How should manufacturing firms prepare for demand uncertainty? Q and A with Laurier expert Xuan Zhao

Feb. 7, 2023

Manufacturing firms operate in uncertain environments, and one of the greatest risks to profitability is fluctuating demand. Xuan Zhao, a professor of Operations and Decision Sciences at Wilfrid Laurier University’s Lazaridis School of Business and Economics, is investigating the most effective risk management strategies for companies facing demand uncertainty.

In her recent article published in Production and Operations Management, a journal ranked in the Financial Times’ Top 50 list, Zhao examined manufacturers’ use of two popular risk management strategies: financial hedging and operational hedging. Financial hedging involves investing in financial instruments that function adversely to demand, which allows firms to reduce their financial risk. Operational hedging focuses on risk mitigation by making decisions that circumvent the negative impacts of fluctuating demand. 

Among Zhao’s findings are that businesses may benefit from using both hedging strategies together, and that it is important to differentiate risk management strategies from competitors. Below, she offers insights on her research.

Why is evaluating consumer demand so challenging for businesses? 

Let’s take traditional newstands as an example. Each day in the early morning, they need to purchase newspapers from their vendors to sell to their customers. If they purchase too many, leftover newspapers have almost zero value the next day. If they purchase too little, unsatisfied customers get upset and might start buying their paper somewhere else. Most manufacturing firms face a similar problem: betting on uncertain demand. They have to produce or deliver a quantity before they observe the demand. 

Can you provide examples of financial and operational hedging?

There are many types of operational hedging, including inventory pooling (car dealerships build a centralized parking lot to stock cars); transshipment (car dealers call each other if they do not have the particular color of car their customer wants); and spot trading (purchasing shortfall of raw materials or selling leftovers to the spot market).

Financial hedging involves investing in financial derivatives, such as options and futures, which have an adverse correlation with demand uncertainty. In our case, we consider purchasing an asset from a financial institution. It can generate a positive cash flow when product demand is low, and it generates a negative cash flow when product demand is high. This helps to reduce profit variability.

How will your research help business leaders prepare for uncertain consumer demand?

This research provides important insights about how to leverage hedging strategies to improve the effectiveness and efficiency of business operations. I hope this information will help senior managers at manufacturing firms to make both strategic decisions, such as what hedging strategies to use and when, as well as operational decisions, such as how to hedge their production investments.

What motivated you to conduct this research? 

As an operations researcher, my job is to help businesses design, operate and improve manufacturing and service systems to ensure that consumers can get what they want, where they want it, and at a price they are willing to pay. 

Previous research about these two risk management strategies has been separated. People in operations care about operational hedging tools and people in finance focus on financial hedging tools. This motivated my research team to explore the interface of the two fields and understand how the two strategies interact. 

Business is an integrated system. Business disciplines such as accounting, finance, HR and marketing should work together for the best performance of the integrated system. I am fascinated by the new perspectives that interdisciplinary research can produce to guide business operations, and I will continue this adventure with my students and research team.