The idea of project flexibility is conceptually desirable and accepted in both corporate strategy and in the design decisions that go into product development. The problem is that it has generally been difficult to quantify the value associated with flexibility, and therefore difficult to justify.
Developing products and services always involves unknowns. Uncertainty in market demand, development costs, development time, capital expenditures, and so on are commonplace. This is especially true for long life, capital intensive systems where market conditions well into the future are unknown.
At the heart of whether or not to use project flexibility is the goal to make better decisions, both now and in the future. If flexibility is not justified, most decisions will be made today since we believe that enough information is available for quality decisions. If flexibility is justified, more of the decisions will come in the future with the belief that better information will be available.
Project flexibility can be used to delay decisions (and investment), take advantage of future opportunities as they arise, or to mitigate potential risks.
A Definition of Flexibility
(Fricke and Schulz 2005) define flexibility as the ability to easily change a system. Flexibility is also known as a real option. Real option is a term coined by (Myers 1977). Real options are analogous to financial options such as calls and puts on stocks except that they are options on tangible investments or systems. An option means that one has the right to change the system without the obligation to do so.
Based on the nature of project flexibility, it requires external action to invoke flexibility. This will be referred to as exercising the option, or simply exercise. This is analogous to exercising a financial option. In this article, I will use the general term flexibility with the implication that there are underlying real options to enable that flexibility.
Acquiring real options generally comes at a price. It may involve higher initial development cost, the cost to acquire patented technology, the cost of a research project that develops enabling technology for a commercial project, and numerous other examples. This additional cost is known as the option premium. To continue the analogy with financial options, the option premium for financial options is the cost to purchase the option.
Once the decision is made to exercise an option, the associated cost is known as the cost to exercise. This is analogous to the exercise price of a stock option. The cost to exercise can be the cost to develop a piece of land, the cost to commercialize a patented technology, the development cost to add a product feature, etc.
Categories of Project Flexibility
In the literature there are two basic types of project flexibility defined as follows:
Another term for this is a real option “on” a project. Managerial flexibility is the option to proceed or cancel an entire project or part of a project. Corporate strategy allows for managerial flexibility and the flexibility, in turn, influences future corporate strategy.
Another term for this is a real option “in” a project or system. Technical flexibility is the option to change some technical aspect of a project.
Product line strategy allows for technical flexibility and the presence of project flexibility, in turn, influences design decisions. Technical flexibility can be further broken down into architectural flexibility and operational flexibility. Architectural flexibility allows for modification of system configuration, while operational flexibility allows for modification of operation without changing the system architecture (Lin et al. 2009).
Advantages of Flexible Systems
Project flexibility can account for uncertainty by preparing for downside risks. Initial investment can be reduced by staging investments instead of a single upfront investment. Flexibility can be used abandon or reduce the scale of projects with less investment at risk.
Maximizes System Potential
Project flexibility can be used to exploit upside opportunities. When opportunities are presented, flexibility allows for quicker, lower cost reaction to meet upside potential.
Allows for Better Decisions
Delaying decisions and gathering more information to make better decisions.
Allows System to More Easily Adapt to Rapidly Changing Markets
Short product life cycles in rapidly changing markets can be better managed with a flexible system. Instead of redeveloping entire new systems to meet changing market demands, parts of the system can be modified more quickly to meet market demand.
Single point forecasts based on averages are always wrong.
The “flaw of averages” (Savage 2000) is something to avoid. When decisions are based on averages or the most likely scenario, there is a tendency to ignore downside risk and upside opportunity.
Single point requirements based on single point averages are usually incomplete or wrong.
Having the capability to adjust the system to meet actual requirements or a range of values increases the utility of the system. It also reduces the risk of deploying a system that doesn’t meet the needs of the stakeholders.
General Types of Flexibility Related to Product, Process, and Markets
Within each category of flexibility there are many types of flexibility. There are many different examples in the literature of organizing types of flexibility. See (Mauboussin 1999; Brealey and Myers 2003) for examples. I have organized types of flexibility as follows:
Flexibility Used to Take Advantage of Opportunities
Call Option – option to buy.
