DTIC ADA487701: Using Options to Manage Dynamic Uncertainty in Acquisition Projects

19 Pages·0.19 MB·English

by  Defense Technical Information Center

Using Options to Manage Dynamic Uncertainty in Acquisition Projects
241
Report Documentation Page Form Approved
OMB No. 0704-0188
Public reporting burden for the collection of information is estimated to average 1 hour per response, including the time for reviewing instructions, searching existing data sources, gathering and
maintaining the data needed, and completing and reviewing the collection of information. Send comments regarding this burden estimate or any other aspect of this collection of information,
including suggestions for reducing this burden, to Washington Headquarters Services, Directorate for Information Operations and Reports, 1215 Jefferson Davis Highway, Suite 1204, Arlington
VA 22202-4302. Respondents should be aware that notwithstanding any other provision of law, no person shall be subject to a penalty for failing to comply with a collection of information if it

does not display a currently valid OMB control number.
1. REPORT DATE 3. DATES COVERED
2002 2. REPORT TYPE 00-00-2002 to 00-00-2002
4. TITLE AND SUBTITLE 5a. CONTRACT NUMBER
Using Options to Manage Dynamic Uncertainty in Acquisition Projects
5b. GRANT NUMBER
5c. PROGRAM ELEMENT NUMBER
6. AUTHOR(S) 5d. PROJECT NUMBER
5e. TASK NUMBER
5f. WORK UNIT NUMBER
7. PERFORMING ORGANIZATION NAME(S) AND ADDRESS(ES) 8. PERFORMING ORGANIZATION
Texas A&M University,Department of Civil Engineering,College REPORT NUMBER
Station,TX,77843
9. SPONSORING/MONITORING AGENCY NAME(S) AND ADDRESS(ES) 10. SPONSOR/MONITOR’S ACRONYM(S)
11. SPONSOR/MONITOR’S REPORT
NUMBER(S)
12. DISTRIBUTION/AVAILABILITY STATEMENT
Approved for public release; distribution unlimited
13. SUPPLEMENTARY NOTES
Acquisition Review Quarterly, Fall 2002
14. ABSTRACT

15. SUBJECT TERMS
16. SECURITY CLASSIFICATION OF: 17. LIMITATION OF 18. NUMBER 19a. NAME OF
ABSTRACT OF PAGES RESPONSIBLE PERSON
a. REPORT b. ABSTRACT c. THIS PAGE Same as 18
unclassified unclassified unclassified Report (SAR)
Standard Form 298 (Rev. 8-98)
Prescribed by ANSI Std Z39-18
Acquisition ReviTeUwT QOuRarItAeLrly — Fall 2002
USING OPTIONS TO MANAGE
DYNAMIC UNCERTAINTY IN
ACQUISITION PROJECTS
B. Kagan Ceylan, Ph.D. and David N. Ford, Ph.D.
Uncertainty in acquisition projects and environments can degrade performance.
Traditional project planning, management tools, and methods can effectively
deal with uncertainties in relatively stable environments. But in more uncertain
environments conditions can evolve beyond the assumptions used in preproject
planning and require major deviations from initial plans. Important uncertainties
often cannot be identified and described adequately during preproject planning
to design optimal strategies. Therefore, rigid project strategies prepared solely
on the most likely outcomes as perceived during preproject planning can result
in sub-optimal performance. In these cases, acquisition planners must explicitly
incorporate flexibility into project plans to keep effective strategies available
until uncertainty resolves adequately to reveal the best choice. Options can
provide an effective framework for designing, evaluating, and implementing
flexible acquisition project strategies and therefore can improve project
performance. A large complex defense project illustrates the potential and
challenges of options and research needs to expand and improve their use to
manage uncertainty.
