Toward an understanding of how organizations create manufacturing flexibility *.

In today's competitive environment, success is not about the surfeit of assets that an organization can flaunt. It is about the flexibility of those assets. It is about how organizations adjust to environmental change, while maintaining optimal productivity and seamless scalability. However, as Hayes (2000) aptly points out, the new demands for such organizational capabilities are different from those that managers have experienced in the past. He encourages us to look beyond the obvious and to scrutinize issues that underlie the decisions made by managers. This is particularly true in the manufacturing environment where high sunk-costs in equipment and processes make it difficult for organizations to respond quickly.

Researchers have made some progress. However, a comprehensive understanding of the creation of manufacturing flexibility has not yet materialized. One plausible explanation is that developments have been impeded by the narrowly defined research focus on manufacturing flexibility and its antecedents. Researchers have focused primarily on one of the antecedents, that is, environmental uncertainty. A wider scope of understanding of the antecedents of manufacturing flexibility will provide a context that is valuable to both researchers and practitioners.

In this article, an option-theoretic perspective will be used to identify factors that influence the creation of manufacturing flexibility, and to suggest a conceptual framework that links manufacturing flexibility to these factors. It begins with a presentation of contemporary perspectives on manufacturing flexibility. Four antecedents of manufacturing flexibility will be identified and a framework will be proposed to explain how these antecedents induce firms to configure their manufacturing flexibility. Six hypotheses will be developed and implications for researchers and practitioners will be presented in the final section of the article.

Option-theoretic Perspectives on Manufacturing Flexibility

Real-options and Real-option Theory

One can visualize a real option as a vehicle that provides an organization with preferential access to a course of action that could not be gained without prior creation of that option. (Unless otherwise indicated, the term "option" refers to a real-option, and not a financial option.) Once an option is created, it gives an organization the right, without the obligation, to take action in the future (Sharp, 1991; Amram and Kulatilaka, 1999). Typically, organizations make small initial investments to create options that can be followed by larger investments when the options are exercised.

Real-option theory grew out of dissatisfaction among academics and practitioners with the traditional methods of capital budgeting under conditions of uncertainty. When managers make investment choices, they are confronted with decisions in three areas: where to invest, how much to invest, and when to invest. Traditional methods of arriving at these decisions, as espoused in the capital budgeting literature (net present value analysis, discounted cash flow, capital asset pricing models, and other capital budgeting techniques), assume predictable risk levels and cash flows that result from relatively static operating conditions in the future. Unfortunately, such methods are less appropriate under conditions of environmental uncertainty.

The traditional approaches of dealing with significant levels of uncertainty include the use of sensitivity analysis, simulations and decision-tree analysis. However, as Bhagat (1999) points out, these approaches have their limitations. For example, carrying out a sensitivity analysis is not difficult. However, this process downplays interdependencies among variables. Simulations have been developed to handle interdependencies. However, these algorithms are somewhat limited in their ability to adequately address managerial preferences. Real option theory (option-theory within the context of organizational assets, as opposed to financial securities) is useful in these circumstances. It provides techniques that allow for the valuation of managerial preferences. This can provide significant strategic/competitive advantage to an organization. Put formally, management's ability to adapt its future actions by creating real options that mitigate or eliminate downside risk introduces an asymmetry in the probabilistic distribution of the projected net present value that expands the investment opportunity's true value (Trigeorgis, 1996). Within an option-theoretic framework, then, the organization's goal is to assemble an appropriate mix of real options that can provide the necessary flexibility to maximize return on its investments.

The Generalized Framework for Manufacturing Flexibility

D'Souza and Williams have defined manufacturing flexibility as: "...(T)he ability of the manufacturing function to make adjustments needed to react to environmental changes without significant sacrifices to firm performance" (2000: page 578). Building on prior research, they suggest that there are four underlying dimensions on which manufacturing flexibility can be defined and measured. Two of these dimensions (volume flexibility and variety flexibility) are externally oriented and address the need to manage uncertainty in the external environment. The other two dimensions (process flexibility and materials-handling flexibility) are internally oriented and address flexibility at the value-adding core activities of the business. Other researchers (e.g., Upton, 1995; Gerwin, 1993) have reasoned that each of the four primary dimensions should have characteristics of "range" and "mobility." Range reflects the scope of deviation from the norm afforded by a flexibility dimension, while mobility refers to the speed and efficiency with which changes can be made on that flexibility dimension. D'Souza and Williams provide details on how the four dimensions of manufacturing flexibility can be operationalized in terms of their range and mobility (2000).

From an option-theoretic perspective, we can now view manufacturing flexibility as the mix of options created on four dimensions, giving the manufacturing function the ability to respond to environmental changes that it could not have accomplished without the prior creation of these options. However, what factors influence the creation of such manufacturing flexibility? Studies have shown that the choice is dependent on several factors. Building on research in real-option theory, Kogut and Kulatilaka (1994) synthesized past research findings and identified three critical factors that induce managers to choose flexibility options: environmental uncertainty, management preferences and time dependency. They have been presented as a generalized framework in Figure I.

If environmental uncertainty did not exist, an option would have no value because all future decisions could be made in advance. Conversely, when uncertainty is high the value of holding an option could be high. However, it is conceivable that although several flexibility options are available, managers will not recognize every option. Even if they do, hey may opt to disregard/ignore some options. On the other hand, hey may overreact to environmental stimuli and make poor choices. Overill, one expects management preferences to influence the creation of flexibility options positively or negatively. Time dependency is the third factor that could influence the creaLion of flexibility options. Options are useful because they allow an organization to exploit the advantages of preferential access to future opportunities. Some options have higher efficacies than others do. Therefore, we can visualize managers creating appropriate options depending on the timeframe within which they expect to exercise the option.

Contemporary Perspectives on the Creation of Manufacturing Flexibility Options

A review of the literature revealed only limited research on the three factors that induce the creation of manufacturing flexibility. However, of the three factors, environmental uncertainty is the one that is most often cited. The operations management literature makes fewer references to the time-dependency dimension. Finally, no work was found to adequately address the role of management preferences in the creation of manufacturing flexibility options. In the following sections, I will survey current research on these three factors, identify their dimensions and isolate measures used in previous research.

Environmental Uncertainty

Uncertainty, as perceived by the manufacturing manager, emanates from environments that are both "external" and "internal" to the organization. Researchers (Dixon, 1992; Watts et al., 1993; Gupta and Goyal, 1989; Gerwin, 1987; Sethi and Sethi, 1990) have identified several factors that contribute to external uncertainty. Among them are: (1) resource and supplier-based uncertainties that are embodied in measures like availability of materials, supplier reliability, stock-outs, fluctuation in input material specifications, etc., (2) manufacturing technology-based uncertainties that reside in incremental and radical changes in the manufacturing technology environment, forced obsolescence of existing technologies and the firm's ability to absorb these new technologies, (3) product-based uncertainties driven by product modifications and new product introductions, (4) uncertainties in the competitor arena embodied in the rivalry exhibited by competitor firms and the speed and intensity of competitor reaction to mov es made by this firm, and (5) demand-based uncertainties that are created by changing demand patterns and customer behavior.