Risk Adjusted ROI of Agile & Waterfall – A simple example

Inspired by Ron’s Comments on the Risk Adjust ROI of Agile and Waterfall post, I wrote a simple example to illustrate the point I was trying to make.

The expected ROI of an investment is often put into a spreadsheet where the present value of future expected cash flows is calculated using a discount factor based on the appropriate interest rate.

The ROI for a Waterfall Project:
equals
Discounted returns of expected future cash flows.
minus
Project Costs

The ROI for an Agile Project:
equals
Discounted returns of expected future cash flows (Higher due to getting cash flows earlier)
minus
Project Costs (Higher due to additional testing & release costs)

The higher value of discounted returns due to getting cash flows earlier is not that significant, especially in low interest rate conditions such as we are currently experiencing. The expected project costs are much higher as the testing and release will happen more times. The person putting the spreadsheet together would rightly assume that if we can reduce these costs, we would do so in both scenarios.

As such, Agile does not fair so well when compared to Waterfall using expected ROI.

Now lets consider the Risk Adjusted ROI.

The RAROI for a Waterfall Project:
equals
Discounted returns of expected future cash flows (The cash flows should be risk adjusted as well as simply discounted due to interest rates, resulting in a much smaller value).
minus
Project Costs

The RAROI for an Agile Project:
equals
Discounted returns of expected future cash flows (Higher due to getting cash flows earlier, especially given risk adjustment)
plus Option to increase investment
plus Option to change requirements
plus Value realised by reducing uncertainty through the tests
minus
Project Costs (Higher due to additional testing & release costs)
less Option to terminate early without losing investment to date
less Option to release without having to manually test

Using RAROI results in a much higher value for the Discounted Cash Flows in Agile than Waterfall. This is because the risk adjustment would be more significant and would have a great impact on the Waterfall cash flows that occur at the end of the project than the Agile project where the cash flows occur earlier. The risk adjustment would take into account for things such as:

  • The longer time before the product reaches the market increases the chance a competitor releases a similar product.
  • The longer the project is running, the more chance it has of being cancelled.

The options cannot be valued accurately. Only snake oil salesmen and fools would advise using Black Scholes. Instead, we make up some values for illustration purposes only. A simple option payoff multiplied by the probability will suffice.

Option to increase investment

If the value of the investment is shown to be significantly more than expected, more can be invested.

e.g. 10% chance of Value being double that expected.

5% chance of Value being ten times that expected.

Option to terminate early without losing investment to date

This option would save an amount of the costs. This option requires that the people on the project can be re-deployed onto something useful instead. For simplicities sake, lets assume that this relates the forty percent of feature never, or rarely used according to the Chaos Report. i.e. Forty percent of costs of the project.

Option to change requirements

So this relates to those forty percent of features cancelled. That money could be re-invested in valuable features instead. A potential up-tick of forty percent in the value.

Option to release without having to manually test

This is a particularly valuable option as it improves the resiliency of the system. Emergency production fixes can be put live without the risk of putting untested fixes into production, and without the delay of manual tests.

It can be seen that the Options in the RAROI create a significantly more robust argument for using Agile than Waterfall.

In summary, RAROI shows that Agile is superior than Waterfall whereas ROI does not. Often people think they are using ROI when in actual fact, they are using RAROI. Whilst it does not make a difference to normal people, it does to people who are experts in finance.

Thank you Ron for your thought provoking comments.

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About theitriskmanager

A IT programme manager specialising in delivering trading and risk management systems in Investment Banks. I achieve this by focusing on risk rather than cost. A focus on costs can lead to increased costs. View all posts by theitriskmanager

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