Increased productivity used to be the main advantage of automation. However, the business environment has changed drastically and economies of scale no longer guarantee success. High productivity is now merely one of many requirements. Plant professionals understand that systems, practices and designs do more than increase productivity, but justifying investment can be difficult because payback calculations are elusive and decisionmakers only see cost centers.
Automation, thoughtful plant design and good maintenance increase your flexibility in the new reality of mature markets, raw material volatility, variable product pricing and general uncertainty. Surprisingly, these choices have financial value. The tool for finding their value is called real option valuation, and using it can help you make better decisions.
Paying a premium can be worthwhile if it grants you the ability to handle wider swings in the price of manufacturing inputs. Even better, the advantage is so profound that it can actually turn losses into profits.
What is a real option?
Simply, options are rights without requirements. Financial options come in hundreds of varieties of puts, calls and collars. It’s not only Wall Street that writes and exercises options. As a plant professional and consumer, you write and exercise them as well. For example, your life insurance policy is a form of an option.
Real options quantify the value of the flexibility that holding a physical asset like a mine or a factory confers on its owner. A good qualitative example is a chess game. Opponents begin with identical conditions, but one side’s movement choices decrease until it loses. Even at checkmate, both kings have identical qualities — but only one has flexibility in movement. In business and engineering, two or more firms might make similar products using similar machinery and similar people and still experience very different outcomes.
How flexibility pays
Consider a plant that makes only one product, P1. It’s possible to make P1 from either of two components, C1 or C2. The future has two possible states for P1: high sales price and low sales price. There’s a 40% chance of being in the high sales price state and a 60% chance of being in the low. The plant makes one million units of P1 per year, and it takes one unit of either component to make one unit of product.
High sales price (40% probability)
C1 = $1 per unit
C2 = $0.90 per unit
P1 = $3.00 per unit
Low sales price (60% probability)
C1 = $0.75 per unit
C2 = $1 per unit
P1 = $0.90 per unit
On the surface, it appears that one should design a plant around C1 only and not C2. There’s a 60% chance of losing money by using C2, whereas C1 is guaranteed to make money no matter which future state prevails. Without an option to expand, the probable value of operating with C1 is $890,000 (40% * 1 MM units * ($3-$1)/unit) + (60% * 1 MM units * ($0.90-$0.75)/unit).
Consider a market change. Producing 2.5 million units of P1 using C1 only gives a probable value of $2,225,000 (40% x 2.5 MM units x ($3-$1)/unit + (0.6 x 2.5 MM units x ($0.90-$0.75)/unit).
Real options change the picture. Given a real option to expand production, using C2 during high times and C1 in low is even better, netting $2,325,000, an additional $100,000 (40% x 2.5 MM units x ($3-$0.90)/unit + (60% x 2.5 MM x ($0.90-$0.75)/unit).
Suddenly, a sure money loser looks better. It’s clearly worth $100,000 to invest in the controls, training and plant capacity needed to handle C2. We’ve already factored probability in: provided there actually is a high sales price, C2 is worth $250,000.
Once C2’s price drops to 32 cents in the high sales price case, the real option to expand makes running with C1 or C2 financially indistinguishable. The plant would turn down or off in the low sales price case to minimize losses. The wider the swings in commodity or product prices, the more valuable manufacturing options become.
Change is real
Can the price of an input really swing as wide as in the example? Experience tells us that nothing varies much, except for computer chips, foreign labor, hurricanes, crude oil prices rising by a factor of five in less than a decade, bankruptcy of major energy and telecom companies, NGOs and government agencies with the ability and desire to close your production completely, real estate bubbles on both coasts and in several foreign countries, and a stock market index above 10,000, then below 8,000, then above 10,000 again within the past five years. Axiomatically, there’s no safe bet. On a positive note, every employee is in a position to increase the organization’s value. Now, let’s put concrete around what you should be doing.
Project options
Put more milestones into your project schedule and build in more decision points. Real options only have value when you can exercise them.
Meet less often. There already exists a reporting structure in water cooler discussions, Skype, grapevines, blogs, informal channels, a control system with Web-enabled viewers, SCADA and management by walking around. It’s expensive to meet frequently merely to exchange what you already should know, but profitable to make decisions.
Be cautious with turnkey projects. They give the maintenance and engineering staff less of a chance to learn details, and the owner has less chance to exercise choices. If you buy at a fixed price, the seller provides no options because speed and schedule are what matter. Contractual agreements exist to limit flexibility, which can limit value. Monitoring isn’t the same as making a decision.
A frequently exercised option is to delay a project. This option is often the most valuable. Delay could require developing mothballing procedures, arranging storage space, buying corrosion resistance and having special staffing plans. If the project ever restarts, but equipment is seized and staffing up is impossible, your option has expired and its value vanished.
Purchasing options
Buy extra capacity in computers, racks, control systems, rooms, expansion slots and cooling. Software applications continue to become more complex, and you’ll need more tools as your environment changes. Design this in from the start.
Buy instrumentation and motors that feature wide rangeability.
Outsource very carefully. If you forge a long, inflexible value chain, you’ll be stuck when the environment changes.
