This blog is about two areas of concern to our clients: avoiding false negatives in their business development efforts and what to do about it. False negatives come about from the over use of traditional financial tools such as net present value (NPV) which tacitly assumes that once a decision is made to invest in a project, it is irreversible and managers cannot allow any deviations from the plan. This is akin to saying that no new knowledge will be gained, nor considered as the project moves forward. What you say? Of course new information will be considered as the project evolves. We agree, but traditional finance does not. NPV is a simple calculation that relies upon adding up all the expected cash flows that will be generated during the life of the new product or service, deriving their present value and then subtracting all costs. If the resulting net present value is positive invest, if not discard the idea. So here is the rub. If the project is perceived as facing uncertainty finance calls for the present value to be adjusted downward to compensate for that risk. Fair enough except that uncertain projects have both a downside and an upside, or else they are not uncertain. Right? If the weather is uncertain it could rain or be sunny. Drawing the analogy further current finance would require that we always carry an umbrella and that no one should buy a convertible car, because it could rain.
Just as we can adjust our need for an umbrella by looking at the weather report, we can modify project plans by looking at what we have learned and adjust accordingly. If the prototype fails we will stop. If the market research is glowing we may increase our price assumptions. If early sales are promising we could sell the product line or enter a joint venture. There are of course a myriad of other possible changes to a plan that can occur when developing something new. But they do not enter into traditional financial thinking that values predictability over flexibility. The issue in a nutshell is that finance is still in the 1950’s whereas management has moved on.
Okay we have identified the problem, but what do we do about it? Playing hide the project in your budget may work, but that has its pitfalls. So a better solution is to use predictive analytics to marry finance with strategy and project management. Predictive analytics is the big brother of dashboards that look at past data to draw conclusions about cause and effect. But if you are doing something new dashboards are not of much help, because there is little data to draw from. Predictive analytics answers the questions of what could happen, or what will happen, and how likely is it?
How does this help with avoiding false negatives? If we use predictive analytics when uncertainty is high we can bring finance into the 21st century by having everyone involved look at the assumptions and data behind a project to make the best decisions with the information at hand. This approach embraces the intuition displayed by smart managers who know that flexibility creates options in new business development; and those options have value. Now we have NPV which values inflexibility and analytics that values flexibility, so the question is are they additive? Yes they are. Think of it this way. NPV is linear so it cannot mathematically value choices and decisions that differ from what is planned. This is fine for iterative projects that face little uncertainty, but it obviously falls apart as a guide to managing true innovation that faces immense uncertainties. Analytics values the options created by a flexible management approach and it is additive to NPV, but they are two sides of a mirror. That is when uncertainty is high there are lots of choices so there are a variety of options that can be exercised. When uncertainty is low there are few choices because the best way to develop a project is well known so there are few choices and NPV works perfectly well. So as a project moves from assumptions to facts, the value shifts from option value to net present value. This is a continuum so the two sources of value exist alongside each other and they are therefore additive.
In the end it’s not about NPV or option value it is about making better decisions. To do that you need a flexible guide to value that reflects how you actually manage complex projects.