The value of production outsourcing: A real options perspective

Production outsourcing is a good way to gain production flexibility and competitive advantage for manufacturers. This paper analyzes the value of production outsourcing and the effect of cost, product price and market demand on production outsourcing, which is considered as a series of European options. The manufacturer has the right to decide whether to outsource at each time interval. A discrete-time model in dynamic environment is designed to evaluate the options. In the model, manufacturing in-house and production outsourcing are supposed as two projects, and each one has its own value. If the value of outsourcing is bigger than that of manufacturing in-house, the manufacturer outsources its production. It's easy to make the decision in deterministic condition, but in dynamic environment it's not easy to do that. In this model, assuming there is no switching cost. And product price, market demand, cost of manufacturing in-house and cost of outsourcing, are considered as the sources of uncertainty. Each of the four variables is assumed to follow a geometric Brown motion. Monte Carlo simulation is used to, simulate these variables. The value of manufacturing in-house and the value of outsourcing are obtained based on the simulation. The manufacturer holds the option to manufacture in-house or outsource according to the result. The effect of some key parameters (volatility of product price, volatility of market demand, volatility of manufacturing in-house cost, volatility of outsourcing cost, and the coefficients of correlation) on option value of production outsourcing is analyzed, and numerical results are given. The novelty of the paper is that four variables are included in the real options model and Monte Carlo simulation, and real options approach is proved as a useful tool to help make decision of production outsourcing. The results will help the manufacturers to decide their production outsourcing.