“Input-price Risk Management: Technology Improvement and Financial Hedging”, Accept by Production and Operations Management (POM)

We study the merits and limitations of technology improvement (TI) initiatives for managing input-price risk. Such initiatives (e.g., energy efficiency projects) typically reduce the consumption of an input commodity and so result in lower production costs, more sustainable operations, and/or an improved competitive position. This paper explores whether TI can also serve to hedge risks. Although TI clearly reduces both average cost and risk exposure, some firms may actually benefit from input-price uncertainty; the result, when combined with production flexibility, is an option value that firms may well be reluctant to forgo. We develop a stylized mathematical model to examine the incentives of different types of firms to adopt TI. Thus we derive a closed-form expression that quantifies a firm’s attitude toward input-price risk by considering the firm’s certainty premium, or what the firm would pay to lock~in the unit input price, and then link that premium to various firm- and industry- specific characteristics. We also compare the risk management advantages of technology improvement versus financial hedging (FH) and give conditions under which these strategies are complements or substitutes. Our results show that, even when input-price uncertainty is desirable for firms, they can still benefit from investing in risk reduction measures – such as
TI and FH – because the uncertainty’s option value could thereby increase. A firm’s ability to adjust its price in response to both market competition and input-price variation mediates the benefit of risk-reducing measures and also affects the complementarity of these two strategies.