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Quantifying Uncertainties is Critical to Identifying IT Business Value Potential

  Article published in DM Direct Newsletter
September 17, 2004 Issue
 
  By P. Bruce Guthridge

Many in the corporate world today quantify return on investment (ROI) to qualify their business investments. This is the normal course of diligent business practice. In the area of IT, significant and uniquely challenging problems arise caused by the very nature of the potential investment. For the most part, IT investments often present:

  • A new set of varied technologies
  • Dramatic changes to existing business practices
  • The learning or obtaining of new skills

These generate many of the associated uncertainties and are often not normally addressed in what is deemed a successful process.

For decision-makers in business, this brings about concerns during the IT justification process. Most believe that information technology, properly applied and positioned in their business, is important to achieving their future business vision: this could be such capabilities as customer relationship management (CRM), e-commerce, enterprise resource planning (ERP), supply chain optimization, portals or any of many other such IT initiatives. Of course, there are the horror stories that are well publicized, and the decision-makers know how much impact a bad decision can have on their business as well as career.

Not all information technology investments are the right investment at any time for any company. Every company is at some different level in their application of IT, and businesses are different not only by business segment but by their business vision, goals, objectives and values. If the uncertainties cannot be quantified, how can the best decision be made?

Uncertainties typically fall into three categories:

  • Benefit assumptions
  • Risks
  • Basic business case assumptions

Benefit Assumptions

As we begin the process of discovering potential business benefits we encounter uncertainties on a business change by business change basis. One of the most significant aspects of the assessment process is to determine the impact of these proposed business changes. In most cases, there are several tangible benefits in this area such as reduction in manpower, lowering of costs and increasing of time to market, all of which are fairly straightforward in valuing.

All the other potential benefits are related to such business changes as:

  • Increased productivity
  • More reliable information
  • Information in a more usable format
  • Information that has been reconciled
  • More timely information
  • More integrated information
  • Increased communications and information sharing
  • Collaborative virtual teams
  • Better knowledge of the customer
  • Linkages with business partners and
  • Other such intangibles

Most of these potential benefits require a knowledgeable judgment as to their impact on the business. In our experience, the best approach is to investigate each potential business change with the associated business representatives and pose the question, so what? From this approach, one or more potential benefits may be identified for each change. The accumulation of these is what we call business assumptions, and they - in total - represent potential business changes and thus, drivers of potential realized benefits.

Risks

As previously mentioned, many business benefits are composed of what are normally termed intangibles. It is also important to consider uncertainties that could impact the business assumptions. We put these in the category of risks (business). We also need to ask the so-what question with each of these business changes to gain insight into their potential impact. This can include such risks as:

  • Time to achieve the ability to completely exploit the new capabilities (learning curve)
  • The ability to organize effectively around the new capabilities
  • The affect on existing company values or morale
  • The impact in other parts of the business process
  • The transition process
  • The number of new initiatives (business changes) that can be accomplished within a given time period

Besides the business benefit area, this process should also include any uncertainties in the areas of:

  • Investment costs: Software, hardware, consulting services, resources and project management
  • Commissioning: Resources and backup planning
  • Training

Basic Business Case Assumptions

Another area of potential risk is the basic financial and other business case assumptions not covered in the two other categories of risk. For example, this includes such items as:

  • Financial assumptions: Inflation factor, cost of capital, future wages and salaries
  • Market growth factor
  • Market share growth factor
  • Cost of goods

Bounding the Uncertainties

Going back to the "so-what" question, it is important to realize that this process may or may not discover potential benefits. If it does, the next activity is to quantify and value these business changes in a realistic and believable manner. Herein lies the most difficult barrier to being able to proceed. People, by nature, resist change and most often are not willing to commit to a single (benefit) value. In our defense, we do not have an experience basis upon which to make a confident prediction. Our experience has shown that the way to address this difficulty is to bind the potential benefit with a range of values.

This process has shown that business representatives are much more confident when they are able to think about uncertainties in these terms. This "bounding" process should be performed for all intangibles. What values are selected is less important to the process than the establishment of a bounding range for each uncertainty.

This process, referred to as creating bound-uncertainties, creates a bound range for each uncertainty. As you can imagine, within the scope of a typical investment justification process it is possible to define hundreds of these uncertainties.

Exploiting the Bound-Uncertainties

If you can assume that the above process built a model of the business case based on the expected values for each uncertainty, it is then possible to exploit the developed bound-uncertainties. Why is this important? A typical business case built solely upon expected values lacks credibility as it is based on a series of single "best guesses" and - given the typical number of uncertain values in a business case - the resulting internal rate of return (IRR), cash flow analysis (NPV) or any other such concluding value is uncertain.

To utilize the bound-uncertainties in the business case model data should be submitted to a simulation process whereby the expected values are allowed to vary independently at random in the bound range for each defined bound-uncertainty. This creates a series of independent random values within the bound range for all uncertainties and recalculates the resulting business case results. This is performed over several thousand cycles to provide a realistic simulation of the possible full range of values.

The result is a series of business case results that have been generated by allowing the uncertainties to randomly range within their respective bounds, giving a good representation of expectations on both ends of the spectrum.

In many cases, you may want to perform the simulation using several different scenarios where one of the scenarios will allow all uncertainties to be used and others allow you to examine select parts of the business case in isolation. For example, you may want one simulation scenario without any risks/uncertainties and yet another where only the implementation risks are included.

There are three main categories of uncertainties and they each need to be discovered and bound into sets of bound-uncertainties. Using this approach, the initial business case can be modeled using the expected values. Then, the resultant business case model can be submitted to one or more simulation scenarios to find the most likely business case results.

This process of identifying, bounding and simulating the uncertainties within a business value assessment process provides a reasonable and viable approach to valuing a potential business investment.

...............................................................................

For more information on related topics visit the following related portals...
ROI.

P. Bruce Guthridge is a founding member of IT Executive Partners, LLC and is a senior managing partner in the firm. His expertise includes business process design, investment justification analysis, IT assessment and IT solution architecture. Guthridge is the architect of the Three Dimensional ROI justification approach. He can be reached at pbguthridge@itexecutivepartners.com.



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