Real Options – more than deferring commitment

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, 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.

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

In these coronavirus times many emergency field hospitals were built  in expo halls and sports centres around the world. They were 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 on a nation. 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  statistical understanding of probabilities. When we have no historical  data, 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 a number of 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 are constrained  and 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 flavours, and  restaurants offering vegetarian options and other dietary considerations  on their menu. These are the options they give you, out of which you  have the right – but no obligation – to choose.

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

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

Real (financial) options

Option to delay

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

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

Option to expand

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

Remember the component from 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 to be valuable.

Option to redeploy

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

You have been exploring 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, greater variety of possibilities and ideas is beneficial.” David J. Anderson

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

How can we apply real options thinking into 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 repeatable process, which takes  place, when item moves through the upstream Kanban.

Option to invest:

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

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 “invest” option when economic conditions are favourable.
  • Can be discarded when economic conditions remain unfavourable.

Option to discard:

  • Analysis of the work item indicates unfavorable outcomes.
  • Low level of uncertainty – we know this item should not be considered for investment.
  • Cost incurred needs to be considered a sunk cost.
  • Although this particular item is discarded, the results of analysis may be re-used (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, marshalling them through Discovery Kanban and  applying 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).