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«Information Systems Project Continuation in Escalation Situations: A Real Options Model Amrit Tiwana Iowa State University, College of Business, 2340 ...»

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Decision Sciences C 2006, The Author

Volume 37 Number 3 Journal compilation 2006, Decision Sciences Institute

C

August 2006

Information Systems Project Continuation

in Escalation Situations: A Real

Options Model

Amrit Tiwana

Iowa State University, College of Business, 2340 Gerdin Business Building, Ames, IA, 50011,

e-mail: tiwana@iastate.edu

Mark Keil†

Department of Computer Information Systems, J. Mack Robinson College of Business, Georgia State University, 35 Broad Street, Room 919, Atlanta, GA 30303, e-mail: mkeil@gsu.edu Robert G. Fichman Department of Information Systems, Boston College, Carroll School of Management, 452B Fulton Hall, Chestnut Hill, MA 02467-3808, email: fichman@bc.edu

ABSTRACT

Software project escalation has been shown to be a widespread phenomenon. With few exceptions, prior research has portrayed escalation as an irrational decision-making process whereby additional resources are plowed into a failing project. In this article, we examine the possibility that in some cases managers escalate their commitment not because they are acting irrationally, but rather as a rational response to real options that may be embedded in a project. A project embeds real options when managers have the opportunity but not the obligation to adjust the future direction of the project in response to external or internal events. Examples include deferring the project, switching the project to serve a different purpose, changing the scale of the project, implementing it in incremental stages, abandoning the project, or using the project as a platform for future growth opportunities. Although real options can represent a substantial portion of a project’s value, they rarely enter into a project’s formal justification process in the traditional quantitative discounted cash-flow-based project valuation techniques. Using experimental data collected from managers in 123 firms, we demonstrate that managers recognize and value the presence of real options. We also assess the relative importance that managers ascribe to each type of real option, showing that growth options are more highly valued than operational options. Finally, we demonstrate that the influence of the options on project continuation decisions is largely mediated by the perceived value that they add. Implications for both theory and practice are discussed.

Subject Areas: Decision Making, Escalation, Information Integration, Information Systems, Innovation Management, Investment Decisions, Project Continuation, Project Management, and Real Options.

† Corresponding author.

IS Project Continuation in Escalation Situations

INTRODUCTION

An escalation situation exists when there is “decision making in the face of negative feedback about prior resource allocations, uncertainty surrounding the likelihood of goal attainment, and choice about whether to continue” (Brockner, 1992, p. 122).

The bulk of prior work on escalation has sought to understand apparently irrational instances of escalation where actors persist in courses of action that they could (or should) have known were destined to fail (Staw, Sandelands, & Dutton, 1981;

Brockner, 1992). The main goal has been to isolate nonrational factors (i.e., those leaving the project payoff structure unaffected) that reinforce escalation tendencies.

For example, managers are more likely to escalate when they have a greater need for self-justification, when sunk costs are higher, and when they hold asymmetric information about project status (Keil, 1995).

Despite the primary focus on nonrational factors, escalation researchers have acknowledged the possibility of other rational factors that promote escalation in the presence of negative feedback. An early literature review by Staw (1981) included two rational factors—probability of future outcomes and value of future outcomes—as determinants of continuation tendencies. Bowen (1987) argued that instances of escalation often involve equivocal information about project status and future prospects and that in such cases the common understanding of escalation as an irrational process of throwing good money after bad would not necessarily hold.

In fact, there can be numerous subtleties not readily apparent to external observers that could promote project continuation in spite of negative feedback about project status. In the context of information technology (IT) investment projects, Keil and Flatto (1999) suggested that one of these subtleties is the presence of real options in a given project. In particular, they argued that, in instances that appear to be unwarranted (i.e., irrational), escalation may actually be warranted (i.e., rational) escalation were the value of real options taken into account. In this research, we examine whether real options actually do increase the propensity to engage in what we call warranted continuation in escalation situation, that is, a normatively rational continuation of a troubled IT project that has continued uncertainty about goal attainment.

Opportunities to embed real options are pervasive in IT projects (Benaroch, 2002). A project embeds real options when managers have the opportunity (but not the obligation) to adjust the future direction of the project in response to external or internal events. These adjustments can take the form of deferring the project, switching the project to serve a different purpose, changing the scale of the project, implementing it in stages, abandoning the project, or using the project as a platform for future growth opportunities. Yet, real options, which can represent a substantial portion of a project’s value (Taudes, Feurstein, & Mild, 2000), rarely enter into a project’s formal justification process in practice. Instead, quantitative project valuations are typically based on traditional discounted cash flow techniques such as net present value (NPV) that ignore option value (Busby & Pitts, 1997). Naturally, formal post-mortems are likely to focus on how actual experience comported with expectations on this same NPV basis.





