I’ve agreed to have one of my more popular, recent articles re-posted on Executive Brief: Is There A Better Way To Estimate Capital Projects?
I highly recommend the quality content on Executive Brief to any agile coaches, IT executives , managers, or scrum masters.
There’s a rush and excitement around virtual currencies. Much of it is being driven by social media giants, and the expected virtualization of everyone’s wallet that NFC will soon bring. But which virtual currencies have the greatest potential and do these pose any threat to the fiat currency regimes of the physical world? This article looks at these topics in more detail.
“Measured in real-world U.S. dollars, virtual transactions total $2.1 billion a year in the U.S. and $7.3 billion globally, according to Sometrics’ founder and chief executive, Ian Swanson. That is up 61% since 2008.” ~from Bank Technology News.
Many companies, not just start-ups, are getting into the virtual currency market. Facebook, Visa, American Express and even the big banks see the possibilities of owning, controlling and growing private digital currencies. But what’s fueling this rise? What is everyone getting so hopped up about?
Arbitrage – The most obvious eye popping opportunity is exemplified by the rise and fall of BitCoin. The graphic below comes from Wired Magazine, and shows the phenomenal investment opportunity you had for in 2010.
Tax Shelters – Corporations, the rich, pension funds, hedge funds, and others with too much money are always looking for some way to hide their capital gains from the taxman. What better way than to invest in digital assets using a virtual digital currency? Talk about off the books. But wait…. is that legal? Well it’s not regulated, at the moment, but governments around the world are aware of this phenomenon and many are watching it closely.
Deflation/Inflation Hedge – Particularly pertinent today, the potential for fiat currency de-valuation or appreciation in the face of mounting debts and uncontrolled deficit spending has given everyone with significant wealth an interest in finding a liquid, hedge to the big 3 ( dollar, yen, euro ). Gold has been the traditional favorite in this spot, but with gold prices soaring and the threat of a bubble looming….the need for alternatives is strong.
Power – Less obvious on the radar is the sheer power that comes from managing an entire economy’s money supply. A currency in isolation isn’t much. The dollar without the U.S. economy is little more than paper. What people find valuable in the dollar is the ability to buy goods and services from the single largest economy on earth. For that reason the dollar provides a very stable store of value and means of exchange. Similarly if a private virtual currency were to achieve such economies of scale…..say….dominating the global internet commerce business, then one could imagine the influence available. Even large physical economies like the EU and Japan ( and their respective central banks ) would need to listen to the issuer of such a currency.
Who Will Lead?
So there are three types of virtual currency players in the market today:
The Wildcats – These are the Ven and Bitcoin makers ( among others ). They’ve built their virtual currencies and are asking people to adopt it. It’s a hard road, with little incentive to convert your hard earned dollars, euros, or yen outside of arbitrage….it seems unlikely they’ll gain wide adoption.
The Closed Social Media Economies – With a captured market that has goods only purchasable using their currencies, these companies have modeled the very structure and incentives that make our modern physical economies today. The challenge is extending this concept outside of Facebook ( or whoever ) to other sites. But, the base is there.
The Banks – Ah….the banks. Long ago, private currencies were common place in Scotland and the Wild West of America. But when a bank went belly up…so did its currency….leaving all its depositors and paper holders staring down an empty well. Banks have a ready made market in their dealings with the wealthy, corporations, hedge funds, pension funds, etc.
The Transaction Grabbers – This is PayPal, Google, and maybe Isis. They’re seeking a sliver of the transaction fee market from their mobile payment platforms. But there’s no reason these players couldn’t introduce a virtual currency of their own.
So which group has the highest potential? My money would be in Google Dollars and Goldman Sachs Coins. This isn’t to say innovative new players won’t spring up, but the transaction grabbers and the banks already have the real audience needed to leverage a virtual currency and the financial wherewithal to make it a reality. Clout is important here.
Challenge to Fiat Currency
Private digital currencies at the moment pose no threat to the world’s central banks. But innovation has a way of challenging commonly held assumptions….especially ones as stodgy and long standing as government issued currency. The internet has flattened the economic landscape and opened opportunities for global domination. The digital, internet economy is owned by no country, no government. There are no regulations guiding which currency an e-commerce site should use. There’s nothing to stop someone from trying to capture this global digital economy and manage its money supply. Therein lies the opportunity for those quick enough, connected enough and risk-averse enough to realize it.
Virtual currencies are still evolving, but growing fast. Watch for the Transaction Grabbers and Banks to start making big moves in this space as near field communication and e-wallets become ubiquitous. Historically wildcat banking thrived in the lawless west….today it is thriving in the unregulated digital frontier.