- Research projects that develop enabling technology.
Call Option – option to expand product or process.
- Allow product to be built in-house and/or outsourced to ramp up production.
- Multiple suppliers.
Call Option – option to expand product with new features and options.
- Modular architecture that allows for additional add-on features.
Call Option – option to enter new markets with little or no modification of product or production system.
- Develop a product that can be easily adapted to other markets.
Call Option – option to gain foothold in market with later generations of product becoming more competitive.
- Initially enter the market with first generation product to gain knowledge. Improve competitive position with successive generations of the product as new knowledge is gained.
Flexibility Used to Maintain the Status Quo
Defer Option – Learn more information before proceeding.
- Acquire patented technology, and wait to commercialize as information about the potential demand is gained.
- Wait to commercialize internal patents until it is advantageous to do so.
Continue Option – Maintain status quo as long as it’s desirable.
- Month to month lease terms (higher cost) instead of long term lease.
- Short-term supply contracts (higher cost) instead of longer-term contracts.
Flexibility Used to Reduce Risk Exposure
Put Option – option to sell or abandon.
- Outsource production despite higher unit cost. If bad result, then abandon. Avoids initial investment of production capability in-house.
- Use contract labor instead of internal employees. Lower cost to abandon.
Put Option – option to shrink product or process.
- Use a mix of contract labor along with in-house employees to reduce scale-down cost.
- Outsource production and scale down if needed.
- Lease vs. buy capital equipment.
- Modular architecture that allows unprofitable product features to be eliminated.
Put Option – option to shrink market, leave certain markets and stay in others.
- Re-purpose production equipment for products in a more attractive market.
Switching flexibility is a special subset of the three types listed above. Depending on the circumstances, switching flexibility can be used to take advantage of opportunities, maintain status quo, or reduce risk exposure.
Switch Option – option to change process or supplier.
- In-house production vs. outsourced production.
- Switch from automated to manual production or vice versa.
Switch Option – option to change input to process.
- Use coal or gas as input to a power plant.
- Use different materials for components. Use 6061-T6 aluminum instead of A36 steel for fabricated part.
Switch Option – option to change component or configuration of product.
- Use commercial off the shelf components (COTS).
- Over-design to allow for extra adjustability.
Switch Option – option to change output.
- Switch production mix on a bulk processing or chemical plant.
Examples of Flexibility Throughout the Organization
Product or Service
Base model with options. The base model is designed so that interfaces to the system allow for additional modules or add-on services. The base model may also be designed in such a way to easily reconfigure as needed depending on the service conditions.
Platform design where multiple products are built from a single base architecture. The base architecture is reconfigured for use in different products and services.
Isolate uncertain, potentially high risk parts of the design that are likely to change, and add flexibility to this area (Smith and Farnbach 2011).
Using modular, plug and play components that can be easily added, subtracted, or switched.
Loose coupling of subsystems. Subsystems are relatively independent so that a change in one subsystem has little or no effect on connected subsystems.
Serve different markets with the same or slightly modified product.
Manufacturing & Supply Chain
Scalable manufacturing process. Add a 2nd shift, bring a second assembly cell online, outsource in tandem with in-house production.
Alternate/additional suppliers to add volume.
Re-purpose alternate resources for temporary increase in volume. Cross train employees to produce multiple items as needed.
Shell design. Design in extra floor space in a factory to add additional production equipment in the future.
Make vs. buy. Ability to switch between in-house and purchased components.
Alternate suppliers for cost, quality, or availability issues.
Use of commercial off the shelf (COTS) components to switch/add suppliers as needed.
Multiple ways to manufacture (manual, automated, etc.).
Multiple modes of shipment. Flatbed, shipping container, etc.
Geographical staging of components.
Flexible packaging types for shipment. Packaging for local vs. international shipment.
Deployment & Use
Multiple methods to deploy. Factory trained installation, general contractor such as a local plumber, or user installation.
Multiple users. Company representative, third-party user, or general public.
