Real Options – more than deferring commitment

Real Options – more than deferring commitment

Author: Anna Radzikowska, Accredited Kanban Trainer and Coach

Uncertainty is a big concern and a headache for thousands of managers around the world. How to make decisions when we need to operate in a constantly changing business environment? How to answer with confidence? What can we do to choose wisely the path our enterprise should follow?

So, you say you have no other option than doing this? Lucky you! I am seriously jealous right now!

Having “no other option” means no uncertainty about the future, or that we are so constrained that we have no choices, and no need to worry about making a good choice. Is any of us able to say we are 100% sure, what is going to happen tomorrow? Are we sure there is no uncertainty in our work, process, or life? Are we sure we´re making the right choice? To have no uncertainty about the future is to allow you to close options and make early commitment. To simply have no choice because of constraints, is to be powerless to cope with uncertainty in the future.

In these coronavirus times, many emergency field hospitals were built in expo halls and sports centers around the world. They were real options. Insurance policies. In the end, many haven´t been needed and were recently dismantled. However, our governments had to pay for the insurance policy because the prospect of their regular health system becoming overwhelmed could have caused a huge human tragedy and severe economic pain to nations. Real options have a price!

Uncertainty

When we are not able to predict the outcomes with confidence and precision, when there is uncertainty and a range of possible outcomes, we need to hedge the risk of undesirable outcomes. We do this using a statistical understanding of probabilities. When we have no historical data, and no understanding of the range and uncertainty, then we must hedge against the worst possible outcomes.

Dealing with everyday life situations we need to consider the future and the future is uncertain, that is why we use several different techniques and methods to minimize the impact of uncertainty on our actions and decisions: like having a small house with a garden, maybe you can build an extension later when you get a pleasant surprise that another baby is coming. If you live in an apartment, you have constrains as you cannot add an extra room to your home.

One such method for managing the risk of an uncertain future is to apply real options to our initiatives.

What are Real Options?

Real Options are alternatives or choices that may be available for the business when appraising work items. When a decision-maker has the right (but no obligation) to take a specific action, we say the option exists. Think about ice cream vendors having many flavors, and restaurants offering vegetarian options and other dietary considerations on their menu. These are the real options they give you, out of which you have the right (but no obligation) to choose from.

Having real options means you embody flexibility in the process of decision-making and development of work. They represent a form of insurance or means to take advantage of a favorable situation and support making investment decisions when NPV* for current projects is unfavorable.

Real options are “actual options” – actual choices you can make about investment opportunities, but for them to exist there must be uncertainty about the future. In certain circumstances  applying or even considering options does not make any sense.

Real (financial) options

Option to delay

You see that the NPV of the initiative taken now is unfavorable, hence you delay starting/finishing of this initiative to avoid loss or generate additional cash flow.

Imagine building a new product, which turns out to require additional component. You know that the component will be available in 6 months. You decide to delay solution delivery and take advantage of adding this component to your product.

Option to expand

The NPV of your initiative is unfavorable in its current shape. Expanding the solution by additional functionalities, further investments, or by entering a new market will make NPV positive and the whole product worth delivery.

Remember the component from the previous example? Now it is available immediately. You can still deliver your solution without this component, but investment in purchase and expanding your product by it will turn out to be valuable.

Option to redeploy

The option to redeploy exists when you decide to use already built or produced assets for initiatives other than the original one. This switch should take place only when the benefits of a new activity exceed the cost of switching. Otherwise, you should exercise the option to abandon.

You have been exploring a few different solutions investing time and effort in gathering information and requirements for each of them. You realize that researching for one of these solutions should not be continued, but you still can utilize the prototypes or testing in another one.

Option to abandon/withdraw

Sometimes the most reasonable choice is to abandon your initiative and stop investing time and money in it. You should be able to identify such options as quickly as possible and actively remove  them.

Real (Kanban) options

“In the presence of real options, a greater variety of possibilities and ideas is beneficial.” David J. Anderson

Real options are an easy and handful method to manage the upstream (discovery) Kanban system, where we must deal with multiple ideas and a high level of uncertainty. The greater the uncertainty, the more options are required altogether with a greater percentage investment in upstream options development (in comparison to downstream delivery).

How can we apply real options thinking to discovery Kanban?

Look at each of the items in your ideas pool and decide, whether you should invest in it, discard it, or shelve it to come back to it later. This filtering and decision-making is a repeatable process, that takes place when an item moves through the upstream Kanban.

1. Option to invest:

  • Analysis of the work item indicates favorable outcomes.
  • Low level of uncertainty – we know we should consider this item for investment above all.
  • Can also transform into the option to expand if the conditions turn out to be more favorable than expected.

2. Option to shelve:

  • Delays taking the work item until a later date.
  • Applies to the high uncertainty in returns or missing information about the product.
  • Can be turned into an “invest” option when economic conditions are favorable.
  • We can discard it when economic conditions remain unfavorable.

3. Option to discard:

  • Analysis of the work item indicates unfavorable outcomes.
  • Low level of uncertainty – we know we should not consider this item for investment.
  • The cost incurred needs to be considered a sunk cost.
  • Although this particular item is discarded, the results of the analysis may be reused (re-deployed) in another project.

Real Options are one of the teachings from our new Kanban for Design and Innovation class. If you want to learn more about managing options in your pool of ideas, marshaling them through Discovery Kanban, and applying the pragmatic sequencing method, join the upcoming KDI classes.

*NPV – Net Present Value is the difference between the present value  of cash inflows and the present value of cash outflows over a period of  time (definition by Investopedia).

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