Better sourcing decisions by using Real Options
The use of financial business cases to guide sourcing decisions is common practice. And with the current pressure on lowering cost, needs even the smallest investment to be accompanied with a business case showing a solid financial return. The effectiveness of the typical financial business case can be further improved in two key area’s. These are:
The typical DCF calculation assumes a static scenario, ignoring the financial value represented by the flexibility to change course during an (outsource) project. In real life people learn during a project, and want to adjust their decisions accordingly, effecting the business case. Think of a manager who wants to change the speed or scope of an outsourcing after the first part of the transition turned out to be more cumbersome than expected. Real Options enable an organization to incorporate this kind of dynamics into their business case, creating more insight into the true value of the decision to outsource.
The DCF calculation assumes that the original course of action will be executed in full. In practice, companies like to have the option to adjust their planning by postponing, speed up or cancelling an decision to outsource/invest. This flexibility represents a financial value, which is not captured in standard DCF calculations.
For those outsourcing or shared service projects which represent a lot of value to the company is it however important to adjust the speed and direction of the project. Project managers have already their tools to manage the dynamics and complexities of day-to-day life by applying funnel management, stage gates and working with phases. Including them into the business case without having to resort to very complex financial models, is however less common.
By applying the Real-Option methodology, different outcomes and scenario’s get a financial value. This is done by adding options to the business case, but without the original complexity embedded in the methodology created by Black & Scholes (1973). The approach allows to value ‘flexibility’, something which is required of anybody participating within a sourcing project.
Risk and return are firmly interlinked with each other and as the expected return of outsourcing if higher than internal production, has the risk profile also higher (assuming no free lunches exist). This means the required discount rate will be higher, (WACC) resulting in a lower DCF keeping the return constant.
The value of an option increases on the other hand if the risk increases. The option to exit from a shared service or outsource initiative becomes higher if the risk profile increases. Higher risk also leads to a larger spread between the best and worse case scenario’s in the business case. This means that the value of the options at disposal to the management can represent a substantial value, increasing the insight in the true financial potential of a business case. The value of the options can be demonstrated, quiet easily, by using option price models (these can be far less complex than the original models by Black & Scholes (1973)).
Using options to structure investment decisions enables the management to analyze the financial impact of decisions made during the whole life cycle of an outsourcing or shared service initiative (cradle to grave). Applied in its simplest form is outsourcing an call option, the right but not the obligation to outsource certain activities. The value of the option can change during the engagement as for example economic developments impact projected growth figures. Is the value in the new situation equal of higher, than the management executes the option. Is the value of the option lower, the option becomes void.
Other types of options related to outsourcing are increasing the scope (e.g. processes, countries) or the decision to invest in a transformation. The right to sell (put option) can be translated among others in terminating the contract, decreasing the scope or a transition to another vendor (this last one combines a put option with a call option). The third type of option is an investment to learn. Think for example of the cost involved with a due diligence or benchmark. A learning option influences the value of a call or put option, by reducing its risk/uncertainty.
Applying real options to business cases enables an organization to capture better the true dynamics of an outsourcing deal because the business case can be adjusted to reflect the changes in economic and organizational reality. This at the same time increase the value and importance of monitoring the investments and return envisioned in the business case. In a future post I will provide a concrete example on how it looks in an excel sheet. The focus of this post was to provide some theoretical background.
Sources:
T. Blommaert, S. van den Broek, E. Curfs, Methodiek voor betere besluitvorming van (strategische) IT investeringen, Informatie, 2009.
T. Copeland, P. Keeman, Making Real Options Real, McKinsey Quarterly 1998 no 3.
T. Luehrman, Strategy as a portfolio of real options, Harvard Business Review, september-october 1993.
- Monitoring whether the expected return and investment envisioned in the business case materialize and,
- The limitations of the standard Discounted Cash Flow (DCF) methods as it ignores the required flexibility required to define, execute and manage investments.
The typical DCF calculation assumes a static scenario, ignoring the financial value represented by the flexibility to change course during an (outsource) project. In real life people learn during a project, and want to adjust their decisions accordingly, effecting the business case. Think of a manager who wants to change the speed or scope of an outsourcing after the first part of the transition turned out to be more cumbersome than expected. Real Options enable an organization to incorporate this kind of dynamics into their business case, creating more insight into the true value of the decision to outsource.
The DCF calculation assumes that the original course of action will be executed in full. In practice, companies like to have the option to adjust their planning by postponing, speed up or cancelling an decision to outsource/invest. This flexibility represents a financial value, which is not captured in standard DCF calculations.
For those outsourcing or shared service projects which represent a lot of value to the company is it however important to adjust the speed and direction of the project. Project managers have already their tools to manage the dynamics and complexities of day-to-day life by applying funnel management, stage gates and working with phases. Including them into the business case without having to resort to very complex financial models, is however less common.
By applying the Real-Option methodology, different outcomes and scenario’s get a financial value. This is done by adding options to the business case, but without the original complexity embedded in the methodology created by Black & Scholes (1973). The approach allows to value ‘flexibility’, something which is required of anybody participating within a sourcing project.
Risk and return are firmly interlinked with each other and as the expected return of outsourcing if higher than internal production, has the risk profile also higher (assuming no free lunches exist). This means the required discount rate will be higher, (WACC) resulting in a lower DCF keeping the return constant.
The value of an option increases on the other hand if the risk increases. The option to exit from a shared service or outsource initiative becomes higher if the risk profile increases. Higher risk also leads to a larger spread between the best and worse case scenario’s in the business case. This means that the value of the options at disposal to the management can represent a substantial value, increasing the insight in the true financial potential of a business case. The value of the options can be demonstrated, quiet easily, by using option price models (these can be far less complex than the original models by Black & Scholes (1973)).
Using options to structure investment decisions enables the management to analyze the financial impact of decisions made during the whole life cycle of an outsourcing or shared service initiative (cradle to grave). Applied in its simplest form is outsourcing an call option, the right but not the obligation to outsource certain activities. The value of the option can change during the engagement as for example economic developments impact projected growth figures. Is the value in the new situation equal of higher, than the management executes the option. Is the value of the option lower, the option becomes void.
Other types of options related to outsourcing are increasing the scope (e.g. processes, countries) or the decision to invest in a transformation. The right to sell (put option) can be translated among others in terminating the contract, decreasing the scope or a transition to another vendor (this last one combines a put option with a call option). The third type of option is an investment to learn. Think for example of the cost involved with a due diligence or benchmark. A learning option influences the value of a call or put option, by reducing its risk/uncertainty.
Applying real options to business cases enables an organization to capture better the true dynamics of an outsourcing deal because the business case can be adjusted to reflect the changes in economic and organizational reality. This at the same time increase the value and importance of monitoring the investments and return envisioned in the business case. In a future post I will provide a concrete example on how it looks in an excel sheet. The focus of this post was to provide some theoretical background.
Sources:
T. Blommaert, S. van den Broek, E. Curfs, Methodiek voor betere besluitvorming van (strategische) IT investeringen, Informatie, 2009.
T. Copeland, P. Keeman, Making Real Options Real, McKinsey Quarterly 1998 no 3.
T. Luehrman, Strategy as a portfolio of real options, Harvard Business Review, september-october 1993.
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