Hubbard Decision Research The Applied Information Economics Company Intro to Quant. Methods Finding 1 The effect of Risk Analysis Finding 4 Scope Creep

HubbardDecision Research

The Applied Information Economics Company

Intro toQuant. Methods

Finding 1 The effect of Risk Analysis

Finding 4Scope Creep

Finding 2 What to Measure

Finding 3Tech. Regret

Finding 5AIE Value

Quantitative Methods Make A Difference








Finding 5AIE Value

Overview

• Quantitative methods (probabilistic analysis, operations research, etc.) are widely used in other industries, but mostly lacking in IT investment analysis

• Over the past 7 years, we have been focusing specifically on the application of more advanced quantitative methods to IT

• This presentation will review the key findings from the application of quantitative methods to over 30 projects








Finding 5AIE Value

Quantitative Methods Include:

• Computing uncertainties and risks

• Computing the economic value of information

• Measurement methods for many items usually considered intangible

• Optimizing solutions when there are huge combinations of options for:– Roll-out priorities of systems

– Selection of a portfolio of functions

– Any other problem where different alternatives about different aspects of the investment generate lots of possibilities








Finding 5AIE Value

AppliedAppliedInformationInformationEconomicsEconomics

EconomicsEconomics

Decision/Game Decision/Game TheoryTheory

Empirical Empirical Decision TheoryDecision Theory

StatisticsStatistics

Information TheoryInformation TheorySoftwareSoftwareMetricsMetrics

InformationInformationEngineeringEngineering

Modern PortfolioModern PortfolioTheoryTheory

Operations Operations ResearchResearch

Method: AIEApplied Information Economics is the practical application of

scientific and mathematical methods to quantify the value of IT-enabled business investments








Finding 5AIE Value

Some HDR Clients• Booz-Allen & Hamilton• Accenture w/ the State of North Carolina• Giga Information Group • American Express • The Discovery Channel• U.S. Federal Government:

– Department of Treasury– Bureau of The Census– Department of Veterans Affairs– General Services Administration– Housing and Urban Development

• The Axa Group – 6 major companies• The Banking Industry Technology Secretariat • Blue Cross Blue Shield of Illinois








Finding 5AIE Value

What Do the Critics Say?

• “Quantifying the risk and comparing its risk/return with other investments sets AIE apart from other methodologies. It can substantially assist in financially justifying a project -- especially projects that promise significant intangible benefits.” The Gartner Group

• “AIE represents a rigorous, quantitative approach to improving IT investment decision making…..this investment will return multiples by enabling much better decision making. Giga recommends that IT executives learn more about AIE and begin to adopt its tools and methodologies, especially for large IT projects.” Giga Information Group

• “AIE-like methods must become the standard way to make (IT) investment decisions.” Forrester Research, Inc.








Finding 5AIE Value

Five Key Revelations1. Quantifying risk radically changes IT investment

priorities2. Current measurement priorities are “upside-

down” when compared to priorities based on economic value of information

3. “Technology regret” is a significant and overlooked factor in the the value of IT investments

4. The true cost of “scope creep” is much higher than most would think

5. The value of quantitative analysis would make it the best investment in most IT portfolios








Finding 5AIE Value

Finding 1: Risk Analysis• When IT computes risk in the same way

that an actuary would, many IT investments will look completely different

• We define risk a “The probability of a quantified loss”

• Risk analysis of IT investments involves a probabilistic analysis of all uncertain variables








Finding 5AIE Value

Normal Distribution

Uniform Distribution

Lognormal Distribution

Hybrid

Threshold confidence 15% 85%

Ideal Values: Point

Real-world Meas.

