Thursday, March 17, 2011

Valuing Flexible Options in Product Development

Valuing Flexible Options in Product Development

By David Rosenbaum

Matt Harper, SDM '10
Photo by Kathy Tarantola Photography
MIT System Design and Management (SDM) student Matthew Harper wants to use concepts from Real Options Analysis (ROA) to reduce the cost of product development projects. In his thesis, supervised by ESD Professor Richard de Neufville, Harper combines the systems thinking approach he learned at SDM with ROA methods typically applied to financial and capital investments.

"ROA has gained significant traction within the general management sphere over the past 10 years," says Harper, although the concept has been around since the early 1970s. While options are used extensively in financial investments and markets, ROA places value on a company's decision to increase, decrease, or cease investment in facilities or projects. Harper's SDM thesis extends the concept to product design and development. Instead of considering options on the scale of a project, Harper's approach considers options on the scope of a product's market focus.

For example, at Prudent Energy, where Harper is a product manager, the question arose whether it was best to design a product for a specific market or for a broad category of applications. "We could optimize the product for market arbitrage (storing energy when prices are low to sell when prices rise), or we could include features that would allow us to participate in emerging, but potentially lucrative, secondary markets." What fascinated Harper was not so much the answer to that question as the concept that a systems thinking approach, combined with the notion of flexible options, could improve strategic decision-making in the development, design and manufacture of new products and capabilities.

If, Harper explains, one wants to maximize the returns from a product over its lifecycle, it would seem logical to build as much flexibility as possible into the product's design and manufacturing system, given that the future is always uncertain. (How much will demand change? Will energy costs go up, down, or remain level? Will new competitors emerge?)

However, Harper's thesis stresses that flexibility has a cost that needs to be accounted for to properly assess a product's ultimate return on investment. By having a product include options for features rather than features themselves, companies can reduce their product development costs while retaining the flexibility to address markets as they develop.

"For example," he explains, "say I'm developing a new carafe. There's a pretty good market for coffee carafes, but I think there might be a future market for tea carafes, too. At the outset, I may attempt to design for both markets. However, ROA can allow me to quantify the savings realized by delaying the decision to include features for the tea carafe market, executing that option in the future only if doing so is economically justified."

The application of such options-based analyses to physical things (as opposed to financial instruments) has led Harper to the very systems thinking-like conclusion that though making effective strategic decisions is important, employing effective processes for framing and analyzing such decisions is even more powerful. "Your option model," Harper says, "may or may not exactly match reality, but the market research, scenario analysis and cost examination you use to develop that model is priceless."

The personal end-state Harper hopes to arrive at, enabled by the knowledge he's gained at SDM, is one that will allow him to fill a role where he can, he says, "conceptualize and deliver truly exceptional products, collaborate with phenomenally talented individuals, and leave the world in a better state than I entered it."

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