Capacity Choice under Demand Uncertainty: Effects of Production Postponement and Product Flexibility

Abstract

This paper deals with the optimal capacity choice under demand uncertainty. A single period two product model with stochastic demand has been developed to determine the optimal capacity level that maximizes the expected profit. Dedicated plant with no production postponement strategy has been considered as base case. The model has been extended to examine the effect of production postponement and product flexibility on optimal capacity decision. While it is apparent that the cost of over-production has been eliminated under production postponement, the other major benefit depends on whether the products have been produced in a single product flexible plant rather than dedicated plants. It has been shown that investment in flexible plant makes sense only if the possibility of production postponement exists. The model has been extended to multi-product situation with correlation in demand. Simulated data based optimization procedure has been applied to solve the multi-product problem as the same is analytically intractable. The concept of PdPPF Index has been introduced to observe the effect of production postponement on product flexible plant. Finally the effects of imposing service level objective on firm’s optimal profit and capacity have been studied for both dedicated and flexible plant strategies.