Example 1: Evaluating Flexibility at Trips Logistics The manager at Trips Logistics must decide whether to lease warehouse space for the coming three years and the quantity to lease. The long-term lease is currently cheaper than the spot market rate for warehouse space. The manager anticipates uncertainty in demand and spot prices for warehouse space over the coming three years. The long-term lease may also end up being more expensive if future spot market prices come down! In contrast, spot market rates are high and warehouse space from the spot market will be expensive if future demand is high.

The manager is considering three options:

1. Spot market option: Get all warehousing space from the spot market as needed.

2. Fixed lease option: Sign a three-year lease for a fixed amount of warehouse space and get additional requirements from the spot market.

3. Flexible lease option: Sign a flexible lease with a minimum charge that allows variable usage of warehouse space up to a limit with additional requirement from the spot market.

One thousand square feet of warehouse is required for every 1,000 units of demand.

The current demand at Trips Logistics is for 50,000 units per year.

The manager forecasts that from year 1 to year 2 demand may go up by 30% with a probability of 0.2 or go down by 10% with a probability of 0.8. However, demand does not change from year 2 to year 3. The probabilities of the two outcomes are independent.

The general manager can sign a three-year lease at a price of $0.5 per square foot per year.

Warehouse space is currently available on the spot market for $1.20 per square foot per year.

From one year to the next, spot prices for warehouse space may go up by 10% with probability 0.5 or go down by 10% with probability of 0.5. The probabilities of the two outcomes are independent and unchanged from one year to the next.

Each unit Trips Logistics handles results in revenues of $1.35.

Trips Logistics uses a discount rate of 0.15 for each of the three years.

The answer should be in the from similar to the one pictured below.

Periodo Period 1 Period 2 D = 144 Pe $1.45 0.25 0.25 D=144 p=$1.19 D=120 p=$1.32 0.25 0.25 D=96 Pe$1.45 0.25 0.25 D=100 P$1.20 D=120 p= $1.08 D=144 p= $0.97 0.25 D=96 D=80 p= $1.32 P$1.19 0.25 D=96 p = $0.97 D-80 p= $1.08 D=64 P= $1.45 D=64 p = $1.19 D=64 P$0.97