Flexible production resources and capacity utilization rates: A robust

optimization perspective

Aldis Jakubovskis

ABSTRAK

This paper presents a novel application of robust optimization (RO) in the

context of optimal choices of product-dedicated and flexible capacities in a
spatial setting. Specifically, we examine the impact of acquiring flexible
production technologies on a firm’s overall capacity utilization rates under
demand uncertainty. Uncorrelated, negatively, and positively correlated
demands are considered. We implement an efficient RO algorithm, which can
solve large samples of robust min-max problems in a realistic amount of time.
This paper examines the impact of three critical factors that lead to different
capacity utilization and resource flexibility outcomes: the degree of solution
robustness selected by the decision-maker to accommodate uncertain
demand realizations, the flexible capacity costs relative to dedicated capacity
costs, and the level of correlation between product demands. One of our
results show that according to robust solutions, the total capacity may not be
fully utilized because of the distinction between largest (in unit terms) and
costliest demand realizations. The second result shows that increasing the
proportion of flexible capacity can increase capacity utilization; however, our
results report less than full utilization even when using flexible capacity only.
We show that the optimal amount of flexible capacity, and its impact on
overall capacity utilization rate substantially depends on demand correlation.

Introduction

A firm, to be able to meet customer requirements and maintain its

competitiveness, must wisely acquire the means of production that include
various resources and capacities. These acquisition decisions include spatial
aspects as well as temporal aspects, which means that a firm must decide
where to locate these production capacities by taking into account the time
lag between capacity investment decisions, and production and transportation
decisions after uncertain demands are realized.

Today’s global marketplace is characterized by high degree of

unpredictability, resulting from economic, political, and social developments,
as well as from rapidly changing customer demands, excessive product
variety, and short product life cycles. One of the ways to address these
challenges is to employ flexible production resources, or flexible capacities.
Typically, flexible technologies cost more than product-dedicated
technologies; therefore, the technology choice decisions involve the trade-offs
between capacity investment costs, and a firm’s ability to respond to
changing product mix requirements. When designing its production-
distribution network on a global scale, a firm must find an optimal balance
between location costs and transportation costs that include import-export
duties, tariffs, and taxes. A firm must also decide on the technology portfolio
of its production facilities, and the size and location of its safety capacity. The
question about the optimal levels of capacity is an important one as many
firms and industries suffer from chronic or cyclical overcapacity that can
threaten their competitiveness or even survival. Capacity investment
decisions, strategic in nature, are characterized by their long-term impact,
high fixed expenditures, and often irreversible consequences.

Martinez-Costa et al. (2014) present a survey of models for strategic capacity

planning in manufacturing that include decisions such as capacity size and
location, capacity configuration and technology selection, and allocation of
capacity among products. The integrative nature of the strategic level
decisions are recognized in the literature. However, publications dealing with
the choice of flexible vs. product-dedicated technologies in a spatial setting
are relatively scarce. As noted in Verter and Dasci (2002), facility location
models, in general, do not incorporate technology selection decisions
explicitly. There exists a large body of literature in two streams of research
that separately address facility location, and flexible capacity acquisition
problems.

A detailed review and analysis of facility location problems can be found, for
example, in Owen and Daskin (1998), and Klose and Drexl (2005). Snyder
(2006) provides a review of facility location problems under uncertainty,
including two-stage stochastic location problems. Melo et al. (2009) offer a
literature review of facility location models in the context of supply chain
planning and design. An application of robust optimization to a capacitated
multi-period facility location problem is provided in Baron et al. (2011).