Water-Scrum-Fall is the norm in many organizations today. Despite the attempts of scrum coaches and consultants, the weeds of waterfall grow back into the agile garden. What causes this? This article looks at the root cause for the water-scrum-fall phenomenon and makes a suggestion about how to address it.
The Root Cause
Water-scrum-fall’s reality is not the result of people being unwilling to adopt scrum. It’s not the result of a lack of passion for agile processes and practices. Nor is it caused by a lack of executive support. The cause?
In companies that produce software for internal use water-scrum-fall finds it’s greatest adoption. Internally used software is strictly accounted for by the regulations in SOP98-1 and this financial machinery is what guides the need to plan up front.
Capital projects are investments. To determine an investment’s return you need to know the estimated initial cost, and estimated revenue ( or savings ) the project will create. These things are estimated up front so that a decision can be made on whether or not to pursue the investment. The up-front nature of capital budgeting compliments waterfall and BDUF. It is a core financial business process guided and regulated by FASB. Think about that for a moment…and then read on.
Scrum practitioners run up against a wall with capital budgeting. It doesn’t fit their operational practice for developing software. Under scrum….we shouldn’t be designing, estimating and crafting the project up front. Instead we should approach it incrementally. The problem with this? It ignores how enterprise software development projects ( capital investments ) are funded. The result is that everyone compromises and innovates. Water-Scrum-Fall is the child of this compromise.
Scrum and other agile practices pose a challenge to enterprise software development efforts and the capital budgeting process. Indirectly they say “Why are we funding this as a capital investment? It’s not. It’s an ongoing operational cost and should be accounted for that way. If we don’t plan on funding this software development effort for the long haul…then why are we doing it?” Funding a software development effort as an operational expense, as is done within software companies, does fit the scrum operational practice better. But again…the difference between a software development effort being labeled CAPEX or OPEX is guided by FASB. It’s not up to the company.
How Do We Fix Water-Scrum-Fall?
I don’t think there’s a silver bullet here. But in my last article, Is There a Better Way to Estimate Capital Projects? , I threw out a suggestion for how to estimate a capital investment using tolerances. This bypasses the need for an up-front detailed analysis of what the the LOE ( Level of Effort ) would be for the project, but still gets the business what it needs: an initial funding point and resulting NPV that augments decision making.
So water-scrum-fall is a pragmatic reaction by agilists and IT professionals to work with the business and its financial processes. Did the originators of scrum not understand the capital budgeting process? Were they oblivious to the financial architecture of the businesses around them? Maybe…but to their credit; they weren’t trying to address this. Their focus was on how to do software in an adaptive fashion so that it more organically addressed the operational realities of manifesting a complex vision.
My Latest article, an interview with Eric Brende, on InfoQ: http://www.infoq.com/news/2012/01/too-much-technology
Much of what has been written about Stoos is nebulous. For those of us looking to latch onto something concrete….we’re left befuddled. Rather than a deliberate bullet list of actions; the Stoos group posted a wishy-washy communiqué that seems more like a summary of their meeting and a regurgitation of their personal feelings and war stories.
So what’s the point? Is there one?
References to the agile manifesto abound with Stoos. And like the agile group….they were meaningfully vague. In this lap dance of ideas it appears their point was just to get us all thinking again about how organizations work. Fair enough. Things start with questions and wonder-ings. Nothing wrong with that.
Perhaps the only shrivel of ideological meat that provided some sustenance for us definitive types was this from Jurgen Appelo:
For me the most concrete outcome is the core idea of seeing organizations as “learning networks of diverse individuals creating value”
This gets the wheels rolling a bit. Maybe he’s onto something here. Perhaps, with social media, mobility, and agile thinking its time for a new type of organization. A virtual one where human ingenuity is rewarded handsomely and it’s not about doing a job….but seeking, driving and growing value and profiting from it. Meaningfully.
Those of us who work on the virtual cube-o-sphere today know that it’s not about showing up 9-5 and pleasing a boss. If you’re a freelancer, 1099, contractor, inventor or entrepreneur you know it’s about finding your passion, networking and growing your value/brand. Traditional organizations define what you should do for a salary. Perhaps in the new Stoosian organization you define what you’ll do and share in the value it creates for the organization. We dump stability for growth and a life’s mission.
“I don’t understand why you keep asking us to estimate the work. With all the time we’ve spent estimating we probably could have completed the first few requirements already. This is a waste of time!!” Ever heard something like this before? It comes across a little naive with regard to capital budgeting. But there’s a good point in the vehemence…. Waste.
