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.
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.