Optimal Exercise Point

April 13, 2010

Although I have been making use of them over the last 18 months in various presentations and the real options tutorial, I recently realised I’d omitted to publish graphs illustrating the optimal exercise point for real options on this blog. As a result, here they are:

The dotted blue line represents risk entailed by the agilist’s Cone of Uncertainty, and covers technical, user experience, operational, market and project risk – in short anything that could jeopardise your return on investment. The way this curve is negotiated is detailed below, by driving out mitigation spikes to address each risk.

The dotted brown line represents risk from late delivery. At a certain point this will start rising at a rate greater than your mitigation spike s are reducing risk, creating a minimum in the Cumulative Risk curve denoted in red. Remembering that

Feature Value = ((1 - Risk) x Generated Value) - Cost

this minimum identifies the Optimal Exercise Point.

One point worth exploring further is why Delayed Delivery is represented as risk rather than cost. The reason is because Cost of Delay is harder to model. For example, let’s say we are developing a new market-differentiating feature for a product. Let’s also say that there are X potential new customers for that feature in our target market, and that it would take Y weeks of marketing to convert 80% of those sales. Providing whenever we do launch, there remains Y weeks until a competitor launches a similar feature then then the cost of delay may be marginal. On the other hand, if we delay too long and a competitor launches their feature before us then there will be a massive spike in cost due to the loss of first mover advantage. However the timings of that cost spike will be unknown (unless we are spying on the competition), and therefore very hard to capture. What we can model though is the increasing risk is of that spike biting us the longer we delay.

I have found it very helpful to think about this using the insightful analysis David Anderson presented during his excellent risk management presentation at Agile 2009 last year. He divides features into four categories:

  • Differentiator: drive customer choice and profits
  • Spoiler: spoil a competitor’s differentiators
  • Cost Reducer: reduce cost to produce, maintain or service and increase margin
  • Table Stakes: “must have” commodities

Differentiators (whether on feature or cost) are what drive revenue generation. Spoilers are the features we need to implement to prevent loss of existing customers to a competitor, and are therefore more about revenue protection. And Table Stakes are the commodities we need to have an acceptable product at all. We can see how this maps clearly onto the example above. The cost of delay spike is incurred at the point when the feature we intended to be a differentiator becomes in fact only a spoiler.

This also has a nice symmetry with the meme lifecycle in product S-curve terms.

We can see how features start out as differentiators, become spoilers, then table stakes and are finally irrelevant – which ties closely to the Diversity, Dominance and Zombie phases. There are consequences here in terms of market maturity. If you are launching a product into a new market then everything you do is differentiating (as no-one else is doing anything). Over time, competitors join you, your differentiators become their spoilers (as they play catch-up), and then finally they end up as the table stakes features for anyone wishing to launch a rival product. In other words, the value of table stakes features in mature markets is that they represent barrier to entry.

More recently however, I have come to realise that these categories are as much about your customers as your product. They are a function of how a particular segment of your target market views a given feature. Google Docs is just one example that demonstrates how one person’s table stakes can be another person’s bloatware. Similarly, despite the vast profusion of text editors these days, I still used PFE until fairly recently because it did all the things I needed and did them really well. Its differentiators were the way it implemented my functional table stakes. The same is true of any product that excels primarily in terms of its user experience, most obviously the iPod or iPhone. Marketing clearly also plays a large part in convincing/co-ercing a market into believing what constitutes the table stakes for any new product, as witnessed in the era of Office software prior to Google Docs. The variation in the 20% of features used by 80% of users actually turned out not to be so great after all.

So what does this mean for anyone looking to launch a product into a mature market? Firstly, segment you target audience as accurately as possible. Then select the segment which requires the smallest number of table stakes features. Add the differentiator they most value, get the thing out the door as quickly as possible, and bootstrap from there.


One Response to “Optimal Exercise Point”

  1. Gregor said

    I am a weather forecaster and preparing my PhD thesis on weather forecasts. You know, this area is full of uncertainties, for this reason since the very beginning of my job I habe been looking for tools to describe theme and reduce to minimum. I hope that information contained in the article will turn out to be useful form me.

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