Tapping Into Real Options

Computerworld - Even before the jolt of the Sept. 11 terrorist attacks, the U.S. economy was on shaky ground. An impending recession and rigorous budgeting led many IT managers to seek focused IT projects offering quick returns on investment. Was that a reasonable strategy? Not necessarily.

We live in a world of uncertainty. IT professionals have been living facing quandaries for some time. What e-business initiatives should be pursued? What's the next killer app? The answers to such questions are anything but sure bets.

Oil and gas developers also routinely make multimillion-dollar decisions in a fog of ambiguity. In an effort to make the best choices possible under the circumstances, energy analysts often use a methodology called real options reasoning. They advise, for example, on the value of alternatives to drilling whole hog into an oil reservoir of unknown capacity by evaluating options such as spending more on preliminary seismic studies.

Some experts say the same approach should be applied to IT investments.

"In the old world, IT investments improved existing operations, and its success was tied to achieving a particular business outcome," says Martha Amram, interim CEO of Vocomo Software Corp. in Cupertino, Calif., and a writer on the subject of real options. "ROI and other traditional valuation approaches did just fine back then."

But ROI can be misleading when IT is being implemented strategically, rather than for incremental improvement. Sam Israelit, manager at consultancy Bain & Co.'s Boston office, tells of a client in the energy sector that balked at a major enterprise software investment when it appeared that the anticipated benefits were far off. The client used real options to break the project down into three phases.

"That way, they were able to learn about the application and give some thought about how to use it more effectively," he says. "This approach brought about benefits early on in the project."

For instance, end users at the energy firm had to determine the likelihood of achieving the benefits they expected from the application. "Going through this process forced them to think specifically about what they have to do to reach those benefits," says Israelit. "The net result was that they were better prepared to implement the change management needed for a successful implementation."

Through real options, Israelit's client was also able to identify the riskiest aspects of the project. "They put additional emphasis on mitigating the risks in those areas," he explains. "They also thought through the phasing of different project components so that they could start to achieve the lower-risk returns earlier in the project and smooth the overall risk over the life of the project."