Navigating Uncertainty: Advanced Real Option Strategies in Healthcare Supply Chain Management

In order to adapt to the rapid changes and complexities of today's healthcare environment, effective risk management and resilience in supply chain operations are more important than ever. Real options, a financial theory concept, provide a powerful, practical, and adaptable approach to addressing these challenges.

This article looks at ten scenarios in healthcare logistics and supply chain management where advanced real option strategies can be used, such as capacity expansion, stockpiling critical supplies, telemedicine infrastructure investments, supply chain diversification, flexible supplier contracts, joint ventures and partnerships, switching production capabilities, delaying or accelerating projects, emergency response planning, and data-driven decision-making.

By incorporating real options into healthcare supply chain strategies, organizations can better manage risk and build resilience, allowing them to adapt more effectively to dynamic and uncertain environments. This article finally shows step by step how these examples and case studies are implemented to optimize their supply chain operations and enhance overall performance.

Consider a busy hospital that is constantly in need of medical supplies, drugs, and equipment in order to provide life-saving care. The challenge is to manage the complex web of suppliers, transportation, and storage in such a way that these critical items are delivered on time and at a reasonable cost.

Real options are like having a set of adaptable plans that help organizations make better decisions when faced with uncertainty. Instead of trying to predict the future and sticking to a rigid plan, real options allow businesses to adapt to change and make decisions based on new information as it becomes available. In the context of a bustling hospital with complex supply chains, real options come into play by allowing the hospital to make strategic choices that keep its operations running smoothly even when faced with challenges or unexpected events.

For example, the hospital may have several suppliers for essential medical supplies. By having multiple suppliers (a real option), the hospital can switch to a different supplier if there’s a problem with the original one, such as a sudden shortage or transportation issues. This flexibility helps ensure that the hospital always has the necessary supplies to provide life-saving care

Traditional thinking in business and investment often assumes that the future is predictable and that decision-makers can plan based on a fixed set of variables. This approach is akin to following a recipe, where each step is clearly defined and the outcome is expected to be consistent every time. However, as we all know, the real world is full of surprises and uncertainties, and the same recipe may not yield the same results every time.

Real options take their inspiration from the world of finance, where options give investors the right, but not the obligation to buy or sell assets at a specific price within a specific timeframe. This flexible approach allows investors to manage risk and make strategic decisions based on market fluctuations.

Real Options examples in healthcare logistics and SCM

Real options are valuable tools for managing uncertainty and making strategic decisions in complex, dynamic environments such as healthcare logistics and supply chains. Here are ten advanced examples of the use of real options in this context:

1. Capacity expansion: Hospitals and healthcare providers can invest in flexible capacity expansion options, such as modular and scalable facilities, to quickly respond to fluctuating patient demand or unexpected health crises like pandemics.
2. Stockpiling critical supplies: Hospitals can invest in options to stockpile essential supplies like personal protective equipment (PPE), medications, or ventilators, enabling them to rapidly respond to sudden increases in demand or supply chain disruptions.
3. Investing in telemedicine infrastructure: Healthcare providers can invest in telemedicine infrastructure as a real option, allowing them to rapidly scale up remote care capabilities in response to changing patient needs or external events such as epidemics or natural disasters.
4. Supply chain diversification: Investing in supply chain diversification options, such as multiple suppliers or alternative transportation routes, can help healthcare organizations mitigate risks associated with single points of failure, political instability, or natural disasters.
5. Flexible supplier contracts: Negotiating flexible supplier contracts with adjustable volume and delivery options can enable healthcare organizations to better manage the risk of supply shortages or demand fluctuations.
6. Joint ventures and partnerships: Healthcare organizations can enter into strategic partnerships or joint ventures to share the risks and benefits associated with new technology adoption, drug development, or market expansion.
7. Switching production capabilities: Pharmaceutical and medical device manufacturers can invest in flexible production capabilities that allow them to switch between different products or product lines in response to changing market conditions, regulatory changes, or supply chain disruptions.
8. Delaying or accelerating projects: Healthcare organizations can use real options to make decisions about delaying, accelerating, or canceling projects, such as new facility construction, technology implementation, or research and development initiatives, based on changes in market conditions or risk profiles.
9. Emergency response planning: Investing in options for emergency response, such as mobile clinics or field hospitals, can provide healthcare organizations with increased resilience in the face of natural disasters or public health emergencies.
10. Data-driven decision-making: Healthcare organizations can invest in advanced data analytics and artificial intelligence tools to monitor supply chain performance, identify risks, and optimize decision-making, enabling them to make more informed choices about exercising their real options.

Implementing real options — Capacity expansion

Consider a hospital that is considering expanding its capacity to meet fluctuating patient demand or prepare for unexpected health crises. The hospital uses a three-period real option approach to make this decision.

Using the three-period real option approach, the hospital can make informed and flexible capacity expansion decisions, ensuring that it can respond efficiently to fluctuating patient demand or unexpected health crises. This approach enables the hospital to optimize resource allocation, reduce risk, and remain adaptable to future changes in the healthcare landscape.

