The Value of Flexibility in Make-to-Order Systems: The Effect of Demand Correlation

We consider a manufacturer of mass-customized modular products who orders components under demand uncertainty, and sets prices, produces to order, and trades excess components in a secondary market after this uncertainty is resolved. The sequence of events reflects, in a parsimonious fashion, the considerable reduction in demand uncertainty between the procurement stage and the selling season, typical of industries with long supply lead times and short product life cycles. We prove that, in contrast to conventional wisdom, the value of production flexibility and expected profit increase with demand correlation if, and only if, commonality between the corresponding products does not exceed a threshold. We also prove that the value of flexibility and expected profit may each increase or decrease with demand variability, depending on demand correlations and component commonalities across the entire product line. Finally, we prove that when demand shocks are independent, the optimal product prices are positively correlated if, and only if, the degree of commonality between the corresponding products exceeds a threshold.

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