Application of Real Options theory to software engineering for strategic decision making in software related capital investments

Abstract

As it stands today, software is the major expense in software intensive systems. Therefore, software is, and should be treated as a capital investment and an approach emphasizing a strategic investment methodology in its acquisition is necessary. The strategic flexibility in software engineering decisions can be valued as a portfolio of options or real assets, much akin to options on financial securities which have real economic value under uncertainty. This approach would emphasize the linking of program management decisions to current and future unknown situations within the stipulated parameters of cost, schedule and functionality thus giving the managers a set of choices or options. This dissertation describes a strategic decision-making process that is based on the general concepts of initiating the software acquisition process with a situation assessments phase, generating the appropriate strategic actions and deriving the benefits or value created either explicitly or in the form of Real Options. We present a framework based on Real Options theory to allow decision makers to better balance customer requirements as dictated by operational needs within financial viability and schedule constraints through the identification, valuation and optimization of strategic decision pathways created in the form of Real Options. We apply the framework to the software component (Future Combat Systems Network) of U.S. Army Future Combat System (FCS). Our study found that when properly formulated, a Real Options approach could be used as an effective risk management tool to guide decision-making at the software acquisition level further complementing the risk-driven spiral development approach currently being utilized in the U.S. Department of Defense (DoD) evolutionary acquisition model.