Beyond Valuation: 'Options Thinking' in it project Management April 20, 2004




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Beyond Valuation: 'Options Thinking' in IT Project Management

April 20, 2004


Robert G. Fichman

Department of Operations and Strategic Management

Boston College, Carroll School of Management

452B Fulton Hall

Chestnut Hill, MA 02467-3808

Telephone: 617-552-0471

Fax: 617-552-0433

Email: fichman@bc.edu



Mark Keil

Department of Computer Information Systems

J. Mack Robinson College of Business

Georgia State University

35 Broad Street, Room 422

Atlanta, Georgia 30303

Telephone: 404-651-3830

Fax: 404-651-3842

E-mail: mkeil@gsu.edu
Amrit Tiwana

Goizueta Business School

Emory University

1300 Clifton Road, Atlanta, Georgia 30322

Telephone: 404-727-6378

Fax: 404-727-2053



E-mail: atiwana@bus.emory.edu

Introduction

Uncertainty is a central fact of life on most large IT capital investments. From enterprise applications (e.g., ERP, CRM) to infrastructure technologies (e.g., knowledge management, wireless networking) to IT-enabled strategic initiatives of every flavor, a common element is doubt about whether the project will achieve its goals, and if so, what payoffs can be expected. This uncertainty arises from many sources—the immaturity, complexity and unpredictable evolution of the technologies themselves; the increasing integration of technologies within and across organizations; and the increasing emphasis on using IT to support innovative products and customer-facing processes with hard-to-predict market appeal. Major investments in IT clearly bear more than a passing resemblance to other high risk organizational activities, like new product development and R&D.

Given the potential for major losses on IT projects, the defensive posture exhibited by many organizations towards these efforts should come as no surprise. One manifestation of this posture is simply downplaying the level of risk. Although it has been demonstrated with some regularity that major IT initiatives produce disappointing results 50% of the time or more,1 this uncomfortable fact rarely makes it into the planning processes of many organizations. Another manifestation of a defensive posture is penalizing projects that have large risks but also large potential rewards by employing an excessively high hurdle rate. A third manifestation is applying a veneer of predictability to IT investments by demanding rigidity in project planning and execution. A final manifestation is the tendency to treat setbacks on IT projects as arising first from the inadequacies of the project team, rather than being inherent in the process of undertaking uncertain ventures.

Ironically, these defensive maneuvers are just as likely to increase an organization’s exposure to unnecessary risk as to reduce it: downplaying uncertainty discourages vigilance to potential problems; rigid project plans invite corner-cutting; and a blame-the-team-first mentality deters forthright communication about project status. A better approach is to assume a proactive stance that fully acknowledges and seeks to manage uncertainty on these projects. We believe that “options thinking,” an emerging investment management philosophy based on the theory of real options, provides an especially promising foundation for this sort of proactive stance.

A real option refers to the right to acquire some real world asset without the obligation to exercise that right. Whenever an IT project has flexibility about which applications and functions to implement, and when or how to implement them, real options are present. These options can be quite valuable, and much of the academic literature on this topic has focused on developing appropriate tools to assist in quantifying option value. Managers, however, do not need to acquire option quantification skills to put options thinking to work. The bigger win comes from using real options concepts to actively create and extract the value of embedded options that can otherwise be difficult to see.

Our goal in this article is to highlight how practitioners can incorporate options thinking into contemporary IT project evaluation and management.2 While we will pinpoint some tools for quantifying option value, we believe it is more important for managers to learn to recognize what kinds of options can be embedded in IT investments; to develop a sound intuition about how options create value; and to understand how to manage projects so that option value that exists in theory is actually realized in practice. It is a certain philosophy of project management—more so than precise quantification—that comprises the essence of options thinking. To illuminate this philosophy, we explain six types of real options that commonly exist on major IT investment projects, with real-world examples to show how the options create value and how value can be increased through active project management. We will also consider the pitfalls associated with each option, the benefits and limitations of different approaches to valuing options, and how organizations can decide whether to undertake the difficult process of practicing options thinking. However, our first task will be to explain why real options are so pervasive on IT investment projects, and why they are valuable.

How Flexibility Creates Option Value on Uncertain IT Investments

If uncertainty is one fact of life on major IT investment projects, another is managerial flexibility. No other technology supports managerial flexibility quite like IT. One aspect of this flexibility is that modern IT systems are themselves highly malleable. While many kinds of assets (traditional equipment, manufacturing plants, real estate) have a relatively fixed set of potential uses, most forms of IT can be applied to a variety of business processes or products. Even so-called “standard” packages come with a large array of potential configurations and associated applications. Further increasing the flexibility of many IT assets—at least those embedded in software—is they can be replicated at low cost, modified if necessary, and then shared or sold. Moreover, the level of flexibility asso­ciated with any given IT system is not pre-ordained. Rather, organizations can enhance flexibility by making systems more generic, multi-purpose, interoperable, and scalable.

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