Technical note: Option‐based costing and the volatility portfolio

• Author: Suzanne Treville,Kyle Cattani,Lauri Saarinen
• DOI: http://doi.org/10.1016/j.jom.2016.12.004
• Published date: 01 March 2017
• Date: 01 March 2017

Technical note: Option-based costing and the volatility portfolio

Suzanne de Treville

a

,

*

, Kyle Cattani

b

, Lauri Saarinen

a

a

University of Lausanne, Faculty of Business and Economics, 1015 Lausanne, Switzerland

b

Indiana University, 1275 E. 10th St., Room CG 2010, Bloomington, IN, 47405, USA

article info

Article history:

Accepted 7 December 2016

Available online 1 February 2017

abstract

It has been clearly established that a cost premium for responsiveness may be justified for profitable

time-sensitive products, and that this cost premium may suffice to render production in a high-c ost

environment competitive. Time-insensitive products considered in isolation seldom justify a cost pre-

mium, leading many decision makers to conclude that their production does not belong in a high-cost

environment. This leads to a manuf acturing-location decision in which profitable and time-sensitive

products are produced in a high-cost environment and time-insensitive products are transferred to a

low-cost environment. Responsiveness, however, requires a capacity buffer that provides the option to

meet a demand peak for a profitable, time-sensitive product. Leftover capacity can then be ideally

deployed to manufacture time-insensitive products to stock. We propose that the cost of the capacity

buffer be considered as an option cost and assigned to the time-sensitive product: “option-based

costing”. We then demonstrate use of demand volatility to create a portfolio of products that are time

sensitive and insensitive to generate profit and increase competitiveness. Option-based costing com-

bined with a volatility portfolio reveals opportunities to produce competitively in high-cost environ-

ments that have typically been considered unfeasible.

©2017 Elsevier B.V. All rights reserved.

1. Introduction

It has been clearly established that supply-chain responsiveness

may well be valuable enough to justify a cost premium for time-

sensitive products, that is, profitable products with high demand

volatility and low residual value at the end of the demand period

(de Treville et al., 2014b,a). This cost premium represents a line of

first defense for those seeking possibilities to produce competi-

tively in a high-cost location that is close to markets or to research

and development.

1

The cost premium that is justified by respon-

siveness increases in profit margin and demand volatility, and de-

creases in residual value.

Local production of products that are time insensitivedhave

low demand volatility and retain much of their value if not sold by

the end of the demand perioddin a high-cost location is difficult to

justify when these products are considered in isolation. Most

managers and academics find it hard to imagine that production of

such products in a high-cost location would ever be worth

considering.

Consider, for example,the production location decision faced by

Timbuk2 as described in the case developed by Cachon et al. (2015).

(For an updated look at Timbuk2's manufacturing see their website

at Anonymous, 2016). Timbuk2's messenger bags can be roughly

categorized as follows: custom bags that cannot be produced to

stock and are highly time sensitive (lead time is measured in

hours), special corporate orders that are time insensitive (lead time

is measured in months), and products in between these extremes

(modest time sensitivity,lead time is measured in weeks). A custom

messenger bag is designed online by the customer and produced in

the company's San Francisco plant, with a target at the time of the

case of shipping the bag within 24 h of receiving the order.

2

The

price premium for a custom bag is close to 100%. A corporateorder

for messenger bags, in contrast, is negotiated between Timbuk2

and the corporate customer many months before delivery, which

allows Timbuk2 to produce the bags to order using low-cost

*Corresponding author.

E-mail address: suzanne.detreville@unil.ch (S. de Treville).

1

The cost premium worth paying to reduce decision lead time and thus avoid

demand volatility for a given product can be calculated using the Cost-Differential

Frontier (CDF) tool available at cdf-oplab.unil.ch, and selecting the option “Switch

to Cost Premium”.

2

The Timbuk2 website now indicates that the custom bag is delivered in less

than 10 daysrather than shipped the following day. Our analysis features the faster

turnaround.

Contents lists available at ScienceDirect

Journal of Operations Management

journal homepage: www.elsevier.com/locate/jom

http://dx.doi.org/10.1016/j.jom.2016.12.004

0272-6963/©2017Elsevier B.V. All rights reserved.

Journal of Operations Management 49-51 (2017) 77e81