In this article we’ll rethink estimation. We’re going to look at the machinery above estimation that catalyzes the need to predict effort and then propose a different way to target capital funding for projects.
I don’t want to lose anyone here so I’m going to go over some basics of capital budgeting for internal use software projects and how that relates to estimating. If you know SOP98-1 already then skip to the next section. Estimating can seem like a game. At best it’s an educated attempt to predict the future using formulas and experience. At worst its a W.A.G. So why do we do it? It all starts with how we account for the expense of developing internal use software. Internally used software is classified, for accounting purposes, as a fixed, long term asset. In accounting speak: a capital expense. That means it can be purchased for a set price and has a useful life greater than 2 years. Capital expenses, like internally used software, can have their cost depreciated ( amortized ) over the useful life of the asset. What does that mean? It means that instead of realizing the entire cost of the custom software effort in one year…..you realize it over the useful life of the asset. So if we intended some custom built workflow system to last 5 years and the entire cost of the initial development effort was $312,333.04 then we’d ( in a simplistic amortization schedule ) realize, report $62,466.61 in expenses per year for 5 years on each annual income statement. Further the software’s depreciated cost would be listed as an asset on the corporate balance sheet each year until the full value had be amortized. The ying to the capital expenditure yang is the operating expenditure. Operating expenditures are incurred, realized as they are spent. There is no depreciation of cost. If I have $125,000.00 in operating expenditures this year then $125,000 in expenses shows up in the income statement. Operating expenditures are not considered assets and companies routinely seek to minimize their cost and flatten their growth. How do they do this? Well….one way is by investing in capital assets that can help increase productivity. So if I invest in some custom workflow system that will reduce the number of FTEs ( full time employees ) I need by 10% then that’s a potential long term realized gain in operating expense reduction: a.k.a. more profit for shareholders. Capital expense accounting can seem like magic if you’ve never heard of it before. But there’s a very real justification behind it. What is that? Simply put: if you’re capital asset increases profits each year after it’s implemented then those profits should be offset each year by the cost to develop that asset. Fundamentally, capitalization of IT expenses is an immense part of why companies invest so much in new technology. The accounting allows us to derive value from capital investments. Yes, technology is wonderful, but if internally used software expenses weren’t capitalized you’d see IT budgets shrink drastically.
Awesome. So how does this relate to estimating the effort on a software project. Remember this line from above: That means it can be purchased for a set price and has a useful life greater than 2 years? A capital project is an investment or a series of investments. Knowing the price up front each year creates two things:
- The funds needed to purchase that investment.
- The cost basis to use in constructing a model of investment return.
Each of these capital investments are compared against each other using a % return ( IRR ) or more commonly using NPV ( Net Present Value ). Some are required and ‘must be done’. But the rest are optional. So leadership uses the projected investment return to determine which ones will benefit the company most. That becomes a short list of capital projects to fund for the fiscal year. Now, when these projects are initially compared developers may have been involved in the estimation process or they may not have been. But regardless the estimate is usually classified as a ROM ( Rough Order of Magnitude ). Once the project is funded another round of more detailed estimating occurs with the development team for the strict purpose of validating the ROM. If our detailed estimation shows we have inadequate funds then we need to make a decision: cancel the project or increase the investment. But if we increase the investment…how does that affect our return? Should we do a different project instead? You see where it’s going. Estimation is a fundamental part of determining the capital project landscape. It’s the basis for determining the initial and subsequent investment to achieve an estimated return. Software is just a means to the real end: increasing organizational productivity.
Capital Budgeting Hasn’t Kept up With Agile Practices
The astute among you will recognize how this financial model of capital budgeting doesn’t fit what you’re actually doing in agile software development. Big shock…right? Agile techniques are operational practices. They aren’t financial, business practices. Estimating each iteration using planning poker or whatever method has no applicability or affect on the overall investment. Just because the development team boosted the number of story points in the release…doesn’t mean someone magically added more money. Capital budgeting doesn’t take place every 2 weeks. It’s usually an annual event in corporations, although some companies will extend their capital planning for longer horizons ( 2 or 3 years ). Accounting is the architectural tool that builds business models. It runs in annual and quarterly cycles.
