All organizations have some amount of resilience, the ability to mobilize resources to absorb negative impacts. Forward-thinking organizations will plan their resilience in advance, perhaps even making investments in “contingent capabilities,” responses that activate only in specific circumstances to carry the organization through the risk impact and back to normal performance.
By their definition, contingent capabilities may never be called into action, benefits never captured, even though the costs were realized. Investments in resilience have quite different characteristics from investments in ongoing operations and cannot be correctly assessed with traditional valuation methodologies.
Even when they explicitly account for risk, traditional valuation methodologies often provide a dramatically inaccurate assessment of the value a particular resilience capability would create for the organization.
Real Options Analysis, on the other hand, uses advancements in modern finance to more accurately value the expected benefits from investments in resilience capabilities.
What is Real Options Analysis?
Real Options Analysis applies financial options theory that is common in the securities markets to the valuation and management of non-financial investments/projects inside corporations.
Financial options represent the “right but not the obligation” to buy or sell financial assets at certain prices. Similarly, a “real option” is a capability that can be used, but not obligated, in specific conditions. If a risk event materializes, this option can be activated to reduce the risk itself. Consider the option of carrying an umbrella on a cloudy day: creating the option to respond requires an upfront investment (carrying the umbrella around), and the response has benefits if needed (staying dry). However, if the risk event does not occur (no rain), then you only realize the expense (carrying the umbrella).
All of these resilience capabilities have option-like characteristics, so the correct cost-benefit analysis for their selection, optimization, and implementation should be done with Real Options Analysis valuation methodology.
- Building up additional sources of spare parts and materials gives you the option to sustain operations during a failure of the traditional supply chain, at the cost of excess inventory.
- Maintaining spare capacity gives you the option to use that capacity in case of production failure, at the cost of carrying unused capability.
- Cross-training employees gives you the option for quick and effective substitution in case of a particular labor shortage, at the cost of time and energy in training.
- Switching between gas and electricity in hybrid cars gives you the option of flexibility in fuel use, at the cost of higher manufacturing cost and complexity.
- Securing revolver-type financing gives you the option to access additional funding in times of liquidity crunch, at the cost of higher negotiated pricing.
- Introducing subscription-type pricing with customers gives you the option to maintain revenues in a situation of usage decline, at the cost of shorter-term contracts.
Evaluating contingent capabilities with Real Options Analysis
An investment project may be represented as a cone of likely scenarios. For every future period, there is a range of possible cash flows with corresponding probabilities. The riskiness of the project is represented with extreme values in the lower tail of the probability distribution.
While the upfront and ongoing expenses for creating contingent capabilities are incorporated in the scenarios, the continuing benefits are modeled as optimally executed options under different risk scenarios.
The option pricing methodology correctly accounts for the risk of each scenario and reflects it in its discount rate. As a result, Real Options Analysis provides a single, NPV comparable value for the contingent benefits, which can be compared with the required expenses and used as a clear Go/No-Go decision rule for resilience-related projects.
As actionable resilience grows in importance, organizations will be facing a distinct set of cost-benefit challenges to determine the value-accretive amount of spending on the management of specific risks and the risk portfolio as a whole. Using Real Options Analysis helps organizations not only to justify and secure sufficient funding, but also to optimize and prioritize the projects to be implemented.