Optimal modular production strategies under market uncertainty: A real options perspective

In this paper, we develop a product modularization model based on real options theory to help a firm determine the optimal modular production strategies under market uncertainty: whether/when to exercise the option of modularization. We find that market volatility has great impacts on the optimal degree of product modularity and the timing for modular production. The results show that when market is more volatile, it is optimal for a firm to postpone modularization, and when a firms investment efficiency at the preparation stage is higher, the firm can start modular production earlier with relatively low product modularity. Also, an increase in market uncertainty will stimulate the firm to improve its product modularity. Finally, by comparing the predictions from the widely used net present value method (NPV) to the results from our real options model, we argue that traditional NPV method underestimates a firms value for modular production and might mislead a firm to modularize earlier.