A: It's true that Real Options may seem an arcane, financial term to IT managers - but the concept is very applicable to decision-making throughout the life-cycle of technology projects, so it's definitely worth understanding. Simply put, in the world of finance, Real Options give managers or executives the right - but not the obligation - to buy or sell an asset at pre-defined price. For IT investments, Real Options value additional follow-on opportunities that may exist as a result of investing in a project.

Recently, I surveyed 130 executives, and found that none are using quantitative Real Options methodology for analyzing technology investments. About 25% are making qualitative decisions that follow the mind-set of Real Options methodology. But many of these executives I talked with were very interested in learning more about how to apply Real Options methodology to information technology investment decision-making. My experience is that IT executives are always interested in learning about better decision-making, and that most express a need for tools that empower better executive management decisions. And Real Options is one possible quantitative tool for improved decision making. Bottom line, executives want to explore what can help them make smarter financial investments throughout their enterprises.

It seems a natural evolution to me to apply Real Options to technology investment decisions. After all, Real Options in the world of finance - for example, as a methodology for valuing stock options - have been around since the 1960s. Other industries - include oil and real estate - began applying the concept to problems, such as deciding whether or not to continue drilling for oil, or whether or not to make a real estate purchase.

And, in fact, quite recently, since the late 1990s, IT has, in a few cases, used Real Options thinking as a way to quantify decisions about whether to commit to one application or another.

However, what's cutting-edge about my colleagues and my research is that we're extending the existing understanding of how Real Options can be applied by asserting that the concept can also be used to make decisions about information technology investments when capital is limited, or rationed. Specifically, we look at enterprise data warehousing investments and value the Real Options that result from data mart consolidation.

A: To answer that question, I first have to explain the financial context within which executives make decisions.

As my colleagues and I pointed out in our paper, Real Options are often discussed in the context of projects that will have a negative net present value (NPV) if option values are not considered. That's because, traditionally, infrastructure investments may have, in purely financial terms, a negative return. So to improve the NPV, and make it positive, Real Options are sometimes considered in order to justify the investment.

But this reality does not apply to today's technology investments. Most technology projects considered for funding are likely to have a positive net present value. For example, a database in your customer service area will enable your company to track customer complaints and respond faster than the competition, and that can directly attribute to the bottom line. How do you choose between this database and, say, software to manage marketing campaigns?

Using traditional NPV assessments, you're assuming that you may invest in a technology all up front, or even over time, but that nothing will change in the course of the project in terms of the company's needs or strategy or management. You're assuming everything is going to run exactly the way you think it will. And of course, the world does not work that way. Applying Real Options to the decision process provides a quantifiable way to value options that are important in the future phases of a project, to look at which options may have the greatest impact on goals and strategies - depending upon the information that will be gleaned in earlier phases. It's a way of valuing management flexibility, of quantifying the intuition that it is less risky if we can make decisions in stages as a project evolves in time, based on what was learned in previous stages, without having an all-or-nothing commitment up front in a project.

This is where our approach is different. We look at how executives can apply Real Options to make decisions about which positive net present value technology projects to pursue, and how to pursue them. Applying Real Options allows an executive to see which projects will enable the best options in the future for adding value to their company's initiatives and strategies.

What, I think, was exciting about this concept to the executives we surveyed is that while they have limited capital to work with, Real Options gives them a tool to assess which technology projects will give them the most bang for the buck.

A: As I mentioned, we specifically applied our theory to decision-making in enterprise data warehouse (EDW) projects. For example, companies are often interested in data mart consolidation. To keep the example simple, let's say a company has 11 data marts to consolidate and $4.5 million for the project. If, instead of consolidating all 11 at once, let's say we consolidate three data marts as a pilot project, for $1.6 million. At the end of this first phase we can then assess our ROI results before deciding to consolidate another three, or perhaps all eight. If we do not realize the ROI we wanted in the pilot project, we'll decide not to go forward. On the other hand, if the ROI is as expected, it makes sense to continue to invest in later phases.

By successfully completing the first phase of an EDW project the downside risk of a large follow-on EDW project can be reduced and the upside potential can be increased. In addition, an EDW once complete might enable Customer Relationship Management and Supply Chain Management. These are all Real Options that should be factored into the initial pilot EDW project investment decision.

This illustrates the true value of Real Options as a tool for technology investment decision-making: Real Options provide a way to quantify management flexibility and the value of reducing project risk by deferring investment decisions into the future.

In addition, Real Options provide insight into the optimal deployment strategy for an EDW project. There is often a trade-off between delaying a project, which delays the cost saving and revenue generation benefits, and the risk of the project. Our research has shown that if there is reasonable level of risk, it can be better to implement a full consolidation than to defer the benefits. However, if the perceived risk is high, a phase-wise deployment strategy is best.

A: Those factors are definitely top-of-mind in today's business world, and they all contribute to risk in decision-making. Of course, we talked about mitigating risk in our previous IT Portfolio Management interview, and certainly Real Options are, in part, about mitigating risk because Real Options take into account risk while giving executives a way to more objectively compare projects.

In fact, in research and development in the pharmaceutical industry, companies often use Real Options to decide in which medications to invest and develop, while still retaining the possibility of changing course as health and medical knowledge changes and grows. Likewise, I believe Real Options strategies can be used as part of IT Portfolio Management to preserve flexibility in technology decision making, yet at the same time, downsizing risk as technology knowledge advances.

A: The Real Options calculations are fairly simple, actually. If you can do ROI analysis, you can do Real Options analysis. Real Options methodology is well known in finance; it's just a mater of applying those methods to technology projects. Those who are interested in more detail can view our paper, Real Options and Enterprise Technology Project Selection and Deployment Strategies, at our Kellogg website: www.kellogg.northwestern.edu/IT/research (click on Research Publications, then on the paper title under the Technology Management Research subheading). We have also included a brief discussion on Real Options in our Kellogg executive program (www.kellogg.northwestern.edu/DrivingResults). This is in addition to in-depth review of ROI, risk mitigation and IT Portfolio management case examples and best practices. And over the course of the next few months, we'll be putting together web pages available from the Kellogg site that will enable executives to download the formulas for applying Real Options.

A: Absolutely!