Capital Budgeting: Rational Outsourcing Decision in VoIP Projects
According to a recent Harvard Business School study, higher IT capability directly correlates with superior revenue growth.
Nearly all IT managers (at more than 150 large enterprises) surveyed for the study said they plan to increase outsourcing, particularly in the areas of application development and IT infrastructure.
Outsourcing is the practice of turning over responsibility of some to all of an organization's information systems applications and operations to an outside firm. This practice is widely believed (sometimes erroneously, according to recent research) to lead to cost savings and/or to free company resources for other activities.
Often, outsourcing enables a business to run faster than if it tried to deploy the same technology using in-house staff. So, where time to market and such is crucial and skilled IT labor is scarce, outsourcing has gained in popularity. U.S. IT managers are adapting to outsourcing and gradually implementing it as a comprehensive corporate strategy, rather than as individual contracts for distinct IT tasks.
However, outsourcing isn't without potential pitfalls. Some firms are less than confident when it comes to giving outsourcers access to their internal operation. What's more, some question how much responsibility an outsourcer will accept when its service isn't sufficient and whether it can integrate its offerings fully with a business's existing infrastructure and legacy applications. Caveat emptor.
With both the findings of the Harvard study and my caveat in mind, this article—the third in a series on capital budgeting—will focus on the use of decision-tree analysis (with real options) to facilitate the buy or make decision of a proposed Voice over Internet Protocol (VoIP) project. (See footnote.) Here, "buy" refers to outsourcing the job of migrating from a traditional analog telephone system to a data-based digital one. The buy or make a particular deliverable decision is crucial in project management in today's business environment.
Decision-tree analysis is a schematic way of representing alternative sequential decisions and the possible outcomes from these decisions, as illustrated in Figure 1. In a sequential decision problem, in which the actions taken at one stage depend on actions previously taken in earlier stages, the evaluation of investment alternatives can become very complicated. In such cases, the decision tree technique facilitates project evaluation by enabling the firm to write down all the possible future decisions, as well as their monetary outcomes, in a systematic manner.
Figure 1. Model of three- (or possibly four-) stage investment decision process for the build branch of an earlier build-inhouse or outsource decision node (shown later in Figure 4).
Figure 1 shows a decision-tree model based on costs (rectangles—with square or rounded corners), probability of successes and, future cost savings (increased cash flow streams). Because this model treats the investment decisions for a proposed project in a series of stages, the solution is a close proxy for real options theory.
You identify the things that could happen to the project and the main counteractions that you might take. Then, working back from the future to the present, you can consider which action you should take in each case. Note, however, that this figure hides many of the real-world details that must be assigned dollar amounts when constructing your capital budget.
VoIP is a potentially cost-saving technology used to transmit voice conversations over a data network using the Internet Protocol (IP). Such data networks may be the Internet or a corporate Intranet. When, as in the case discussed below, a project involves rolling out a major new data-networking application, along with new hardware and infrastructure to support it, the project should be staged and budgeted throughout its life cycle.
Also included will be a look at related issues such as:
- How much unbudgeted downside risk you should manage
- Worst-case scenario (given catastrophic losses) vs. regret
- The value (and cost) of compliance with regulations (for example, SOX)
To present a real-world discussion of decision-tree analysis, I will also explore some of the assumptions made in the penultimate and antepenultimate articles of this series: for example, probability distributions are symmetric and worst-case scenarios need only be considered statistically.
Real Options: The Value of Midcourse Corrections to Projects
One of the fundamental insights of modern financial theory is that options have value. The phrase "We are out of options" is surely a sign of trouble. However, because corporations (and other organizations) make decisions in a dynamic environment, they usually have midcourse options that should be considered in project valuations:
- The Option to Abandon a project: Has value if return (or savings) turns out to be lower than expected
- The Option to Expand a project: Has value if return (or savings) turns out to be higher than expected
- The Option to Delay a project: Has value if the underlying variables are changing with a favorable trend
- The Option to Outsource a project: Has value if internal resources don't have required experience and expertise
In the previous two articles of this series, the widely-practiced Net Present Value (NPV) analysis was used as the basis for selecting or rejecting a project. However, NPV analysis ignores the adjustments that an organization can make after a project is accepted. These adjustments are called real options. In this respect, NPV—the present value of its expected future cash flows, discounted at a rate that reflects the riskiness of the expected future cash flows—can underestimate the true value of a project. This outcome can be exacerbated further when the data from which NPV is calculated stems from an asymmetric probability distribution, as explained in Appendix 1. (Figure 1 shows the full life cycle of a project in which real options are considered.)
