Process Improvement,Learning, and Real Options

We use a real‐options approach to analyze investments in process improvement. We develop a simple, stochastic model of a firm making investment decisions in process improvement. Our analysis offers several interesting insights into investments in process improvement. First, early investment in process improvement results in valuable knowledge, which helps increase the value of the option to invest in process improvement in future periods. This may motivate a firm to invest in process improvements as early as possible. Second, it may be optimal for a firm to stop investing when such investments do not create enough value in the later stages of the investment horizon. Third, although one would expect the state of a firm's process relative to that of other firms to impact a firm's decision to invest in process improvement, this study finds that the impetus is conditional and identifies these conditions. Finally, in such an environment, the delay of investment in process improvement incurs an opportunity cost for a firm, and we show that the traditional net present value rule must incorporate this opportunity cost and the knowledge‐induced change in future option values to lead to a correct investment decision.