Product outsourcing is recognized as a way to gain flexibility for competitive advantage. We formulate the outsourcing problem using real options. We develop a financial model to assess the option value of product outsourcing. Specifically, we consider a three state-variable problem and use Monte Carlo simulation to estimate the value of the option. This valuation gives decision makers a way to choose the appropriate outsourcing strategy based on an integrated view of the market dynamics. A case example from the apparel manufacturing industry is used to demonstrate the application of real options to value outsourcing flexibility. We show that the inability of classical net present value methods to address dynamics in the market condition leads to an undervaluing of the outsourcing strategy. Numerical results and sensitivity analysis show how the real options approach can be used to give a better view of the long-term value of outsourcing.
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