Repair & Maintenance
Multiple modes of R&M. Field, local, factory or 3rd party maintenance and repair.
System Life Cycle
Recycle products and manufacturing by-products.
Re-purpose products and manufacturing by-products.
Identifying Project Flexibility
Identifying project flexibility involves looking at each element of the system (at a logical granularity) and their interactions with other elements to determine possible flexibility. This section looks at some of the methods that can be used to identify flexible design opportunities.
Potential areas of flexibility can be found by using one or more of the following:
- What are the “known” uncertainties? What can go wrong? What needs to happen if something goes wrong?
- What are the potential “unknown” uncertainties? What do we think is relatively certain that might come back to bite us later? Requires creativity and a lot of input from multiple sources.
- Use FMEA to find failure points and add flexibility to reduce risk.
- Identify areas of the system that have high technical, supply chain, or market risks. Use flexibility for theses areas of the system.
- What if most things go better than expected? What needs to happen to take advantage of the upside potential?
- What are the potential unintended uses/markets/purpose of the system? How can this be exploited? This one will require a lot of creativity. Example: Apple iPod impacted the music industry via iTunes.
- How can phasing be used to stage investments? This allows for smaller initial investment and allowing for a change of course as new information arrives.
Exercising Project Flexibility
Once flexibilities have been identified, the exercise of project flexibility becomes a consideration. In order to perform a valuation of candidate designs, there must be a determination of the conditions that will result in exercise of the flexibility option. This usually takes the form of an IF-THEN statement. Some examples are shown below:
IF the price of a service is greater than X, THEN exercise to capture market share.
IF market demand exceeds X, THEN exercise to increase production volume.
IF the cost of outsourcing exceeds X, THEN switch to in-house production.
Maintenance and Exercise of Flexibility
One of the problems with flexible systems is exercising the project flexibility at the proper time. The system designers that installed the flexibility may no longer be involved with the project, the conditions under which the option should be exercised may not be apparent, the means to exercise may not be apparent, the resources to exercise may not be available, and so on. Therefore, it is vitally important for the system designers to enable the exercise of any options when the opportunity presents itself.
The following is a checklist that can be used to help ensure future managers of the system have the information and capability to exercise flexibility at the appropriate time. The list is not exhaustive, and system designers are encouraged to put great effort in ensuring that the cost of adding flexibility is not wasted.
- Sufficient documentation of each option, the assumed conditions under which the option should be exercised, and the means to exercise.
- Assign responsibility for the monitoring of conditions of exercise to appropriate personnel.
- Provide option visibility to the parties responsible for the exercise of each option.
- Periodic review of options in place to decide whether or not to exercise.
- Having the resources in place to implement flexibility once the decision has been made to exercise.
Refer to Chapter 7 of (de Neufville and Scholtes 2011) for more detail on implementing flexibility.
Cases Where Flexibility Is Not Appropriate
Project flexibility generally comes with associated costs such as higher initial development costs, longer development schedules, and carrying costs on each unit produced that allows for the flexibility. It is not appropriate for all situations, and a careful analysis must be performed to ensure that the additional costs are justified. Some examples where flexibility is usually not appropriate are discussed below.
Mature Markets That Won’t Likely Change in the Future
Development related to mature markets where market demand is well understood is usually not an area where flexibility is needed. The risk and upside potential is limited and does not allow flexibility to be an advantage.
Short-Term Projects with Well Known Market Demand
Projects with a short life and well known market demand have too short a life for project flexibility to provide much of a benefit. Because of the short term nature, market demand data is more visible and flexibility will not be helpful to reduce risk, delay decisions, or exploit opportunities.
This should not be confused with short product life cycles where the market is changing rapidly. In this case, flexibility can be an advantage that allows the system to evolve at a faster pace than an inflexible system to meet market demand.
Products That Need Unit Cost as Low as Possible
Products that are extremely cost sensitive generally do not have enough margin to allow for the extra costs associated with project flexibility. Flexibility may also add complexity which will increase capital expenditure, repair & maintenance costs, and training costs. Fit for purpose systems that have specific, well-defined requirements with little opportunity for use elsewhere also fit into this category.