M
aximizing the value of acquisi- defense acquisition projects also include
tion projects in dynamic envi- technology research and development in
ronments is difficult partially dynamic and unpredictable environments.
because project managers must manage a These development efforts can pose sig-
variety of environmental and internal un- nificant risks for the entire project because
certainties as well as more common their outcomes are often predecessors of
project complexities. Miller and Lessard major activities, and failures or delays in
(2000) report that success for 60 large these efforts propagate through the
($985 million average cost) engineering project. How can managers of large com-
projects, including research and develop- plex defense projects plan for and manage
ment projects, depended on how uncer- critical uncertainties?
tainty was managed. Many large complex
242
Using Options to Manage Dynamic Uncertainty in Acquisition Projects
Development projects risk suboptimal uncertainties” and describe in more detail
performance if uncertainty is not explic- why they are difficult to manage.
itly addressed in project planning. Many Three characteristics of uncertainty in
acquisition strategies are based on a large complex defense projects make it
project’s characteristics and environment particularly difficult to manage. First, one-
during front end planning. If these char- of-a-kind research and development ef-
acteristics and environments are relatively forts provide few opportunities to develop
stable, initial plans can absorb changes in routines that can be evaluated and thereby
the project or its environment, changes in improved. Therefore, historical experience
acquisition strategies are not required, and is not available to inform forecasts of un-
traditional preproject planning is adequate. certain features. In addition, one-of-a-kind
But some critical conditions evolve over work provides an inadequate understand-
time and the conditions, times, and mana- ing of new technologies or their imple-
gerial choices for effective decision mak- mentation during preproject planning to
ing cannot be completely and accurately make forecasts that are accurate enough
determined during preproject planning. for strategy selection.
Additional data collection can some- Second, long project durations (e.g.,
times improve descriptions of apparently 10.7 years average in the previously cited
large uncertainties and thereby improve Miller and Lessard study; 2000) allow en-
preproject planning. But traditional vironments to evolve far from preproject
preproject planning can conditions. These dynamic uncertainties
fail to develop adequate can cause strategies that are optimal during
“Designing acqui-
strategies for uncertain- preproject planning to become obsolete in
sition strategies
ties that are, or appear to later stages of the projects.
that can be used
be, too difficult or im- Third, tight coupling among project
to successfully
possible to accurately components create complex dynamic sys-
manage dynamic
uncertainties is an predict and, therefore, tems. Understanding individual project
important but be the basis for effective components is inadequate for understand-
difficult part of strategy development ing the system (Sterman, 1994; Senge,
project planning.” before a project must 1990). This increases project uncertainty
proceed. These residual and the difficulties of forecasting and plan-
uncertainties must be managed both stra- ning. How can defense acquisition project
tegically and dynamically because planners proactively prepare for dynamic
changes that occur during project execu- uncertainty?
tion may render the best course of action Designing acquisition strategies that
suboptimal, as determined during front can be used to successfully manage dyna-
end planning, (Gupta & Rosenhead, mic uncertainties is an important but
1968). Ford, Lander, and Voyer (2002) difficult part of project planning. Uncer-
refer to these uncertain project compo- tainties that cannot be identified or fore-
nents and environmental impacts that only casted can only be managed reactively
evolve adequately for strategy selection with adaptive systems and managers
after preproject planning as “dynamic (DeMeyer, Loch, & Pich, 2002). But many
243
Acquisition Review Quarterly — Fall 2002
dynamic uncertainties can be characterized modularity can provide competitive ad-
adequately to be managed proactively by vantage for modular products, particularly
anticipating multiple scenarios to project in environments in which product life
goals and using flexible strategies to dy- cycles grow shorter. However, tools and
namically choose the best strategy based methods to create and measure options in
on how uncertainty resolves. acquisition projects are not yet available.