The literature on flexible production technology analyzes the intricate

dynamics between product-flexible capacities and optimal profitability
conditions using a variety of methodologies that are determined, in large part,
by linearity assumptions on capacity investment costs. Fine and Freund
(1990) present a two-stage stochastic model, where in the first stage the
capacity investment decisions are made, and in the second stage, after the
uncertain demand is observed, production decisions are made. Van Mieghem
(1998), using analytical approach, shows that flexible technology can be
valuable even in the case of perfectly positively correlated demands. Li and
Tirupati (1994) present a multi-period discrete optimization model that
assumes nonlinear capacity investment cost functions for both dedicated and
flexible capacities, and show that investments in flexible capacity can be
beneficial even at significantly higher investment costs compared to
dedicated capacity costs. The scope of issues analyzed within the context of
flexible vs. dedicated capacities include correlated demands, responsive
pricing, and product substitutability effects, among other issues (see, for
example, Bish and Wang, 2004; Chod and Rudi, 2005; Biller et al., 2006; Lus
and Muriel, 2009; Goyal and Netessine, 2011).

Verter and Dincer (1992) provide a literature review specifically dedicated to

an integrative evaluation of facility location, capacity acquisition, and
technology selection. They identify these three factors as the building blocks
for a firm’s global manufacturing strategies, and claim this integration is even
more important than for domestic production-distribution strategies. The
authors conclude that each of the three factors – location, capacity, and
technology – is a complex area of research by itself, and that there exist
potential for a theoretical synthesis of these areas. Verter (2002) and Verter
and Dasci (2002) present formal models that explicitly include in an integrated
manner the facility location, capacity acquisition, and technology choice
variables. In Verter (2002), a single product model is offered that includes
alternative technologies, which represent economies of scale that affect the
number and size of facilities. In Verter and Dasci (2002), the integrated model
is extended to include multiple products and flexible technologies to capture
the economies of scope in facility location and sizing decisions. The authors
suggest that a firm’s manufacturing strategy can be designed as being
positioned between the market-focus and product-focus ends of the
spectrum, by taking advantage of economies of scope and economies of
scale, respectively.

Lim and Kim (1999) propose a deterministic multiperiod integrated plant

location and capacity acquisition (and disposal) problem, where the types of
capacities include dedicated and flexible technologies. The authors suggest
that their approach may be well suited for global manufacturing companies in
industries that are characterized by rapid changes in capacity and product
requirements, for example, in automotive or electronics industries where the
strategic level decisions have to be made on a more frequent basis.

Several works adapt a more practical perspective. From the automotive

industry, Eppen et al. (1989) present an integrated multi-product, multi-period,
multi-plant capacity planning model under risk. Karabuk and Wu (2003)
provide an example from the semi-conductor industry where the decisions
about capacity levels and the technology mix are inseparable as strategic
capacity planning is an iterative process with the two main components:
capacity expansion and capacity configuration. Another applied strategic
capacity planning case from the automotive industry is presented in
Fleischmann et al. (2006) for a global production network. This includes
decisions to allocate multiple products to multiple plants in a multi-year
dynamic environment taking into account the potential uncertainty in demand
and corporate policies on capacity reserves. Mariel and Minner (2015)
propose a strategic capacity planning model that includes specific
international considerations, i.e., duties and duty drawbacks. It appears that
the more integrative approaches can be found in practical industry cases, and
are primarily driven by the necessity to accommodate the needs of real-world
strategic planning efforts.

Even though the dynamic models dominate in the capacity planning literature,
some authors argue that in some instances the capacity investment decisions
can be reduced to single period models. Van Mieghem (2003) discusses the
theoretical results that indicate that under i.i.d. random variable structure,
stationary environment, and independent periods, a multiperiod capacity
planning problem can be reduced to a single period one. The author suggests
that while being reformulated as static, these models, while losing their time
dimension, become less complex and are able therefore to include more
details regarding the problem specifics, and better express the nature of
uncertainty. Ahmed and Garcia (2003) state that the multi-period (two-stage)
capacity decisions could be in principle converted into a multi-stage
stochastic program; however, at a disadvantage of becoming computationally
almost impossible to solve. Moreover, they argue that the two-stage approach
is a good enough approximation of the multi-stage problem.

