The role of risk preferences and flexibility for risk management: lessons from a custom manufacturing environment

Abstract

In this paper, we study the management of financial risks of a custom manufacturer in the specialty chemicals industry arising from increased volatility of profits caused by market uncertainty and growing competitive pressure due to globalization. We argue that such risk management can be established either by creating and utilizing flexibility or by adjusting the risk preferences. Using a model-based approach, we operationalize flexibility and risk preferences to show their effects on the profit/risk and the decision making of a firm through a stylized example motivated by the specialty chemicals business.

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Notes

  1. 1.

    Here we interpret risk as the unfavorable (negative) outcome of a financial performance measure like the profit (see also Miller 1992).

  2. 2.

    Note that due to the assumption of a single capacity source, w.l.o.g. all demands are given in units of the underlying capacity and the per-unit financial data p i , c u i and c p i are also defined per unit of this bottleneck capacity.

  3. 3.

    Strictly speaking this is not always true, as the optimal α may not be unique. In that case the VaR β is the minimum α for which the CVaR β is minimized.

  4. 4.

    In accordance with our industrial partner, these data are somewhat modified from the real data to better reflect our simplifying model assumptions.

  5. 5.

    Note that all financial measures are given in arbitrary currency units (a.u.).

  6. 6.

    In Reimann and Schiltknecht (2009) we discard this assumption and analyze the interdependence of capacity flexibility and contractual flexibility in a risk-neutral setting.

  7. 7.

    For product 1 the corresponding quantity is zero because of its cancellation probability and the given cost structure.

  8. 8.

    Note that in this case no new setup is needed for this product, as it was the last product assigned to the plant in stage 1.

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Acknowledgments

This work was started when the first author was still with the Institute for Operations Research at ETH Zurich. The authors would like to thank two anonymous referees and the editor for their thorough review of the manuscript and the many constructive comments that helped to improve the paper.

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Correspondence to Marc Reimann.

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Reimann, M., Schiltknecht, P. The role of risk preferences and flexibility for risk management: lessons from a custom manufacturing environment. Rev Manag Sci 3, 117–140 (2009). https://doi.org/10.1007/s11846-009-0028-3

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Keywords

  • Marketing-production interface
  • Risk management
  • Flexibility

JEL Classification

  • L23
  • L65
  • M11