Hubbard

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Applied Information Economics Kickoff for Risk
Return Analysis
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What is AIE?
Applied Information Economics is the practical
application of scientific and mathematical
methods to quantify the value of IT-enabled
business investments
Economics
Applied Information Economics
Modern Portfolio Theory
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Real Solutions to

• the economics of information
• the economics of IT infrastructure
• the economics of risk
• the economics of labor reduction when headcount
  is not reduced
• Bottom Line AIE assesses and prioritizes IT
  investments based on quantitative and
  economically rational methods

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What Do the Critics Say?

• Quantifying the risk and comparing its
  risk/return with other investments sets AIE apart
  from other methodologies. It can substantially
  assist in financially justifying a project --
  especially projects that promise significant
  intangible benefits. The Gartner Group
• AIE represents a rigorous, quantitative approach
  to improving IT investment decision making..this
  investment will return multiples by enabling much
  better decision making. Giga recommends that IT
  executives learn more about AIE and begin to
  adopt its tools and methodologies, especially for
  large IT projects. Giga Information Group
• AIE-like methods must become the standard way to
  make (IT) investment decisions. Forrester
  Research, Inc.

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Basic Risk/Return Analysis
Organization
Procedure
Tools
AIE
Deliverables
AIE
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Describe, Classify Plan

• Purpose Agree on the specific investment to be
  analyzed, Agree on the specific question to be
  answered, Plan the rest of the analysis

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Clarify The Decision Model

• During Clarification we translate the
  Intangibles into measurable units
• These are ultimately modeled in a spreadsheet

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Understanding Measurement(The Measurement.com
approach)

• Gilbs Law Anything can be measured in a way
  which is superior to not measuring it at all
• The perceived impossibility of measurement is an
  illusion caused by not understanding
• the Concept of measurement
• the Object of measurement
• the Methods of measurement
• See my Everything is Measurable article in CIO
  Magazine (got to articles link on
  www.hubbardresearch.com

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Conduct Measurements

• We use the variety of measurement methods
  previously discussed
• We usually start with what we know now (i.e.
  calibrated estimates)
• More elaborate measurements (large controlled
  experiments or surveys) are only taken if we can
  show they are economically justified

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Calibrated Estimates

• Measuring your own uncertainty about a quantity
  is a general skill that can be taught with a
  measurable improvement
• Studies show that most managers are statistically
  overconfident when assessing their own
  uncertainty
• Training can calibrate people so that when they
  provide a 90 confidence interval, it still has a
  90 chance of being right (even though it is
  subjective)

When asked to provide a subjective 90
confidence interval, most managers provide a
range that only has about a 40-50 chance of
being right
Perceived 90 Confidence Interval
Actual 90 Confidence Interval
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Calculate the Value of Information

• The value of additional information can be
  calculated for each uncertain variable in the
  analysis
• Measurement efforts will be more productive by
  focusing on variables that matter the most
  (results are often surprising)
• This method is based on the probability of a
  change in a decision with additional information
  and the difference in the value of the decision

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The Economic Value of Information
The Decision Theory Formula

• What it means
• Information reduces uncertainty
• Reduced uncertainty improves decisions
• Improved decisions satisfy business objectives
  (by definition)

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Conduct Risk/Return Analysis
Administrative Cost Reduction
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10
15
Improvement in Customer Retention
10
20
30
Total Project Cost
2 million
4 million
6 million
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Make Recommendations

• The recommendations include
• To accept or reject the investment
• Possible modifications to the proposed investment
  
• Various risk management tactics
• Deliverables include
• The written report
• The spreadsheet
• The presentation

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Overview of RRA Analysis
Classification
Value of Info.

Intangibles Customer Satisfaction Strategic
Alignment Technology Risk Information
Quality etc.


Measurables Errors in Decision X Change to
Strategic Measure M Productivity in Activity
Y Chance of cancellation, etc.
Risk
Organization's investment limit
Acceptable region of investment
Return
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Workshops

• Much of the initial data gathering is from a
  series of workshops
• We need to schedule 5-6 workshops for the
  following activities
• Define Classify the investment
• Clarify Decision Model
• Measurement (initial)
• Calibration
• Estimation

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Defining the Investment

• What is the objective of this investment? (A
  one-sentence description of why)
• What costs are unique to this investment?
• What benefits are unique to this investment?
• What are the risks of the investment?
• What decision dimensions are important besides
  just an accept/reject recommendation?
• Is all of the investment optional?
• The decision is analyzed on behalf of which
  investor?

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The Concept Of Measurement

• Sometimes one believes that a thing is
  immeasurable only because they do not actually
  understand the concept of measurement
• The Measurement Theory definition of
  measurement A measurement is an observation
  that results in information (reduction of
  uncertainty) about a quantity.
• Any reduction of uncertainty about a quantity
  can be of value

?
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Real-world Measurements vs. Ideal Values
Ideal Values Point
Real-world Meas.
Normal Distribution
Uniform Distribution
Lognormal Distribution
Hybrid
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85
Threshold confidence
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The Object of Measurement

• If a thing seems like and immeasurable
  intangible it may just be ill-defined
• Often, if we can define what we mean by a certain
  intangible we find ways to measure it

?
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The Clarification Chain

• AIE assumes that if a benefit or cost is defined
  unambiguously, then it is measurable.
• If it is Better it is different in some
  relevant way...
• If it is relevantly different then it is
  observable...
• If it is observable then it is observable in some
  amount...
• If we can observe it in some amount then it is
  measurable.

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The Thought Experiment

• Imagine that you are a scientist capable of
  making clones of entire companies and that you
  have a cloned pair of your company
• Change one of the companies so that one has the
  stated intangible and the other does not
• Ask what would you actually observe that would be
  different between the two companies

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Examples of Clarification
The Intangible
Possible Meanings After Clarification

• Less management overhead
• Certain decisions are more accurate and faster

Employee Empowerment
Information Availability

• Time and cost of searching is reduced
• Certain costly errors are less frequent

Customer Relationship

• Increased repeat business

• Tools like The Clarification Chain are used to
  identify unit-of-measure variables hidden beneath
  the intangible label
• I offer a challenge that given any intangible, I
  can clarify it and identify a method of
  measurement within 15 minutes (Ive never lost)