Period 1: Initial Investment
The hospital makes an investment in a modular and scalable facility that can be expanded or contracted to meet future needs. This initial investment includes the development of a core facility that can function independently while also being easily expanded.

Period 2: Monitoring and Decision Point
Over time, the hospital monitors patient demand, emerging health trends, and the potential for health crises. At this decision point, the hospital faces three potential scenarios:

• Increased patient demand or a health crisis: The hospital decides to exercise its real option to expand the facility by adding more modular units, increasing its capacity to accommodate more patients.
• Stable patient demand: The hospital continues to operate at its current capacity, maintaining the option to expand or contract in the future.
• Decreased patient demand: The hospital exercises its option to contract by removing some modular units and reducing operational costs, while still preserving the option to expand again in the future if needed.

Period 3: Final Decision and Outcome
In the final period, the hospital reassesses patient demand and health trends, and makes a final decision regarding its facility capacity:

• Further expansion or contraction: Based on the latest information, the hospital may choose to expand or contract its facility further to match the current demand.
• Maintain current capacity: If demand remains stable or uncertain, the hospital may choose to maintain its current capacity, preserving the option to expand or contract in the future.

Quantifying this example:

Let's put the example into numbers by allocating costs, revenues, and probabilities to each period and decision point.

Period 1: Initial Investment

• The hospital invests $10 million in constructing a core facility with the capacity to serve 100 patients.
• The facility is designed to be modular, allowing easy expansion by adding units, each with a capacity for 25 additional patients, at a cost of $2 million per unit.

Period 2: Monitoring and Decision Point

After one year, the hospital reassesses patient demand and potential health crises. They estimate the following probabilities and associated cash flows:

1. Increased patient demand or a health crisis (40% probability): The hospital can expand by adding two modular units, increasing capacity to 150 patients at a cost of $4 million. The expanded facility is expected to generate $8 million in additional revenue per year.
2. Stable patient demand (50% probability): The hospital continues to operate at its current capacity of 100 patients, generating $12 million in annual revenue without additional investment.
3. Decreased patient demand (10% probability): The hospital contracts by removing one modular unit at a cost of $0.5 million, reducing capacity to 75 patients. The contracted facility generates $9 million in annual revenue, with a reduced operating cost of $1 million per year.

Period 3: Final Decision and Outcome

After two years, the hospital reevaluates patient demand and health trends, leading to the following probabilities and associated cash flows:

1. Further expansion (30% probability): The hospital adds another modular unit for $2 million, increasing capacity to 175 or 200 patients (depending on previous expansion), generating an additional $4 million in annual revenue.
2. Maintain current capacity (60% probability): The hospital maintains its existing capacity (75, 100, or 150 patients), generating the same annual revenue as in Period 2 without additional investment ($9 million, $12 million, or $20 million, respectively).
3. Further contraction (10% probability): The hospital removes another modular unit at a cost of $0.5 million, reducing capacity to 50 or 75 patients (depending on previous contraction), and generating $6 million in annual revenue with reduced operating costs of $1.5 million per year.

Value of Real Options

To calculate the value of using real options in this example, multiply the probabilities of each scenario by their respective cash flows. Then, we can compare the expected values to determine the optimal decision.

Period 2: Monitoring and Decision Point

1.- Increased patient demand or a health crisis (40% probability):

• Additional revenue: $8 million
• Expansion cost: $4 million
• Net cash flow: $8 million — $4 million = $4 million
• Expected value: 0.4 * $4 million = $1.6 million

2.- Stable patient demand (50% probability):

• Annual revenue: $12 million
• No additional investment
• Net cash flow: $12 million
• Expected value: 0.5 * $12 million = $6 million

3.- Decreased patient demand (10% probability):

• Annual revenue: $9 million
• Contraction cost: $0.5 million
• Reduced operating cost: $1 million
• Net cash flow: $9 million — $0.5 million + $1 million = $9.5 million
• Expected value: 0.1 * $9.5 million = $0.95 million

Total expected value for Period 2: $1.6 million + $6 million + $0.95 million = $8.55 million

Period 3: Final Decision and Outcome

We will use the expected values from Period 2 to simplify the calculations for Period 3:

1. Further expansion (30% probability):

• Additional revenue: $4 million
• Expansion cost: $2 million
• Net cash flow: $4 million — $2 million = $2 million
• Expected value: 0.3 * $2 million = $0.6 million

1. Maintain current capacity (60% probability):

• No additional investment
• Net cash flow: $8.55 million (from Period 2)
• Expected value: 0.6 * $8.55 million = $5.13 million

1. Further contraction (10% probability):

• Annual revenue: $6 million
• Contraction cost: $0.5 million
• Reduced operating cost: $1.5 million
• Net cash flow: $6 million — $0.5 million + $1.5 million = $7 million
• Expected value: 0.1 * $7 million = $0.7 million

Total expected value for Period 3: $0.6 million + $5.13 million + $0.7 million = $6.43 million

The value of using real options in this example is the ability to make decisions that maximize the total expected value of cash flows over the three periods.

By incorporating real options into their decision-making process, the hospital can adapt to changing conditions and optimize its capacity expansion or contraction strategy, resulting in a total expected value of $6.43 million in Period 3.