Flexible Capacity Investment Strategies for Global Firms

The relationship between the cost of flexible capacity and the optimal capacity investment de-cision has been studied under demand uncertainty. In this paper, we investigate the changes in this relationship under joint demand and exchange rate uncertainty. Representing the correlations among demands and exchange rates with a flexible multivariate input model and using the newsven-dor network method with Monte Carlo simulation, we characterize the firm’s optimal strategy of investing in product-dedicated capacities and/or flexible capacity. We find that investing in a fully flexible manufacturing facility (i.e., investing only in flexible capacity), which is suboptimal under demand uncertainty alone, can be optimal, despite the high cost of the flexible capacity, due to the exposure of the investment decision to exchange rate uncertainty. Investing in full flexibility can also be optimal not only when demands are perfectly positively correlated, but also when they are deterministic. However, full flexibility is not optimal, despite the joint demand and exchange rate uncertainty, under purchasing power parity. Full flexibility continues to be suboptimal for perfectly positively correlated exchange rates approximating pegging exchange rate regimes. We also find that expected profit might decrease with increasing exchange rate variability, which is contrary to the intuition prevalent in the academic literature, for perfectly positively correlated exchange rates. A computational study demonstrates the important role of the joint distributional properties of demands and exchange rates on the flexible capacity investment strategy.