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Optimal Sourcing and Lead-Time Reduction under Evolutionary Demand Risk

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Abstract

We develop a real-options model for optimizing production and sourcing choices under evolutionary supply-chain risk. We model lead time as an endogenous decision and calculate the cost differential required to compensate for the risk exposure coming from lead time. The shape of the resulting cost-differential frontier reveals the term structure of supply-chain risk premiums and provides guidance as to the potential value of lead-time reduction. Under constant demand volatility, the break-even cost differential increases in volatility and lead time at a decreasing rate, making incremental lead-time reduction less valuable than full lead-time reduction. Stochastic demand volatility increases the relative value of incremental lead-time reduction. When demand has a heavy right tail, the value of lead-time reduction depends on how extreme values of demand are incorporated into the forecasting process. The cost-differential frontier is invariant to discount rates, making the cost of capital irrelevant for choosing between lead times. We demonstrate the managerial implications of the model by applying it first to the classic Sport-Obermeyer case and then to a supplier-selection problem faced by a global manufacturer.

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