We contribute to the literature by formulating and solving an integrated facility

location and technology choice model under stochastic demand conditions
using RO methodology, extended to incorporate multi-dimensional correlated
uncertainty sets. We offer insights into utilization rates for product-dedicated
and flexible production facilities for correlated demands, considering different
robustness levels specified to accommodate uncertain demand realizations,
and different flexible capacity costs relative to product-dedicated capacity
costs.

Conclusions

In this paper we present a model with a purpose of examining the relationship

in a spatial setting between the overall capacity utilization rates and the
proportion of flexible technologies that a firm acquires under uncertain
demand conditions. An efficient robust optimization algorithm is implemented
that allows solution of a large number of sampled problem instances and
making of statistical inferences.

It is sometimes assumed in the literature that the second stage production

costs are technology independent and thus assumed to be equal. However,
in a spatial environment the second stage costs include not only production
costs, but also transportation costs that are different for different demand
locations. Applying the uncertainty set robust optimization approach we
conceptually present the distinction between largest and costliest demand
deviations in a spatial setting, and show that the difference between the two
can lead to an imbalance between the total capacity and total demand
realizations, even with perfect information about the nominal demands and
corresponding deviation intervals. Our computational studies support the
existence of this imbalance when using either flexible or dedicated capacities
only, or a mix of flexible and dedicated capacities in varying proportions.

We also demonstrate that acquisition of more flexible capacity indeed can

lead to higher overall utilization rates. The optimal flexible capacity proportion
in a firm’s capacity portfolio depends primarily on the flexible-to-dedicated
cost ratio; however, it appears also to be sensitive to specific configuration of
location-product demand quantities and distances from potential facility
locations to customer zones. We suggest that this sensitivity is implied by the
moderately wide confidence intervals for the proportion of flexible to total
capacity for varying levels of flexible-to-dedicated technology costs. At the
same time the narrower confidence intervals for the overall capacity utilization
rates suggest that these rates are not too sensitive to the spatial configuration
of facility locations and spatial demand distribution.

The main contribution of this paper is the following insight. A direct

consequence of our model formulation, which uses the two-stage approach
and incorporates robust uncertainty sets, is that an optimal solution will likely
have slacks in capacity constraints due to simultaneous maximization for
largest and costliest demand deviations within specified robustness level.

We show that the overall capacity utilization depends on the magnitude of

these slacks, which in turn depends on (i) flexible capacity as a proportion of
total capacity, (ii) robustness level, and (iii) correlation between uncertain
demands. Our approach and results provide a new robust optimization
perspective on acquiring flexible capacities on a firm’s overall capacity
utilization rates under correlated demands in a spatial setting.

An additional contribution is a practical and methodological one. Compared to

stochastic programming, which requires a complete description of individual
and joint probability distributions, often not available in practice, RO allows to
build reliable models based on only partial information about random
parameters by using uncertainty sets. We propose extensions to the simple
uncertainty sets commonly used in RO: our generalized correlated multi-
dimensional uncertainty sets have potential practical benefits as these sets
may better capture the complexity of real-world applications. As noted in the
introduction, practical industry models tend to be more integrative in nature,
and therefore may require more flexible modeling options. Our approach is a
step in that direction.

We recognize the challenges associated with the implementation of strategic

level models, such as the one presented in this paper, compared to tactical or
operational level models. Strategic level decisions, due to the high degree of
uncertainty, often rely heavily on qualitative judgment-based approaches, as
opposed to data-driven approaches, more appropriate in tactical and
operational contexts.

Among the limitations of our study is that it considers only two product
environment, and a rather small number of customer zones and potential
facility locations. However, this limitation is compensated, in our opinion, by
solving a large number of robust min-max problem instances in a realistic
amount of time, using an efficient RO algorithm, and examining the solutions
“on average.” Our discrete optimization approach has incorporated more
realistic cost structures, in contrast to linear capacity costs often assumed in
analytical models, i.e., fixed charge linear cost functions for both dedicated
and flexible capacities.