The optimal mix of flexible and dedicated manufacturing capacities: Hedging against demand uncertainty

A firm that faces uncertain demands for several product groups needs to decide how much of relatively inexpensive dedicated capacity and how much of more expensive flexible capacity to acquire. We model this situation as a two-stage decision problem: investment and allocation. We pay particular attention to the dependence of acquisition policy on existing capacities, as most firms facing the problem are not likely to be entirely new. We show that if initial capacities are lower than the levels that would be optimal in absence of initial capacities, the investment decision is a simple "acquire-up-to" (optimal levels) for each capacity type. However, if some initial capacity is "too high", the optimal additions to others depend on its value in a non-linear, yet intuitive, fashion. We also pose the issue of choosing the degree of flexibility, as the realized product mix will affect the performance of partially flexible machines.