Options can provide a framework for A lack of structured methods and tools that
using flexible strategies to describe, de- can guide planners in building flexible
sign, evaluate, and implement strategies project plans to manage dynamic com-
directed at dynamic uncertainties. An plexity remains a barrier to improved ac-
option is a right without an obligation to quisition project management.
take specific future actions depending on In the current work, options are de-
how uncertain conditions evolve (Amram scribed and evaluated as a tool for man-
& Kulatilaka, 1999). Mathematical aging dynamic uncertainty from a mana-
models first developed to value options on gerial perspective. Based on this evalua-
financial assets (Bookstaber, 1982; Cox, tion, we hypothesize that the lack of a
Ross, & Rubinstein, 1979; Black & theory of options prac-
Scholes, 1973) have been adapted to real tice constrains the de-
“Both options —
assets and analyzed (Brealey & Meyers, scription, evaluation,
theory and
2000; Trigeorgis, 1993, 1996; Dixit & and advancement of
decision analysis
“Rigid st
Pindyck, 1994; Kemna & Vorst, 1990), options to improve ac-
—provide formal
planning
applied to engineering (Benaroch, 2001; quisition. To specify, mathematical
ods have
Baldwin & Clark, 2000; Park & Herath, clarify, and support our methods for
inadequa
2000), and promoted as a strategic plan- hypothesis, descriptions valuing options
the high
ning aid by both academics (Miller & of approaches to manag- that have been
plexity a
Lessard, 2000; Amram & Kulatilaka, ing uncertainty are fol- designed.” dynamics
1999; Bierman & Smidt, 1992; Kensin- lowed by a description large pu
ger, 1988) and practitioners (Leslie & of options from a managerial process per-
Michaels, 1997). spective. One use of options in a large
Both options — theory and decision complex defense project is described to
analysis — provide formal mathematical illustrate the use of options in practice and
methods for valuing options that have been to identify research needs to improve
designed. However, less research exists on acquisition planning and management.
option design, assessment, and implemen-
tation processes for practicing planners
TRADITIONAL PLANNING TOOLS
and managers. The recent option design
research has primarily focused on modu- FOR MANAGING UNCERTAINTY
larity in product development (Baldwin &
Clark, 2000), where options are created Many domains address aspects of
by allowing the mixing and matching of managerial decision making under uncer-
product modules in response to changing tainty. Among them, strategic manage-
conditions in the environment without ment, preproject planning, and risk man-
changing the entire product. Thereby, agement provide planning tools and
244
Using Options to Manage Dynamic Uncertainty in Acquisition Projects
methods that can be applied to managing levels, but these concepts have not been
development project uncertainty. Relevant developed into implemental processes for
portions of these theories and their use by managing projects.
defense agencies are briefly described and Rigid strategic planning methods, such
evaluated to establish the available mod- as those using the critical path method
els of options to manage dynamic project coupled with risk analysis, have proven
uncertainty in large complex defense inadequate for the high complexity and
projects. The potential contributions of dynamics of large public acquisition
some other theories to the managerial use projects (Hughes, 1998). As a result,
of options are then described. several federal agencies (e.g., the Depart-
ment of Defense [DoD] and the National
STRATEGIC MANAGEMENT Aeronautics and Space Administration
Strategic management explicitly ad- [NASA]) abandoned rigid approaches as
dresses the management of uncertainty early as the 1960s in favor of more strate-
with flexible plans and strategic adapta- gic and adaptive approaches (Sayles &
tion after initial strategy selection (Mintz- Chandler, 1971; DoD, 2001; Department
berg, 1978; McGrath & MacMillan, of Energy [DOE], 2002; Department of
2000). Although strategic management Navy [DON], 2001). For example, Depart-
focuses on ongoing en- ment of Defense Regulation 5000.2-R
terprises, uncertainty (DoD, 1996) requires a phased decision-
“Rigid strategic
also must be explicitly making process with exit criteria reviews
planning meth-
incorporated into project at each phase and the parallel development
ods have proven
strategies to maximize of multiple concepts. These provide op-
inadequate for
the high com- performance (Miller & tions to abandon portions of projects as a
plexity and Lessard, 2000). Strategic means of strategic adaptation if the ob-
dynamics of planning integrates envi- jectives can no longer be justified in the
large public ronmental opportunities light of unfolding events.