But It’s Wasteful
Ok, so back to the top. It may be fundamental to determining the annual capital project garden for XYZ Inc., but the estimates are usually inaccurate and they waste precious time in construction. Regardless of method…capital projects rarely hit their exact mark. This pushes many companies to see IT as a money pit to minimize. Isn’t there a better way for determining our cost basis for capital projects? Maybe one that doesn’t require us to estimate anything? Everything about capital budgeting is hard to change because it isn’t up to the company. It’s regulated by FASB. They define all these rules, and help to police them. The government recognizes FASB’s standards in lawsuits and for that reason they have the affect of law. Creative experimentation with accounting standards inside companies is something that people go to jail for. So change in accounting practices and standards is slow and carefully considered. After all you’re monkeying with the monetary machinery of global industry. There had better be a good reason for any change. So the next section proposes an idea for change to FASB’s capital budgeting rules. Do NOT exercise this idea in your company. There is no provision for this idea in FASB’s standards to my knowledge. I offer it up simply for conversation and debate….not actual practice.
When we’re looking at capital projects we need to know the expected revenue ( or savings ) generated by the project after completion and the expenses ( investment ). Estimating, at least in IT land, deals mostly with the expense side. This is usually done in a very detailed fashion, but with relative targets I’m proposing we skip the estimation and just come up with a tolerance level. How does it work?
1. Determine your expected revenues ( or savings ) if the project is implemented.
2. Determine your return thresholds. There should be three. You could do this with NPV or IRR.
- The return you’d ideally like to get.
- The worst return you’d tolerate ( yes it can be negative ).
- The middle ground between these.
3. Once you have these 3 thresholds you can then back calculate the capital requirements necessary to fulfill these return levels. We’ll work through an example in a moment. But here is the formula we’d use:
Formula to calculate investment for targeted NPV
C = NPV – ∑ R / ( 1 + r )
- NPV = Targeted NPV
- C = Investment required to reach targeted NPV
- R = Revenue realized in each period
- r = discount rate
4. Next you’d do a gut check. Can we really do this project for anyone of the calculated capital thresholds identified? If we can’t…then we shelve the project. If we can then we would setup 3 tranches of capital per project correlating to the thresholds. You’d start off by shooting for the ideal return scenario. If that didn’t work…you’d make a decision to move on to the middle ground threshold or cancel the project and expense the loss. The same would occur for the worst case return.
So let’s say we have a project that we know will generate the following savings in years 1, 2 and 3. Year 0 is our capital investment and what we’re trying to solve for.
Year Cash Flow
Ok, so we know our estimated benefits from doing this project. Now we need to figure our our three thresholds for year 0 capital funding. Ideally we want to maximize our benefit. So let’s say in consultation with the business we determine that these are our NPV thresholds:
- The return you’d ideally like to get: The most ideal return would be one that requires no investment at all and we receive the present value of the expected benefits – $580,015.02. But this is unrealistic. It does, however, give us an upper boundary to our ideal return. So we’ll say that a more realistic ideal scenario is $400,000.00 in NPV.
- The worst return you’d tolerate: This could be negative. Maybe you’re willing to lose money to get this software project completed. Good examples would be where there is a regulatory requirement associated with completing the project. In this example we’ll say that the worst return we’re willing to tolerate is $100.000.00. This is above zero, but shows that we’re looking for some monetary benefit.
- The middle ground between these: I’ll just take the average between these two…..$250,000.00.
Great…now we just plug these values back into our formula to derive the initial maximum investment allowed to hit each threshold. We’ll use 10% as our discount rate.
$400,000 – ($200,000/(1.10 ) + $300,000/(1.10²) + $200,000/(1.10³)) = -$180,015.02
This says that the most ideal return would require for our investment to not exceed $180,015.02.
$100,000 – ($200,000/(1.10 ) + $300,000/(1.10²) + $200,000/(1.10³)) = -$480,015.02.
This says that to achieve the worst investment return tolerable the investment must not exceed $480,015.02.
$250,000 – ($200,000/(1.10 ) + $300,000/(1.10²) + $200,000/(1.10³)) = -$330,015.02
Here we believe that to get a return of $250,000 we’ll need to make sure our investment does not exceed $330,015.02.
Now that we have our tolerances we can do a gut check and see how realistic it is to complete the project based on each level of funding: $180,015.02, $330,015.02, and $480,015.02….or anywhere between them.
If our gut check tells us we can complete this project then we’d fund the tranches and start on the project. If not then we’d drop this project altogether.
Relative targets take us out of the game of detailed estimating and instead push us to delivery within some tolerances. This is a more natural way to manage a risky endeavour and affords us some built in cushion that everyone agrees is acceptable to the business’ needs. We also pre-build fault tolerances, trigger points that force us to reflect on the project’s viability. Here I suggest that there should be three of these tolerances, but there’s nothing preventing a company from setting up 4,5, or 10.