Agile Economics John Favaro Consulenza Informatica Pisa, Italy NAME Workshop 17 October 2002 Bolzano-Bozen, Italy

NAME Workshop, 17/10/2002 Agile EconomicsJohn Favaro Slide 2 Summary My consulting work in Agile Methodologies has been primarily directed at management. I have found that without a sound strategic and economic case, management is generally resistant to their introduction. My approach has been a framework derived from value- based management (VBM) that introduces the concept of “strategic options” and makes use of both traditional and advanced financial valuation techniques. I disseminate these strategic and economic arguments in professional development seminars and workshops, and in book and journal publications.

NAME Workshop, 17/10/2002 Agile EconomicsJohn Favaro Slide 3 The Elements of Value-Based Management StrategicFinancial Value Based Management is a systematic approach to managing companies to maximize wealth creation over time Value-Based Management is built on two pillars

NAME Workshop, 17/10/2002 Agile EconomicsJohn Favaro Slide 4 The Integration of Strategy and Finance StrategyFinance Finance is inherently myopic — it needs strategy for vision Strategy needs finance to be grounded

NAME Workshop, 17/10/2002 Agile EconomicsJohn Favaro Slide 5 Framework for Work in Agile Economics Value Based IT Management MECP Framework,... Strategic Options Contingent Claims Analysis,... Operational Economics Discounted cash flow,...

NAME Workshop, 17/10/2002 Agile EconomicsJohn Favaro Slide 6 Strategic Elements: The MECP Framework Cost and Asset PositionDifferentiation Usually Unprofitable Always Unprofitable Usually Profitable Always Profitable AdvantagedDisadvantaged Unattractive Attractive Two direct forces Four limiting forces Market Economics Competitive Position

NAME Workshop, 17/10/2002 Agile EconomicsJohn Favaro Slide 7 Financial Elements: DCF and CCA qAgile Methodologies such as XP generate both operational and strategic economic benefits qSome operational benefits:  Lower costs – great emphasis on keeping costs down  Lower defect rates – great emphasis on quality and testing qSome strategic benefits:  Flexibility to respond to changing user requirements  Ability to take advantage of new information, whether technical or business-related, whether good or bad Advanced Valuation: contingent claims analysis (CCA) Traditional Valuation: discounted cash flow (DCF)

NAME Workshop, 17/10/2002 Agile EconomicsJohn Favaro Slide 8 XP is an Options-Driven Process “We need to make our software development economically more valuable by spending money more slowly, earning revenue more quickly, and increasing the probable productive lifespan of our project. But most of all, we need to increase the options for business decisions.” - Introduction to Chapter 3, Economics of Software Development, XPEX, p. 11 XP has been explicitly described as an agile, flexible process for the creation of strategic business options We are interested in the strategic and financial consequences of this

NAME Workshop, 17/10/2002 Agile EconomicsJohn Favaro Slide 9 Strategic Options in Agile IT Processes Waiting to see whether the customer really needs the feature before implementing it Technologies and practices that keep the cost to a minimum if the project is modified or cancelled Talented, trained personnel able to switch course rapidly with new or modified stories Checkpoints after every iteration where the customer can take mid-course decisions Feature Option

NAME Workshop, 17/10/2002 Agile EconomicsJohn Favaro Slide 10 Financial Analysis of Strategic Options in XP Waiting to see whether the customer really needs the feature before implementing it Technologies and practices that keep the cost to a minimum if the project is modified or cancelled Talented, trained personnel able to switch course rapidly with new or modified stories Checkpoints after every iteration where the customer can take mid-course decisions Feature Option

NAME Workshop, 17/10/2002 Agile EconomicsJohn Favaro Slide 11 Typical Financial Analysis (Option to Abandon) Customer Development Right #1 “You have the right to be informed of schedule changes, in time to reduce scope to restore the original date. You may cancel at any time and be left with a useful working system reflecting investment to date.” - Ron Jeffries

NAME Workshop, 17/10/2002 Agile EconomicsJohn Favaro Slide 12 Optional Scope XP Contracts qOptional scope contracts are a central management feature of XP q As the team “exercises” the options in the contract, completing the features, the customer has to decide which new options to exercise q These may be  options that were in the original scope  options that were under consideration originally but not in the original scope  newly discovered options q Optional scope contracts are introduced to management as an alternative way of managing flexible IT process development Contract life Feature Option

NAME Workshop, 17/10/2002 Agile EconomicsJohn Favaro Slide 13 Dissemination in Books and Journals qExtreme Programming Perspectives, Chapter 43  Erdogmus, H. and J. Favaro, “Keep Your Options Open: Extreme Programming and Economics of Flexibility,” in: XP Perspectives, ed. M. Marchesi & G. Succi, Addison-Wesley Professional Series, Fall 2002.

NAME Workshop, 17/10/2002 Agile EconomicsJohn Favaro Slide 14 Seminars qAimed at project and enterprise-level managers qIntegration of strategic and financial treatment qValue of flexibility in IT processes qExamples of options taken from XP qTreatment of optional scope contracts qImplications for process and risk management q1-2 days

NAME Workshop, 17/10/2002 Agile EconomicsJohn Favaro Slide 15 Typical Seminar Contents qIntroduction: Strategic Options in IT processes  Flexible IT processes in an increasingly uncertain world – the example of Agile Methodologies  Evaluating the “intangible” benefits of IT processes  The relationship between finance and strategy qBasic Economic Valuation  Present Value concepts, DCF, NPV, DTA  Motivation for active management qAdvanced Economic Valuation  Option Pricing Theory  Black-Scholes, Binomial Method, Risk-Neutral Valuation qReal Options and Flexible IT Processes qSmall initial investment: option to grow qThe technical premise of XP: option to abandon qYou Aren’t Going to Need It: option to defer investment qIncremental releases: learning option qThe value of flexibility: option to switch qImplications for Management qContinuous option formulation (spikes), total risk management qOptional scope contracts qNegotiable requirements and customer rights

NAME Workshop, 17/10/2002 Agile EconomicsJohn Favaro Slide 16 Relationship to other Disciplines qThe economics of AMs is closely related to the economics of several other software engineering disciplines  Reuse  Product lines  Component-oriented development qReason: they are mostly about cost savings, flexibility and support for strategy qResults in one area will help in the others AMs Reuse Components Product Lines

NAME Workshop, 17/10/2002 Agile EconomicsJohn Favaro Slide 17 The Way Ahead qAMs are sufficiently different from traditional methodologies that a convincing management argument is needed for acceptance  This is a very active area (e.g. SIP from Beck, ideas from “Lean Management”) but no clear emerging direction yet qOne approach: success stories  As more become available, this approach will become more valuable qAnother approach: show how AMs support management best practices  This is the approach I am taking in my consulting work  Many IT managers do not have backgrounds in management – they came up through the IT ranks  There must be a process of education first in management (strategic and financial) best practices, then the link to AMs  It must be viewed as a discipline worthy of study and training, not an ad hoc add-on to technical project management