I consult, write, and speak on running better technology businesses (tech firms and IT captives) and the things that make it possible: good governance behaviors (activist investing in IT), what matters most (results, not effort), how we organize (restructure from the technologically abstract to the business concrete), how we execute and manage (replacing industrial with professional), how we plan (debunking the myth of control), and how we pay the bills (capital-intensive financing and budgeting in an agile world). I am increasingly interested in robustness over optimization.

I work for ThoughtWorks, the global leader in software delivery and consulting.

Friday, February 29, 2008

Minimising the Speculative Risk of IT Investments

The cost of IT is often confused with its value. Consider earned value management: delivery, time and cost are combined in an attempt to better represent project performance. This might show the rate of cash burn to total expected effort by a development team, but it isn’t an indicator of value as the name might imply. This is simply another way to present cost. Cost is a measure of money out of pocket, whereas value is a measure of returns. The cost of an IT project is at best the liquidation value of a project – the capital that could be raised by selling the intellectual property produced. But it is not value. Value is return, and like any use of capital, an IT investment has to provide a return that exceeds the firms cost of capital.

So what is the value of an IT project? Equities are valued by asking, “what is the market willing to pay for a dollar of profitability.” Equity is far more liquid, and more sophisticated in its measures: for example, we have P/E ratios that help us to gauge whether or not a firm’s valuation is overweight or underweight relative to forward expectations of returns (specifically through the increase of market capitalisation and dividends). IT projects don’t offer this much technical analysis, but conceptually we can borrow some concepts.

The intrinsic value of an IT asset under development is the net present value of future profitability that is expected to be derived from putting the asset to work. From an IT perspective, intrinsic value has both tangible and intangible components to it.

  • The tangible value is the return realised from that portion of the solution that is in production and contributing to EBITDA. Something in production is complete and increasing bottom line results, so the benefit of this asset isn’t ambiguous.
  • The intangible value is entirely speculative: how much additional profitability does the business expect to derive from what remains to be delivered?

All IT solutions are of speculative value until they are delivered and expectations of returns are shown to be viable. Tens of thousands of person hours and millions of dollars may be expended in development of millions of lines of code, but unless that code is in production, the firm derives no value from the investment.

Like all speculative investments, returns are at risk. The risk with which IT must be most concerned is delivery risk. Until an asset is released to production, there is a probability that the asset will fail to be developed correctly. The possibility of failure in delivery creates the threat of reduced returns. Delivery risk is eliminated once software is in production.1

The speculative component of an IT asset is at greater risk the further into the future it is expected to be completed. The probability that business, people or technology will change increases with each additional day that an IT asset is being developed. The probability of slippage in functionality, time and investment introduces volatility to the IT portfolio.

Volatility can generate windfall returns in finance. Market speculation can wildly change the value of a stock or bond relative to its purchase price. The holder can exploit this delta (up or down) to book a profit. By comparison, returns driven by operations are rarely so flexible. Software delivery is work performed over time, and time cannot be recovered. Experience has shown that an IT project is more likely to suffer delays in delivery and depress returns, than it is to accelerate delivery and increase returns. Volatility in delivery is thus a downside force, and needs to be minimised.

Traditionally, IT has attempted to apply deterministic management as a means of reducing volatility. We build elaborate project plans, we map out a predefined collection of tasks, we plot a task order down to the hour, and we track activity of what people do day by day as our barometer of progress. This top-down approach to management has low tolerance for anything that happens in the “left-to-right,” or over the course of time. This approach offers little more than wishful thinking. “Plans are useless,” said Dwight D. Eisenhower, “but planning is indispensable.” Intricate plans that forecast future activity in detail have low tolerance or complete disregard for the impact of changes that occur over time, such as staff, capability, business or technology. Indeed, deterministic project planning holds the business solution static, any staff interchangeable, and any technology change turnkey. Experience has shown overwhelmingly that this is not the case. Projects with intricate plans tend to have continuous cycles of replanning as things change. Deterministic management doesn’t decrease volatility; it simply adds overhead to the IT project, and drives down returns.

A plan cannot increase the tangible value of an IT asset. Only the asset can do that. We should therefore focus energies on rapid and incremental delivery. Tangible value is realised when some functionality is delivered that produces value. With each incremental delivery, and every increase in tangible value, the intangible or speculative value decreases.2 The reduction in speculative value at risk represents a reduction in the total value that can be depressed through delays in delivery. Thus, early delivery reduces the risk of speculative value not being realised. Simultaneously, it reduces the volatility of returns.

By itself, IT doesn’t generate business value. The business must consume the assets that IT produces in such a manner that it can put them to work efficiently and profitably. But that doesn’t mean IT is just a cost center. It can, in fact, drive alpha returns for a business. Corporate capability is largely driven by technology. IT is often the plurality, if not the majority, of spend on business initiatives. Incremental delivery of system components can increase returns on corporate investments where time is more important than cost. With capital under management that is expected to deliver returns, IT governance has a portfolio management obligation. As portfolio managers, IT must do things that maximise yield of invested capital. Concomitant with maximising yield is minimising risk. Risk is minimised through asset realisation.

1 Provided, of course, that what is delivered is functionally and non-functionally fit, and of sufficient quality. These should never be assumed outcomes.
2 New information may lead us to conclude that the impact of the asset will be different than originally forecast. For example, an asset under development might suddenly provide more impact to a firm because of changing market dynamics, making some portions of the application of greater value than others. For sake of simplicity, intrinsic value is assumed constant in this example.