The famous “Show me the money” catchphrase from the movie Jerry McGuire today is more than a clever quip. Thanks to regulations and increasingly vigilant executive management and boards of directors, corporate management is no longer satisfied with vague promises. It wants to see the actual economic return on their investment.
A client recently said to me: ”if the ROI of a new IT project is longer than 13 months it’s most likely going to be rejected.” It’s unclear where the 13-month figure came from, but the a detailed—and frequently unrealistic—return on investment (ROI) model is a prerequisite for almost any significant investment in IT project.
Generating an accurate and, at the same time, credible, ROI analysis is often difficult. If the ROI period is too conservative, management will not consider not attractive enough. If it is viewed as too rosy, it will not be believable and you will be sent back to the drawing board, or, if approved, you are running the risk of not meeting your plan.
The ROI Dilemma
With all its advantages and widespread use, ROI is not a foolproof investment decision method. What constitutes a reasonable rate of return for new innovation? How do you ….
The Industrial Internet of Things (IIoT) is a typical IT and business innovation that poses a challenge for those who demand unequivocal ROI. IIoT requires a significant upfront investment in communication and security infrastructure, software systems, and new product design before the IIoT can be operational.
Then, there’s unpredictability and inherent risk in defining new business models based IIoT and migrating the users to new service and outcome-based contracts.
These clearly push the expected payoff and time to positive cash flow well beyond whatever ROI period management expects. Furthermore, when uncertainty and sunk cost in non-recurring engineering are high, management tends to understate the value of investments in new IT.
But there is an alternative.
Real Options Model
In 2004, Prof. Robert Fichman of Boston College’s Information Systems Department published a paper titled Real Options and It Platform Adoption: Implications for Theory and Practice in which he describes a model of the option value associated with investments in innovative IT platforms. This model differs from conventional ROI based approaches to evaluating new technologies. This section is based on the principles outlined in this paper.
Instead of gauging the investment in IIoT in terms of time to revenue and positive cash flow, we can look at the investment in terms of real options. Under this approach, we view initial investment in innovative IT as an early investment in a platform with growth options.
Growth options confer the right, but not the obligation, to obtain benefits from future deployments of the technology. A simple example of this notion is investing in a new technology for R&D such as a pilot project or a prototype. This technology represents an option, but not the commitment, to exploit the benefits associated with further development and deployment of the technology.
Many IT “platforms” are such an investment. In and of themselves, these platforms do not have significant intrinsic value. Rather, they offer a foundation (hence the term “platform”) to explore and selectively implement future product and services that provide strategic and monetary value. To quote Mark Andreessen: “A platform is a system that can be … adapted to countless needs and niches that the platform’s original developer could not possibly have contemplated.”
When using real options to evaluate IT platform investments, the cost of the initial positioning investment is considered as a one-time price paid to obtain the set of options enabled by the platform. As such, the initial investment in the foundation is does not necessarily require to demonstrate a typical or acceptable return on investment, because, in itself, it has no business value. Each follow-on project enabled by the positioning investment is modeled and appraised independently as a separate option.
Separating the future economic value of disruptive products and services such as the Industrial Internet of Things and the technology foundation upon which they are built, helps organizations gauge the potential value of emerging technologies and make better investment decisions, which, in turn, will accelerate the adoption of innovative technologies and business models. In his paper, Prof. Fichman proposes that “Increased option value will increase the propensity of firms to make positioning investments that support the initial adoption of IT platforms.”
Image: Tom Cruise in Jerry Maguire (1996)