A real options approach to manage flexible contracts in the telecommunication networking industry

Abstract

One of the biggest challenges facing Original Equipment Manufacturers (OEMs) and Electronic Manufacturing Services (EMS) providers in the telecommunication networking industry is to predict the spending patterns of the telecommunication service providers due to uncertainties in the economy, intense competition, short product life cycle in the industry and many other factors. While studies over the years have focused on optimizing the expected profits by minimizing the risk of excess inventory, companies are also unwilling to forgo profits on unmet demand. This is especially so in a market that is worth well over $100 billion even during the economic downturn. Including the cost of damaged relationships and future market opportunities, the cost of lost sales can be very significant the increasingly competitive market. This thesis explores the use of real options to enable a telecommunication networking company to structure their supply chain so as to better exploit the upside opportunities

when actual customer demand significantly exceed forecasted demand and actual demand can only be confirmed when the delivery lead-time is less than the normal supply lead-time. The thesis sets forth a framework for developing real options analysis and evaluated three approaches against the current supply contract between the OEM and EMS provider. Recommendations that will allow the company to improve their profits in the event of surged demand were then made. The main finding of the thesis is that in times of increased demand, the real options approaches studied all generated higher value for the company than simply relying on demand forecasting. However, beside projected demand, companies considering using real options must consider a number of parameters time. The thesis sets forth a framework for developing real options analysis and evaluated three approaches against the current supply contract between the OEM and EMS provider. Recommendations that will allow the company to

(cont.) including the option price, strike price, cost of lost sales and salvage value of the product concerned. In the case of the company concerned in the study, it is recommended that they establish a safety stock option with their EMS provider.

improve their profits in the event of surged demand were then made. The main finding of the thesis is that in times of increased demand, the real options approaches studied all generated higher value for the company than simply relying on demand forecasting. However, beside projected demand, companies considering using real options must consider a number of parameters