Even though real options are rarely considered explicitly, some studies beyond the IT context indicate that operational managers often implicitly recognize Tiwana, Keil, and Fichman 359 the value of real options (Busby & Pitts, 1997; Kogut & Kulatilaka, 2004). Therefore, there may be instances in which projects that appear to external reviewers employing an NPV logic to have undergone an irrational escalation actually underwent a warranted continuation owing to implicit recognition by operational managers of real options external to the original justification decision. However, this would only be a pervasive phenomenon if it were true that operational IT managers were likely to place a significant value on real options and were more prone to continue troubled projects when they do.

In this research, we investigate the effects of real options on IT project continuation in escalation situations. Our approach is to use a conjoint study to examine how the presence of one or more different option types affect managers’ perceptions of project value and their expressed likelihood of continuing investment in troubled projects. In particular, we study escalation scenarios where there is negative feedback and considerable uncertainty about goal attainment and where managers should be indifferent toward continuation from a traditional NPV perspective (i.e., the NPV is set at zero). Making the base-case indifference toward continuing allows us to better isolate the effects of having one or more real options present.

The key question for us is not whether IT managers might place some positive value on real options. Prior research outside IT (Busby & Pitts, 1997) suggests that they often do, and we see no obvious reason why either the IT project context or the escalation context per se would prevent managers from recognizing option value. Rather, we see the key research issues as being: (i) how strongly option value translates into an increased propensity to continue a troubled project and (ii) what differences exist in how different types of real options (i.e., to switch use, change scale, stage investments, abandon, or strategically grow a project) are valued in escalation situations. The first issue gives an indication of how pervasive the phenomenon of warranted continuation due to recognition of options might be in practice. The second issue can provide some initial insights into possible biases in how options are valued.

Our results show that the presence of real options does lead to a tendency toward continuing projects (i.e., warranted continuation), and this tendency increases with the number of real options that are present. Second, our results show that in escalation situations managers place a much higher value on options that spawn new investment opportunities (strategic options), as compared with options that allow them to reconfigure such elements as the timing, scale, and scope of an investment (operating options). Some options, such as the option to abandon, are given very little comparative value.

Negative feedback about project progress and uncertainty about goal attainment are very common occurrences on IT projects (Wallace, Keil, & Rai, 2004).

Decisions about whether to continue or to terminate these troubled IT projects are among the most difficult that IT managers face. To come to a full understanding of these escalation situations and to advise managers appropriately, researchers must endeavor to sort out the rational forces from the nonrational. This study complements the large body of previous work examining nonrational factors that promote unwarranted escalation by considering a pervasive but subtle rational factor—the presence of real options—that could lead to warranted continuation.

IS Project Continuation in Escalation Situations The remainder of the article proceeds as follows. In the next few sections, we review the relevant literature on escalation, describe real options analysis (ROA), and use real options theory to develop our hypotheses. Then we describe the methodology and data collection and present our analyses and results. Finally, we discuss the theoretical and normative implications of these results, identify directions for future research, and conclude with a summary of the study’s key contributions.

ESCALATION AND REAL OPTIONS

Escalation of Commitment The concept of escalating commitment refers to the human tendency to adhere to a course of action even in the face of negative information concerning the viability of that course of action (reviews of the escalation literature can be found in Staw & Ross, 1987a; Brockner, 1992). Much of the prior literature characterizes escalation as a phenomenon that arises from flawed decision-making processes. The prevailing view is that these flawed—often irrational—decision-making processes lead to flawed decisions and dysfunctional organizational outcomes. As Brockner et al.

(1986, p. 122) observe: “The tendency for decision makers to continue allocating resources to an ineffective course of action can be extremely maladaptive, both for individuals and organizations.” A similar perspective is expressed by Staw and Ross (1987a), who tend to view escalation as a dysfunctional response.

In fact, all three dominant theoretical perspectives that have been invoked to explain the phenomenon—self-justification theory, prospect theory, and agency theory—paint escalation behavior as irrational. Self-justification theory describes escalation as an attempt by individuals to rationalize their previous behavior against a perceived error in judgment (Staw & Fox, 1977). Prospect theory describes escalation behavior as decision makers acting contrary to the invariance criterion of rational choice (Kahneman & Tversky, 1984). Similarly, agency theory views escalation behavior as the agent pursuing a course of action that is irrational from the principal’s perspective (Harrison & Harrell, 1993). Normative prescriptions in the literature suggest that an escalated project should be terminated because it is irrational to throw good money after bad (Boehm, 1981; Staw & Ross, 1987b).



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