and threats with internal
strengths and weak- PREPROJECT PLANNING
nesses into potentially flexible strategic Preproject planning includes a project
plans that are the basis for specific projects strategy selection process (Mintzberg,
(Mintzberg, 1995). 1978) that is widely used by industry
According to Mintzberg (1978), stra- (Construction Industry Institute [CII],
tegic planning traditionally depicts a 1995; CH2MHill, 1996) and defense
highly ordered and neatly integrated pro- agencies (DoD, 1996; DOE, 2002; DON
cess. In response to dynamic environments 2001). Preproject planning compares al-
strategic management uses strategic ternative technologies, sites, etc. to iden-
adaption, which updates strategies con- tify the best feasible project strategy
tinuously, thereby remaining flexible (Por- within project constraints. This method is
ter, 1980). Strategic management, plan- effective in some contexts, but assumes
ning, and adaptation processes exist for that planners are fully informed about the
ongoing enterprises at relatively aggregate project and that the project environment
245
Acquisition Review Quarterly — Fall 2002
is relatively stable, or at least predictable OTHER DOMAINS
(Mintzberg, 1978). Therefore, preproject Other research domains provide insight
planning does not provide the flexibility into particular aspects of how planners and
required to successfully manage the dy- managers can and do address uncertainty.
namic complexities inherent in many de- Research on decision making potentially
fense projects. contributes to understanding the manage-
rial use of options through decision analy-
RISK MANAGEMENT sis and game theory. By addressing the
Risk management tools and methods process of decision making by isolated
are also widely used by industry (CII, individuals under uncertainty, decision
1989; Chapman & Ward, 1997; Koller, analysis (Luce & Raiffa, 1957; Raiffa,
1999) and defense agencies (DoD, 2001; 1970) provides a potentially effective
DOE, 2002; DON, 2001) to manage approach to structuring and managing
project uncertainties by identifying criti- uncertainties that can be characterized in
cal risks, marshalling resources to absorb sufficient detail to select optimal strategies
the consequences of uncertainty resolu- during preproject planning.
tion that threaten project performance, and However, in highly complex and dy-
developing contingency plans. These namic acquisition project environments
methods often react to uncertainties after such as those investigated here, project
they resolve in undesired ways. For ex- planners may not be able
ample, contingency funds can be used to to assess all uncertainties
“In marshalling
respond to uncertain site conditions (e.g., with the well-defined
resources, risk
poor soils) by paying for the additional probability distributions
management
costs of excavation, but only after the site required for decision
aggregates risks
conditions have been revealed and the un- analysis. In these cases, to assess their
certainty has resolved in an undesirable flexibility in the form of impacts and
way. options can address this thereby estimate
In marshalling resources, risk manage- residual uncertainty and slack resource
ment aggregates risks to assess their im- improve solutions. For requirements.”
pacts and thereby estimate slack resource example, Mandelbaum
requirements. While useful for analysis and Buzacott (1990) show that using
and modeling, aggregating risks contrasts options in a manufacturing setting with
sharply with the reductionist approach residual uncertainty after preproject plan-
used by managers to isolate specific indi- ning can improve decisions over those
vidual critical uncertainties for customized made solely using decision analysis. Game
management. Although sometimes used theory (Luce & Raiffa, 1957) adds com-
with options, the identification of critical petition with others to decision analysis
risks and contingency planning have not and can provide insight if the managed un-
been developed operationally in risk man- certainty conforms to the assumptions
agement to provide managers guidance used to characterize competing decision
concerning how to use flexibility to makers (e.g., payoff maximization or rec-
improve project performance. onciliation objectives). The contribution
246
Using Options to Manage Dynamic Uncertainty in Acquisition Projects
of game theory may be limited when the managerial practice as well as manage-
managed uncertainty has a significant rial theory.
natural or random nature (i.e., not human
decision making), such as those addressed
OPTIONS AS TOOLS FOR STRATEGICALLY
here.