Some Systems that are Highly Optimized for Some Performance Aspect
Systems that perform a single, highly optimized function may be degraded by adding flexibility. One example is adding extra capabilities for future expansion that degrade the performance of a measurement tool. When performance is much more important than all other considerations, this case may apply.
Real Option Thinking
“Real options thinking” is the conscious effort to embed real options into systems. This isn’t a new concept. Managers build options into their systems as a matter of good business practice to reduce risk, and take advantage of changing markets. For more on flexibility and real options refer to the article on Flexibility as a Strategy.
System Level Real Options
Real options can be employed at the system level to enhance overall profitability. An example is the introduction of a new product. The system consists of, but is not limited to, the product itself, manufacturing, sales, installation, maintenance and repair functions.
The company is reasonably certain that the product will be a success with high growth in sales during the next five years. Due to financing constraints and risk aversion by company management, the company is not willing to make a full investment to optimize profit for the anticipated sales during the next five years.
In order to better manage risk, the company decides to use as much commercially available off the shelf technology (COTS) as possible to reduce upfront investment in specialized manufacturing process equipment. The COTS components are more expensive than specifically designed components, but the difference in cost is the price of risk mitigation. The company also decides to use contractors to perform installation, maintenance and repair operations in the short term. The contractors cost more than company employees, but workforce levels can be varied to meet product demand without excessive cost. This strategy can be changed in the future to use company employees if product demand is strong enough to justify cost. The sales costs are generally incurred through sales commissions and are therefore a function of sales.
By employing the strategies above, the company has embedded several real options at the system level. The first, by employing COTS components, the company has limited initial investment. It has created an option to design more cost optimized components in the future to reduce cost with an additional investment. Also, there may be multiple suppliers of COTS components which will allow for expansion of production capability if demand increases.
Additional real options are created by the use of contractors for installation, maintenance and repair operations. Personnel levels can be varied to meet demand more easily than by using employees of the company. Additionally, if demand increases, multiple contractors may be employed to meet the increased need for their services. Finally, once product demand and staffing levels can be determined with more accuracy, a trade study may indicate that hiring new employees of the company may result in a cost savings, and the company will have an option to do that at a later date.
Subsystem or Lower Level Real Options
Optimizing a subsystem by locking the design into a specific, unalterable design may hinder overall system performance. By embedding options at the subsystem level, we have the option to change subsystems to improve overall system performance, or in general, to ensure system requirements are met.
By writing requirements such that design/software engineers allow for multiple configurations to meet anticipated future needs, a real option can be created at lower levels of the system. The additional cost must be weighed against the added flexibility created by the real option.
Real Option Thinking and the Organization as a Whole
Real option thinking lends itself particularly well to organizations that are in developing industries. Organizations that are in established, competitive industries are generally focused on optimizing their operations, whereas developing, or knowledge-based industry companies are more focused on what-if operations (Arthur 1996). Systems that are flexible, can be upgraded, changed, or perform functions that it was not originally designed to do are more valuable than systems that cannot do these things. An important, and valuable goal should be to try to build as much flexibility into systems as possible while balancing the additional cost that usually comes with added flexibility.
Fricke, E., Schulz, A. Design for Changeability (DfC): Principles To Enable Changes in Systems Throughout Their Entire Lifecycle, 2005, Systems Engineering, Wiley Periodicals, Vol. 8, No. 4, pp. 342-359.
Myers, Stewart C., Determinants of Corporate Borrowing, Journal of Financial Economics, Volume 5, Issue 2, pp. 147-175, November 1977.
Mauboussin, Michael J., Get Real – Using Real Options in Security Analysis, Credit Suisse First Boston Corporation, New York, NY, June 23, 1999.
Brealey, R., and Myers, S., Principles of Corporate Finance, 7th Edition, New York, NY: McGraw-Hill/Irwin, 2003.
Smith, P., Farnbach, J. Designs Change. Deal with it!, 2011, Machine Design, March 17, 2011, Vol. 83, Issue 5, pp. 38-41.