There are many arguments for open software and for proprietary systems. Proprietary systems may prove to have better performance, but understand that technology vendors seek to impose switching costs and to lock in profits from their customers. Open-source software prevents this.
Although having a single supplier has become fashionable, having additional sources can yield better terms, alternate designs, different quality levels and a more competitive environment.
Design options
Assume that your plant will be obliged to do more with less. Assume the performance measures that are acceptable now will shortly become intolerable. Expect an expansion of some type, whether new process units or more productive people. Regulatory permitting is at least as difficult as construction, so buy it now because it will be needed later.
Accessibility matters. Make it possible to lift a new vessel into place three years hence by providing adequate spacing in the pipe rack. Design control rooms with extra space. Racks need enough room to access terminals and allow hot cutover. Provide plenty of extra space, even in junction boxes.
Stricter compliance rules in safety and ergonomics will arrive. Give your plant choices with extra floor space.
Select metallurgy, materials, gaskets, tools and handling equipment to allow the same equipment to produce more than one product. Revamps have less chance of succeeding otherwise.
Consider the example presented earlier. Running with different feedstocks is appealing, but the necessary modifications don’t exist in a vacuum. Flexibility is the result of quick-change fittings, quick recalibrations, control system display templates at the ready, well-labeled I/O points with spares, and modular tooling. Another way that a factory can use instrumentation as a differentiator is to allow lots of headroom when designing instrumentation buses.
Your options have value because of their sequential nature, getting you in position for the next activity. Be ready to execute the next project in the sequence.
Operation options
Expect to retune your controllers frequently. Referring back to the example, different feeds, raw material quality and scheduling mean that the same tool, pump or valve must operate over a wider range. It’s impossible without robust controller tuning.
Run more capacity tests and debottleneck before it’s required. Knowing exactly what the plant can produce will help determine whether a real option exists. A plant running at 100% capacity is generally unhealthy and has few options.
Shift people’s functions as much as possible so they can discover options and interrelations and reward them for process, not for outcomes. Never stop training them or sending them to classes. The shelf life of knowledge and talent is continually getting shorter.
Options in scope
A plant that excels in manufacturing wooden cases might become good at producing wooden tools. But, it can never expand its market without skills in laboratory and design engineers, pilot plants, experimenters, parallel production lines, and managers who don’t shoot messengers.Convincing management
Even though the real option value technique works, only one company in four considers it when executing a project. Organizationally, dollars come from elsewhere. Find managers in your organization who can champion real option thinking. It’s not your job to understand the risk-neutral probabilities and volatility, which determine the value of options. It’s your job to understand that those real options exist and to find them.
Academic research shows that some industries gain a lot of value by building growth options into their thinking. Computers, electronics and chemicals tend to lead. Textile mills, furniture and fixtures, stone, clay, glass and concrete are industries that tend to show little value from this source.
Common sense
This advice may seem idealistic, but economic scarcity is real and you can’t do everything. The key point is that because real option values can be found, use them to make choices. Every situation is different.
Being different from your competitors matters and is valuable. Market volatility has great value to the factory that knows how to handle it. Companies that keep reinventing themselves are going to thrive.
Domestic automakers that focused on truck production and design at the expense of cars did so because the value of a certain input, fuel, was low and stable. Change in that single input called into question the survival of the entire value chain. The result of not designing flexibility into contracts and plants is an extremely long turnaround and revamp cycle. Even if developing an excellent small car was a financially poor idea in the short term, not having done so could mean the demise of an entire industry.
If you don’t build and manage flexibility and tolerance into your plant, when the economy swings, volatility will destroy earnings. Careers, factories and companies don’t last long in that situation. You have the option to avoid that fate. Exercise it.
Robert A. Dunlap is president of Core/Global Consulting in Austin, Texas. Contact him at [email protected] and (512) 423-2280.
Bibliography
- Ross, Stephen A., Randolph W. Westerfield and Jeffrey Jaffe. Corporate Finance. McGraw-Hill, New York, 2002. Pg 612.
- Driouchi, Tarik, Giuliana Battisti and David Bennett. Downside Risk Implications Of Multinationality And Real Options. 2006, p.2
- Grinblatt, Mark and Sheridan Titman. Financial Markets and Corporate Strategy. McGraw-Hill, New York, 2002. Pg. 443
- Gary Shilling’s Insight, September 2005.
- Friedman, Thomas L. The Lexus and The Olive Tree. Anchor Books, New York, 2000.
- Gates, Bill. Business at the Speed of Thought. Time Warner, New York, 1999. Pg 20
- Alesii, Giuseppe. Rules of Thumb in Real Options Analysis. 2003, Pg 14.
- Tong, Tony W. and Jeffrey Reuer. Corporate Investment Decisions and the Value of Growth Options. 2004. Pg 5.
- Goldratt, Eliyahu M and Jeff Cox. The Goal: A Process of Ongoing Improvement. North River Press, Croton-on-Hudson, 1984. Pp 85, 86
- Graham and Harvey quoted in Dias, Marco, Katia Rocha and Jose Paulo Teixeira. The Optimal Investment Scale and Timing: A Real Option Approach to Oilfield Development. 2004. Pg 3.
- Tong, pg 20.
Two of many Web sites dedicated to real options: