Technical note: Option‐based costing and the volatility portfolio

Abstract It has been clearly established that a cost premium for responsiveness may be justified for profitable time‐sensitive products, and that this cost premium may suffice to render production in a high‐cost environment competitive. Time‐insensitive products considered in isolation seldom justify a cost premium, leading many decision makers to conclude that their production does not belong in a high‐cost environment. This leads to a manufacturing‐location decision in which profitable and time‐sensitive products are produced in a high‐cost environment and time‐insensitive products are transferred to a low‐cost environment. Responsiveness, however, requires a capacity buffer that provides the option to meet a demand peak for a profitable, time‐sensitive product. Leftover capacity can then be ideally deployed to manufacture time‐insensitive products to stock. We propose that the cost of the capacity buffer be considered as an option cost and assigned to the time‐sensitive product: “option‐based costing”. We then demonstrate use of demand volatility to create a portfolio of products that are time sensitive and insensitive to generate profit and increase competitiveness. Option‐based costing combined with a volatility portfolio reveals opportunities to produce competitively in high‐cost environments that have typically been considered unfeasible.