Senge (1990) describes why dynamic MANAGING DYNAMIC UNCERTAINTY
systems are complex and difficult to plan
and manage. He recommends systems One means of achieving flexibility to
thinking as an approach address dynamic complexity is to delay
to managing dynami- committing to a strategy until uncertainty
“Options add
cally complex systems. resolves, new information becomes avail-
value by allowing
Simon (1996) used able, and the better strategy is clearer
managers to
bounded rationality to (Gupta & Rosenhead, 1968). For example,
capture more
explain how the cogni- Ward, Liker, Cristiano, and Sobek (1995)
benefits or shift
risks depending tive limitations of deci- report how delaying the selection of
on how one or sion makers influence automobile systems creates competitive
more uncertain their information pro- advantage for Toyota in time-to-market
parameters cessing and behavior. In and quality. Options structure managerial
behave.” this context, managerial flexibility into delayed opportunities with-
options can be seen as a out obligations to change strategies to
tool for bridging the gap between the com- improve asset performance. Options add
plexities of defense acquisition projects value by allowing managers to capture
described by Senge and the cognitive more benefits or shift risks depending on
capacities of managers described by how one or more uncertain parameters
Simon. Ford (2002) provides a specific behave. For example, a contract clause
example of a traditional tool for bridging permitting the termination of the contract
this gap in development projects. if a critical technology is not developed
In summary, strategic management as provides the government with an oppor-
described by defense agencies and indus- tunity (but not an obligation) to terminate
try provides general guidelines for project depending on how the technology
flexibility. But the processes, methods, feasibility uncertainty resolves.
and tools for developing flexible strate- Option taxonomies have been based on
gic plans for projects and adapting to the nature of the managed asset, the ob-
changes have not been operationalized jective of the management (risk mitiga-
adequately to be applied in the manage- tion or increased benefits), the timing of
ment of dynamic project uncertainty. delayed strategy selection decisions and
Preproject planning, risk management, uncertainty evolution, and actions taken
and other management decision-making on strategies (e.g., abandon, expand,
theories also do not provide operational switch, etc.). Trigeorgis (1996) and others
processes to proactively use flexibility to categorize and describe these classifica-
manage project uncertainty. A theory of tions. Options, as investigated here, are a
options practices in projects would reflect specific structure for the flexibility
247
Acquisition Review Quarterly — Fall 2002
through dual sourcing recommended in Managers recognize the need for flex-
defense acquisition guidelines (DoD, ibility when a possible resolution of un-
2001; Section 5.6.2; DON, 1998, Chapter certainty (a scenario) using a basic strat-
1). egy generates a performance scenario to
A managerial approach to options is be avoided (e.g., large costs) or captured
adopted here as the basis for investigating (e.g., improved product performance). In
their potential, challenges, and research the example, the depletion of design
needs as a tool for project planning and expertise could increase future costs be-
management. This approach focuses on yond budgets, constrain weapon develop-
the strategy design, assessment, and im- ment, or both, and the development of
plementation processes. It differs signifi- design expertise could improve weapon
cantly from existing approaches that focus performance.
on option valuation (Trigeorgis, 1996; Alternative strategies that could in-
Amram & Kulatilaka, 1999) or the strate- crease project value under specific uncer-
gic advantages of options (Courtney, Kirk- tainty resolution scenarios are then de-
land, & Viguerie, 1997; Andersen, 1999). signed. Examples for the weapon system
This managerial approach also differs could include contracting for the right to
from some addressed by defense acquisi- continue design after the current contract,
tion researchers and practitioners, includ- guaranteeing employment of critical em-
ing procurement quantity and perfor- ployees, or contracting
mance duration issues addressed in codi- other work to the vendor
“Options are
fied federal acquisition regulations (FAR; that develops design ex-
valuable only
subpart 17.2) and dual-use sourcing pertise. Option designs
when their
methods (DoD, 1996, section 3.3.1.2). include specific decision
benefits exceed
Despite the extensive use of options by rules for implementation
their costs.”
