Decision Rules for Allocating a Limiting Factor Across Products in a Stochastic Production Environment: A Real Options Approach

This paper extends the current class of managerial decision rules appropriate for selecting a multiproduct firm's profit maximising product mix in the presence of a limiting factor of production by developing an approach based upon real options. The analysis makes several contributions. The central result is to formulate a decision rule for allocating a limiting factor across products based upon the ranking of the different products' real option values per unit of the limiting factor. We demonstrate that this rule gives a more efficient allocation of the limiting factor than other potential methods for dealing with uncertainty, for example, an allocation rule based upon a products' expected profit contribution per unit of limiting factor. The analysis also introduces the concept of the supporter. The supporter is a product which effectively acts as insurance for the firm whenever a previous decision to defer production of a given product turns out to be of limited value, or even worthless. Alternatively stated, the option to defer ends up being insufficiently 'in-the-money', or even 'out-of-the-money'. We also summarise the results obtained from the application of the approach in an environment of generalised production uncertainty. This analysis reveals the relevance of two important, but often neglected sources of production flexibility, namely intra-product and inter-product flexibility. Intra-product flexibility is shown to be the main factor contributing to option value in the presence of positive price correlation across the firm's product mix, while inter-product flexibility is relatively more important in an environment of negative price correlation.