Real-world Measurements vs. Ideal Values








Finding 5AIE Value

When asked to provide a subjective 90% confidence interval, most managers providea range that only has about a 40%-50% chance of being right

When asked to provide a subjective 90% confidence interval, most managers providea range that only has about a 40%-50% chance of being right

Actual 90% Confidence Interval

Calibrated Estimates• Measuring your own

uncertainty about a quantity is a general skill that can be taught with a measurable improvement

• Studies show that most managers are statistically “overconfident” when assessing their own uncertainty

• Training can “calibrate” people so that when they provide a 90% confidence interval, it still has a 90% chance of being right (even though it is subjective)

Perceived 90% Confidence Interval








Finding 5AIE Value

Distribution-based ROI

Administrative Cost Reduction

Total Project Cost

% Improvement in Customer Retention

5% 10% 15%

10% 20% 30%

$2 million $4 million $6 million

ROI-50% 50% 100

%0%

Inputs








Finding 5AIE Value

Analyzing the Distribution

25% 50% 75% 100% 125%-25% 0%

Risk of Negative ROI

“Expected” ROIROI = 0%

Probability of Positive ROI

Return on Investment (ROI)

The “cancellation hump”








Finding 5AIE Value

Return

Risk

10%

20%

30%

40%

10% 20% 30% 40% 50% 60%

Pro

babi

lity

of le

ss th

an a

ri

sk-f

ree

retu

rn

A proposed IT investment with a 15% risk and 54% return

X

Plotting the Risk and Return








Finding 5AIE Value

Example of Risk Effects

50%

40%

30%

20%

10%

0%

0% 50% 100% 150% 200%

Expected IRR over 5 years

Cha

nce

of a

neg

ativ

e IR

R• These are real IT investments of $2M-$3M plotted against a client’s investment boundary• The 27% ROI investment is actually preferred to the 83% ROI investment

Region of Unacceptable Investments

Region of Acceptable Investments








Finding 5AIE Value

10%

100%

1000%

20% 40% 60% 80% 100%

20%

30%

50%

200%

300%

500%

Size of the Project Relative to the Entire IT Portfolio(i.e. 50% = project makes up half the work in the entire portfolio)

Req

uire

d M

inim

um R

etur

n (I

RR

ov

er 5

yea

rs)

Most Risk

Avers

e

Approximate Median

Most Risk Tolerant

Range of Typical “Hurdle Rates”

Risk Increases Required ROI’s• Adjusting for risk causes some previously-acceptable projects to be

rejected• Also, some low return but low risk projects would now be acceptable• More projects with “intangible” benefits are now economically

justified• The net result: A completely reshuffled deck of IT project approvals








Finding 5AIE Value

Using Risk Analysis to Improve Decisions

If the Risk is significant (it usually is), consider doing the following:

• Reduce the size and functionality of the proposed system - focus on fewer high-return features

• Wait until specific uncertainties in the environment subside - e.g. major mergers, reengineering, etc.

• Wait to tackle big projects until proper skills are developed and methods are in place

• Consider purchased packages that aren’t a perfect fit but close enough - they may look more attractive now

• Invest more on a proper economic analysis of the largest IT investments - this should reduce uncertainty about critical quantities

• Include deferred benefits in any estimate of scope creep costs








Finding 5AIE Value

Finding 2: Measurements

• Information has a value that can be calculated with a formula known for 50 years

• Computing the value of additional information on uncertain variables causes some surprising changes in what gets measures








Finding 5AIE Value

EVI p r V p r V p r V p r EVi j j ij

z

j j i l j j ij

z

j

z

i

k

( ) max ( | ), ( | ),... ( | ), *, , ,1

12

111

The Decision Theory Formula:

What it means: Information reduces uncertainty Reduced uncertainty improves decisions Improved decisions satisfy business objectives (by definition)

The Economic Value of Information








Finding 5AIE Value

The IT Measurement Inversion

Typical A

ttention Eco

nom

ic R

elev

ance

Receives Most Attention

Least Relevant to Approval Decisions

Receives Least Attention

Most Relevant to Approval Decisions

• Costs– Initial Development Costs

– Ongoing Maintenance/Training Costs

• Benefits– A specific benefit (productivity,

sales, etc.)

