Capacity Management in Agricultural Commodity Processing and Application in the Palm Industry
Abstract
This paper studies the capacity investment decisions of an agri-processor that uses a commodity input to produce a commodity output and a byproduct. Using a multi-period model, we study the one-time processing and (output) storage capacity investment decisions, and the periodic processing and inventory decisions in the presence of input and output spot price uncertainties and uncertain production yield. We identify three capacity investment strategies, investing in storage-dominating, processing-dominating or mixed portfolio, and provide conditions under which each strategy is optimal. Using a calibration based on the palm industry, we provide rules of thumb for capacity management: The processor should decrease its processing capacity with an increase in price correlation; and with an increase (a decrease) in input or output price volatility when this volatility is low (high). The storage capacity should be adjusted in a similar fashion only as a response to a change in output price volatility, otherwise it should not be altered. We find that not accounting for the byproduct revenue or inventory holding possibility in capacity planning leads to sizeable profit loss. Ignoring production yield uncertainty has a significant negative impact on profitability if the capacity planning is made based on the maximum yield possible, as often done in practice; but it has an insignificant impact if the planning is made based on the average yield.