Valuing Flexibility in Production Technology: The Advantage of Being Different

Using what we have learned about strategic options, particularly the option to expand,

it is possible to demonstrate that in many instances a firm can gain a competitive advan-

tage by being different from its competitors. This subsection shows that firms that have

the option to vary their output levels may want to choose a method of production that

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Strategy, Second Edition

Chapter 12

Allocating Capital and Corporate Strategy

441

differs from that of their competitors. By doing this the firm increases risk, thereby

increasing the value of its flexibility option.

Consider, for example, a firm that produces and sells refined sugar in a market with

a large number of competitors. It must decide whether to purchase equipment that

allows it to produce the sugar from sugarcane or from sugar beets. The other sugar pro-

ducers in its market use sugarcane as their input for refined sugar production. As a

result, the price of refined sugar immediately reflects any increases in the price of sug-

arcane. However, because the competing firms currently do not use sugar beets as an

input, fluctuations in the price of sugar beets are not as tied to the price of refined sugar

as is the price of sugarcane.

Afirm that lacks flexibility about how much sugar it will be producing will want

to design its facilities to use the input with the lowest present value of its costs. How-

ever, as Example 12.7 shows, if the firm has a plant that gives it the option to increase

production, the added uncertainty linked to using an input (sugar beets) that differs from

the inputs used by competitors (sugarcane) can be valuable.

Example 12.7:The Effect of Capacity Expansion on the Choice to Be Different

The tree diagram in panel A of Exhibit 12.9 illustrates some of our assumptions, namely:

•	In a good economy, the cost of producing refined sugar with sugarcane is $0.60 perpound and the cost of using sugar beets is $0.54 per pound.
•	In a bad economy, the cost of producing refined sugar with sugarcane falls to$0.40per pound.However, the demand for sugar beets is somewhat less cyclicalthan sugarcane because it is not generally used to produce refined sugar.Thus,thecost of producing refined sugar with sugar beets falls somewhat less to $0.50perpound.
•	The risk-neutral probabilities associated with each of these two states of theeconomy (seen next to the branches of the tree diagram in panel A of Exhibit 12.9)are assumed to be .5.
•	The price of refined sugar is always $0.03 per pound greater than the cost of production using sugarcane, which is reasonable because virtually all producers usesugarcane as their input.

Assuming that the fixed cost of building a sugarcane and sugar beet plant are the same,

which method of producing refined sugar is better when (a) capacity is fixed, or (b) capac-

ity is flexible in that the firm is committed to producing at least 1 million pounds of refined

sugar in the plant but, at a cost of $40,000, the firm can double capacity to 2 million pounds

upon discovering the state of the economy?

Answer:(a) Capacity is fixed.Using the risk-neutral probabilities of .5 and .5 to compute

expectations, the expected production costs, from panel A in Exhibit 12.9, are $0.50 per

pound [ .5($.60/lb.).5($.40/lb.)] for sugarcane and $0.52 per pound [ .5($.54/lb.)

.5($.50/lb.)] for sugar beets.Hence, sugarcane is the better input.

(b) Capacity can be doubled.If the firm uses sugarcane as its input, then the firm will

earn $30,000 from selling 1 million pounds of sugar in both the good and bad economies,

as seen in panel C of Exhibit 12.9.Since the cost of additional capacity, $40,000, exceeds

the profit from expanded capacity, $30,000, a firm using sugarcane will choose not to exer-

cise its option to double capacity.However, if the firm chooses to use sugar beets as its

input, it will earn $0.09 per pound if the good state of the economy occurs because the price

of refined sugar in this state of the economy is $0.63 per pound while production costs are

$0.54 per pound.The firm will therefore make $90,000 on the first 1 million pounds of pro-

duction.By exercising its option to double production, the firm makes $90,000 $40,000

$50,000 on the second 1 million pounds of production.Hence, as seen in panel B of

Exhibit 12.9, the total profit in the good economy is $140,000.In the bad economy, the firm

using the sugar beet input loses $70,000 at the lower refined sugar price of $0.43 per pound.

Grinblatt898Titman: Financial	III. Valuing Real Assets	12. Allocating Capital and	© The McGraw898Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

442	Part IIIValuing Real Assets EXHIBIT12.9Production of Refined Sugar

Panel A

Product and input prices

Good economy

refined sugar = $.63/lb

.5sugar cane = $.60/lb

sugar beets = $.54/lb

	Bad economy refined sugar = $.43/lb
.5	sugar cane = $.40/lb sugar beets = $.50/lb

Panel B

Cash flows with beet input and expansion in good state

.5	Good economy
	$140,000 = 2 million($.63 – $.54) – $40,000

.5	Bad economy
	–$70,000 = 1 million($.43 – $.50)

Panel C

Cash flows with sugar cane input and no expansion

Good economy

.5$30,000 = 1 million($.63 – $.60)

Bad economy

.5$30,000 = 1 million($.43 – $.40)

Despite this loss, however, the firm’s expected profit using sugar beets is $35,000, which

exceeds the $30,000 in expected profits it achieves using sugarcane as its input (Panel C).

Thus, with the capacity to expand, sugar beets represent the superior raw input for produc-

tion of refined sugar.

What is the intuition for the conclusion in Example 12.7 that sugar beets are a bet-

ter raw input than sugarcane, despite being the more expensive input, on average? For

Grinblatt900Titman: Financial	III. Valuing Real Assets	12. Allocating Capital and	© The McGraw900Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

Chapter 12

Allocating Capital and Corporate Strategy

443

the sugar beet input, the lower output price in the bad economy reflects the drop in the

price of sugarcane, the dominant raw material for producing refined sugar. Because out-

put prices are correlated with the price of the dominant input, sugar producers who use

sugarcaneas the raw input generate profits that are partly insured against swings in the

economy. However, producers who use sugar beetsas the raw input in the production

of refined sugar experience only a small decline in their input price when prices for

refined sugar and sugarcane drop dramatically. Refined sugar production using sugar

beetsas the raw input is thus subject to wild swings in profit—earning $140,000 in

the good economy and losing $70,000 in the bad economy. While this might seem like

a disadvantage, it can be turned into an advantage if options such as the option to expand

capacity exist. This is simply an application of the principle learned in Chapter 8 that

options become more valuable when there is more volatility to the underlying asset.⁹

It is important to emphasize that the benefits of being different are not a principle,

only a possibility. Had the numbers in Example 12.7 been different, one could easily

have concluded that sugarcane manufacturing was still the cheaper method despite the

option to increase capacity. Irrespective of which production method in the last exam-

ple is cheap, however, one always would conclude that the advantage associated with

being different is greater when there is more uncertainty and when the firm has greater

flexibility to expand.