department of Public and Business Administration ( email )

75 Kallipoleos Street
P.O. Box 20537
Nicosia CY-1678
Cyprus
00357 2 338762 (Phone)
00357 2 339063 (Fax)

King's College London ( email )

Strand
London, WC2R 2LS
United Kingdom

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

77 Massachusetts Ave. E62-663
Cambridge, MA 02142
United States

Benjamin Avanzi

UNSW Australia Business School, School of Risk and Actuarial Studies ( email )

UNSW Sydney, NSW 2052
Australia

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