– Utilization (when usage starts and how quickly usage grows)

• Chance of Cancellation

See my article “The IT Measurement Inversion” in CIO Magazine(its also on my website at www.hubbardresearch.com under the “articles” link)








Finding 5AIE Value

Finding 3: Technology Regret• Most business cases treat IT investments implicitly

as a “now or never” choice• Technology regret is an economic quantity

associated with committing to a technology after which, for whatever reason, becomes regrettable

• The equivalent of “buyers remorse”• Technology regret becomes and important

consideration in any environment where changing technology is a constant

• The issue becomes balancing technology regret (which tends to defer IT investments) vs. the opportunity loss of deferring the benefits of making the investment now








Finding 5AIE Value

0

50

100

150

200

250

300

350

Year

Rel

ativ

e C

ompu

ting

Pow

erPe

r $

(198

0=1)

19951980 1985 20001990

32% Annual Growth Rate

Some Areas of Growth:• Processors & Memory

(Moore’s Law)

• Storage• Communications

(Payne’s Law)• Internet Users• Sensory devices

Competition makes capitalizing on new technology more critical to survival

Changing Technology








Finding 5AIE Value

Changing With Technology

A C

riti

cal Tech

nolo

gy

Measu

re

Time

How often should you change with technology? Avoiding “technology regret” is often a major driver in IT decisions.

Upgrade 1

Upgrade 2








Finding 5AIE Value

“Real Option” Theory

Sin

gle

Per

iod

Opt

ion

Val

ue(V

alue

of

Wai

ting

one

per

iod)

Invest in this cycle, high priority

Net Value of the Investment0 +

Invest this cycle, low priority, may be deferred if resources are strained

-

Re-evaluate in the next decision cycle

Reject the investment

1. The option value tells us when an investment, even if it looks positive now, should be deferred until the opportunity is better

2. In the case of IT, waiting for the possibility of better technology around the corner should be considered








Finding 5AIE Value

The Effects of Tech Regret

• Very long duration IT projects that commit to a proprietary solution tend to look much less favorable

• Short turnaround projects based on non-proprietary standards tend to look better

• Large scale commitments to the fastest improving technologies (like data storage, bandwidth) tend not to be favorable








Finding 5AIE Value

Finding 4: Scope Creep

• The cost of adding one additional function to an software development project is rarely addressed properly

• If anything, the only cost of new features considered is development cost

• Long term maintenance, increased risk of cancellation plus deferred benefits is much more significant








Finding 5AIE Value

True Scope Creep Costs• 24%: Initial development

costs

• 24%: Future maintenance costs (computed over 5 years)

• 1%: Incremental contribution to probability of total project cancellation

• 51%: Deferred benefits of the other functions delayed by the proposed new function

24%

24%

1%

51%








Finding 5AIE Value

Finding 5: Value of Quant.• Organizations have successfully adopted more advanced

quantitative methods for evaluating IT investments• The cost of analysis routinely comes in below 1% and has always

been under 2% of the investment size - including initial training• This is still less than non-IT investments of similar size and risk• It is also sometimes less time-consuming than the previous non-

quantitative analysis techniques used by the firm (One of the reasons this analysis is efficient is we conduct a Value of Information Analysis - we only measure what is economically justified)

• Using the standard VIA calculation for the value of AIE analysis, AIE itself was the best investment of all the IT investments we analyzed - very conservative measures of payoffs put $20 to every $1 spent on AIE








Finding 5AIE Value

Overview of RRA Analysis

Intangibles“Customer Satisfaction”“Strategic Alignment”“Technology Risk”“Information Quality” etc.

MeasurablesErrors in Decision XChange to Strategic Measure MProductivity in Activity YChance of cancellation, etc.

5% 10% 15%

10% 20% 30%

$2 mill $4 mill $6 mill

Measurements

$

$$$

$$

Value of Info.

Calculate Risk/Return Position"expected" ROI

50% 100% 150% 200% 250%-50% 0%

Probabilityof a negative ROI

Probability of a positive ROI

Organization's investment

limit

Acceptable region of investment

Return

Risk

Classification








Finding 5AIE Value

In Conclusion…

• Quantitative methods like AIE cause major IT decisions to be very different – and better

• Advanced methods can and have been learned and adopted by IT organizations

• More quantitative analysis can be the highest return investment in your IT portfolio

Documents

Hubbard Decision Research The Applied Information Economics Company Intro to Quant. Methods Finding 1 The effect of Risk Analysis Finding 4 Scope Creep