When you use discounted expected future cash flows—the basis for the NPV calculation—to value a project, you implicitly assume that the organization will hold the asset passively. But, managers are not paid to be passive. After they have invested in a new project, they do not simply sit back and watch the future unfold. If things go well, the project may be expanded; if they go badly, the project may be cut back or abandoned altogether. Managers get to manage projects—not simply accept or reject them.
In practice, companies sometimes have other choices. They can delay the decision until later, when more information is available. Or, they can call in outside help, even after having deciding not to do so at the outset. Such investment timing options can dramatically affect a project's estimated mean NPV and risk. Projects that can easily be modified in these ways are more valuable than those that do not provide such flexibility. The more uncertain the outlook, the more valuable this flexibility becomes.
Consider a proposed project where there is uncertainty about the state of the economy. Suppose it can be either good or bad and it's as likely to be one as the other. If it is good, your investment project returns $5. If it is bad, you lose $6. The cost of doing nothing now and waiting to see what the economy looks like at a future date is $1 (you might, for example, have to pay the salaries of software developers or others who become under-utilized as you wait).
An NPV calculation, where you invest now or never, values the project at 50%x$5 – 50%x$6 = -$0.50. If you sink $1 and wait and see, the real option value of the project is 50%x$5 – 50%x$0 – $1 = $1.50 as you don't have to invest if the economic climate is bad. So flexibility can be profitable!
The final decision as to whether to build in house or outsource is determined by which of the two choices has the lower discounted cash flow (NPV) after probabilities are used to weight the expected cash flows. Remember, the entire model in Figure 1 represents only the make branch of the make-buy decision. Both branches are shown in Figure 4.
When are real option values most significant?
- Uncertainty: There must be high uncertainty about the future. In fact, the option value increases with increasing uncertainty. This is in contrast to most traditional thinking; instead of fearing the uncertainty (risk), option thinking is actively taking advantage of uncertainty.
- New information: It must be very likely that you will receive new information (decreased uncertainty) over time.
- Managerial flexibility: If there is high uncertainty and new information decreases this uncertainty, there is no option value unless management is able to respond appropriately to this new information.
Obviously, for some projects flexibility is of great value while to others flexibility is of minor interest. Which factors are important to increase the Real Option value?
The Decision Tree shown in Figure 1 is a simplification created to satisfy the needs of this article. Figure 2 indicates that, although decision trees alone can be helpful when a project is characterized by high flexibility but low uncertainty, decision trees with the addition of real options is the methodology of choice when the project is characterized by both high flexibility and high uncertainty.
However, it is generally felt that real option analysis does not provide much value in investment decisions on projects with very high NPVs, because the projects are already attractive for investment and the additional value that may be provided would not change the decision. Similarly, on projects with very low NPVs, the additional value provided by real options would most likely be so negligible that the investment decision would still be a "no go." That is, real options offer the greatest value on projects with an NPV close to zero (either positive or negative) and positioned in the upper-right quadrant of Figure 2.
Figure 2. Real options have value when both uncertainty and flexibility characterize a project.
The bottom line: Breaking up the inflexible investment bet represented by the upper path(s) in Figure 1 into two smaller investment bets represented by the lower path(s) enables the project manager (or Project Management Office) to use options to improve his or her allocation of resources to the project as new information becomes available. Appendix 3 contains a discussion on the place of real options in the real world.
Before continuing, as I have been, with issues from the perspective of the CIO or PMO head, you should take a look at some of the issues that the CTO will be concerned with while evaluating the buy-make decision for this proposed project. Understanding one helps understand the other.