Project Management Under Risk: Using the Real Options Approach to Evaluate Flexibility in R&D

• Authors: Arnd Huchzermeier;Christoph H. Loch
• Venue: Management Science
• Year: 2001

Managerial flexibility has value in the context of uncertain R&D projects, as management can repeatedly gather information about uncertain project and market characteristics and, based on this information, change its course of action. This value is now well accepted and referred to as "real option value." We introduce, in addition to the familiar real option of abandonment, the option of corrective action that management can take during the project. The intuition from options pricing theory is that higher uncertainty in project payoffs increases the real option value of managerial decision flexibility. However, R&D managers face uncertainty not only in payoffs, but also from many other sources. We identify five example types of R&D uncertainty, in market payoffs, project budgets, product performance, market requirements, and project schedules. How do they influence the value from managerial flexibility? We find that if uncertainty is resolved or costs/revenues occurafter all decisions have been made, more variability may "smear out" contingencies and thus reduce the value of flexibility. In addition, variability may reduce the probability of flexibility ever being exercised, which also reduces its value. This result runs counter to established option pricing theory intuition and contributes to a better risk management in R&D projects. Our model builds intuition for R&D managers as to when it is and when it is not worthwhile to delay commitments--for example, by postponing a design freeze, thus maintaining flexibility in R&D projects.