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Economic Frameworks


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This class presents the idea of using economic frameworks for portfolio and project management. We’ll begin with an overview of the three horizons model, and discuss the economic models that are suitable in each horizon. We’ll then discuss and experiment with economic tools that can be applied in each horizon, including the Value of Information, Monte Carlo and Cost of Delay.

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Economic Frameworks

  1. 1. i290 lean/agile product management unit 2: economic frameworks @jezhumble This work © 2015-16 Jez Humble Licensed under a Creative Commons Attribution-ShareAlike 4.0 International License.
  2. 2. grasp the principles of cost of delay understand the principles of decision theory calculate the value of information make product decisions in an economic framework know how to apply optionality learning outcomes
  3. 3. “you may ignore economics, but economics won’t ignore you” — Don Reinertsen “The measure of execution in product development is our ability to constantly align our plans to whatever is, at the moment, the best economic choice.” — Don Reinertsen
  4. 4. decision theory The analysis of complex decisions with significant uncertainty can be confusing because 1) the consequence that will result from selecting any specified decision alternative cannot be predicted with certainty, 2) there are often a large number of different factors that must be taken into account when making the decision, 3) it may be useful to consider the possibility of reducing the uncertainty in the decision by collecting additional information, and 4) a decision maker's attitude toward risk taking can impact the relative desirability of different alternatives. Craig W Kirkwood, Decision Tree Primer, p1
  5. 5. risk matrix probability (0-1) impact($) low probability low impact high probability low impact low probability high impact high probability high impact
  6. 6. decision tree temperature sensor: • development cost: $100k, revenue $1m • probability of success: 0.5 pressure sensor: • development cost: $10k, revenue $400k • probability of success: 0.8
  7. 7. decision trees Craig W Kirkwood, Decision Tree Primer, p4 EV=$400,000 EV=$310,000 EV=$0 EV=$400,000
  8. 8. exercise
  9. 9. value of information • information reduces uncertainty about decisions that have economic consequences • information affects the behavior of others, which has economic consequences • information sometimes has its own market value Douglas Hubbard, How to Measure Anything (3rd edn), p145
  10. 10. measurement A quantitively expressed reduction of uncertainty based on one or more observations Douglas Hubbard, How to Measure Anything (3rd ed.), p31
  11. 11. perfect information Value of information = EV after - EV before = $100k
  12. 12. value of information Expected Opportunity Loss (EOL) = chance of being wrong x cost of being wrong Expected Value of Info (EVI) = Reduction in EOL; EVI = EOLbefore info — EOLafter info Expected Value of Perfect Info (EVPI) = EOLbefore info (since EOLafter info is zero if info is perfect) Douglas Hubbard, How to Measure Anything (3rd ed.), ch. 7
  13. 13. build-measure-learn
  14. 14. not normally binary decisions — a continuum humans are risk averse when the stakes are high use utility functions; reduce stakes don’t capture time dependence use calculus monte carlo analysis problems with decision trees
  15. 15. opportunity cost In microeconomic theory, the opportunity cost of a choice is the value of the best alternative foregone, where a choice needs to be made between several mutually exclusive alternatives given limited resources. Assuming the best choice is made, it is the "cost" incurred by not enjoying the benefit that would be had by taking the second best choice available. Wikipedia
  16. 16. time is money t = m Δt = Δm Δt ( ) = Δm cost of delay
  17. 17. cost of delay Task A: upgrade package to support credit card encryption CoD: fine of $50,000 per day we’re not in compliance. Duration: 2 weeks Task B: Complete a feature for a key customer CoD: we’ll close $100,000 per week with this feature Duration: 1 week
  18. 18. cost of delay Task A: 2 weeks, CoD $250k / week Task B: 1 week, CoD $100k / week
  19. 19. urgency profiles
  20. 20. exercise Should I wait for the feature? We have completed sufficient features for 85% of our target customers. We can: • Take 2 more months to finish last 15% • Launch what we have, add last 15% in next release, 6 months from now Cost of delay for project: $200,000 / month
  21. 21. exercise Delay 85% of functionality by 2 months: $200,000 x 0.85 x 2 = $340,000 Delay 15% of functionality by 6 months: $200,000 x 0.15 x 6 = $180,000
  22. 22. technology adoption lifecycle Geoffrey Moore, Crossing the Chasm
  23. 23. three horizons Baghai, M., Coley, S. and White, D., The Alchemy of Growth
  24. 24. Intuit horizons and metrics
  25. 25. optionality Nassim Taleb, Antifragile