acquisition project practitioners (Miller & that describe the condi-
Lessard, 2000), few options processes are tions that trigger a
described in the literature, and most of change in strategy. Options are imple-
those are normative. Based on fieldwork mented by monitoring the uncertain
at the project described later, a typical parameters, analyzing them as necessary
process begins when a manager recog- to determine the status of the trigger, and
nizes (perhaps through risk assessment) changing strategies if and as indicated by
that the value of a managed asset may be the option design.
significantly impacted by how an un- Options are valuable only when their
predictable parameter behaves in the benefits exceed their costs. Options can
future. For example, a defense project provide a variety of benefits including
manager may recognize that the costs and improvements in economic performance,
planned development of a specialized stronger strategic position, broader man-
weapon (the asset) may depend on the agerial perspectives, expanded planning
design expertise of a critical vendor after processes, and increased productivity.
the end of an existing contract (the uncer- Options also generate costs, most visibly
tain parameter). in financial terms. Both initially purchasing
248
Using Options to Manage Dynamic Uncertainty in Acquisition Projects
the opportunity to choose strategies in the OPTIONS IN PROCUREMENT FOR
future and implementing strategy changes THE NATIONAL IGNITION FACILITY
can incur costs. In the weapon example, an
extension clause might increase the con-
Lawrence Livermore National Labora-
tract price and include computer upgrades
tory (LLNL) is developing the National
at government expense if the clause is in-
Ignition Facility (NIF) under contract with
voked. The economic valuation of options
the U.S. Department of Energy (DOE).
as a basis for strategy selection has been a
DOE’s goal is to generate the thermo-
primary focus of options research
nuclear conditions created in nuclear ex-
(Howard, 1976; Trigeorgis, 1996). Valua-
plosions in a laboratory setting. NIF will
tion methods for real assets compare net
be the world’s largest experimental fusion
asset values with a specific option strat-
facility, using 192 lasers to compress and
egy to asset values using a rigid strategy
heat a small capsule of material to fusion
to estimate option values. Ford, Lander,
ignition. The project budget is $2.248
and Voyer (2002) developed a simple nu-
billion to be spent over approximately 11
merical example of how an option can
years (Moses, 2002). Project success de-
increase the value of a development
pends on several large simultaneous
project.
research and development efforts to
Many acquisition project managers rec-
produce unique subsystems.
ognize the value of flexibility in manag-
Data were collected on the use of op-
ing dynamic uncertain-
tions to manage uncertainty at NIF by
ties and use options.
“Theories of observing four public presentations on the
However, the practice is
managing uncer- project by DOE and LLNL management,
rarely structured into the
tainty and valu- reviewing project documents, interview-
frameworks developed
ing options in ing the DOE project manager and LLNL
particular do not by options theoreticians. project and procurement managers, and
reflect options Theories of managing
visiting the site twice, including tours of
practice by acqui- uncertainty and valuing
the facility while under construction. NIF
sition planners options in particular do
managers were found to use options (al-
and managers.” not reflect options prac-
though they do not typically use that term)
tice by acquisition plan-
to manage many of the large uncertain-
ners and managers. This may be due to
ties inherent in the project. The LLNL
the complex, multi-dimensional nature of
project manager attributed the manage-
actual option settings, the difficulties of
ment team’s frequent use of flexibility (in-
integrating widely varying data types for
cluding options) to their focus on project
formal analysis, and the resulting infor-
objectives instead of specific solutions.
mal and tacit processes used by practitio-
This allows managers to identify multiple
ners. The process gap between options
potential strategies and scenarios to
theory and options practice limits the
success (Moses, interview, December 13,
description, evaluation, and improvement
2001). As will be illustrated, NIF manag-
of options use practices.
ers used these strategy: scenario sets to
design options.
249