I heard a very interesting presentation by Late Peter Bernsteing knownt to be an expert in managing risks...he made very interesting remark about risks and gave some real-life examples from the finance industry where options are effectively used to manage risks...He had this very interesting articulation of the idea of risk through few anecdotes that sparked my imagination and led to some very interesting insights about IT outsourcing industry....Lets see some of the anecdotes he used and how they relate to our IT industry...
1. Finace industry always revolves around making decisions based on incomplete information. This leads to us taking risks and an expectation to be rewarded commensurate to the risks (the whole idea of CAPM by Modiglani and millers, the Betas our ability to quantitatively assess our risks).
In IT outsourcing contracts, we do similarly solution and price a fixed price deal based on incomplete information (estimates, scope of work, etc.). This is a risk that we undertake for which our rewards are the margins that client pay us. Now unlike financila industry there is no standard quantitative model we use to assess risks and can expect to get rewards commensurate to the risks we take....So the question arose within me why do we bid for fixed price projects when we do not have complete information? (It is a completely different topic to define what completeness in information mean...we will discuss this hopefully in some post in the future)
2. When we buy shares of a company we have a passive control over the decisions of the company and the decisons we make as passive investor is reversible. On the contrary if we look at the Executive or management has active control and make more decisions on behalf of the company but their decisions are irreversible. The do take equal amount of risks for making decisions as we do and their rewards are obviously paid in stock options and % commissions (maybe Obama thinks that CEOs of funded companies shouldnt be paid at all....:-))..Now in IT outsourcing contracts when we do a fixed price 3-5 year deals the client and service provider do make an irreversible decision for a fixed duration. Their decisions are irreversible and are actively involved, and seem to control the engagement through extensive management. Now paradoxically we do sign lot of Fixed price projects knowing fully well risks-rewards dont match, besides we make irreversible decisions which we presume to control when we dont/cant...(well there are other contract T&C to put a boundary around these changes but then what the heck the change management always are active and manage the heck a lot of change out of clients)
3. In finance industry we have instruments such as Futures, derivatives and Options that gives us the right but not the obligations to manage the risks with at a manageeable (Only for those who know how these markets operate and also note i'm not sayin small) price... So what it effectively gives a passive investor is the ability to make further choices in reversability of decisions but ofcourse at the cost of not being able to control the decisions of companies that has bearing on the outcome...Now lets turn to our IT industry the fixed price contract are risks with unknow outcomes, uncontrollable and active decisions require to manage a contract and finally has no instruments (forget the Change managers) to manage the reversability of decisions when we bid with limited information....
Given all the above tenets, why do we do fixed price contracts at all....Doesnt it make us stick out our ostritch neck to be chopped off by a predator, or sticking out a thumb that invariably turns sour....
Whats driving us to Fixed price projects that are based on limited information other then the seemingly predictable revenues that we fool ourselves to be getting out of these deals :-)....
Now why cant all the deals where we have incomplete information be contracted using the real options model that is prevelant in the Finance industry...come to think of it, this will lead us to consider all engagemetns where we are bidding with limited information to statrt off as T&M deals.. we can build a real option (:-)...if I can use the term here) to convert this to a fixed price engagement maybe 6 months to 9 months into the delivring on the deal...during this time we will definitely have lot of data and complete information to know what is the risk we will be underwriting through a fixed price contract...now to get the benefit of defering the decision of making an engagement with incomplete information to fixed price we need to compromise on the fact that the deal may not materialize for us at all at the end of 6 months or 9 months....we give client that right (but not the obligation to convert this to a fixed price deal), so it is like the client buying the call option if you will from us to convert it to a fixed price model...so what do we do as a firm selling the fixed price option to cover our cost for lost opportunity if the deal does not materialize...we will expect client to pay us for the T&M project in the interim of 6 months to 9 months and the cost of reversing this decision still exist with client and with the service provider......ofcourse imagine if we also have an exchange where different service proividers can trade this...we can in effect trade these options with several supplier out there in the market..and ofcourse the underlying resources need to move with this too that are serving the client....
Looks like this idea is too raw and i'm almost at the boundary of being called insane...but nevertheless a good topic to explore further....What is your thought here...pls share your thoughts on my jabber....
Friday, June 19, 2009
What lies on the other side of Economic Event Horizon for IT Outsourcing industry?
The economic event of meltdown and slowing growth that we are witnessing today is unprecendeted in its nature in terms of the following:
1. The scope of coverage (includes all the industries)
2. The scale (effects felt globally) unlike the prior Japanese, Argentinian currency crisis, Russian bond market initiated crash or the East Asian BoP crisis
3. The intensity/depth of effect it has had on the industry
4. The speed at which it propogated; virtually in 6-9 months timeframe it had affected the scope and scale
What lies on the other side of the unprecedented economic event horizon...No brownies for guessing it for the Financial industry as almost every one has seen and will see in terms of regulation, infusion and bailouts by governments, recapitalization, more stringent monitoring of risk exposure...read more of it in RGE Monitor an article written by NY Stern school of business. Lets look at our IT outsourcing market alone for a moment. I just happened to come out of a leadership meeting at work and was quiet amazed that every one claiming that the other side of the event horizon will be fundamentally different from what we have witnessed in the past...But no one knew what exactly what it really means :-)...either they thought we may not understand it or they themselves were not so sure.... I for one believe that they might've thought we would not understand it.
The IT outsourcing industry has witnessed just one such downturn in Year 2000 & 2001 (Popularly called DotCom Crash) when the Telecom & Technology industry led downturn had immense impact on us (we will compare and contrast this in a separate post) . Having seen through that downturn and journeying through several organizations and roles, here are my insights:
1. Client will demand more value (one can define it in many ways) to be delivered by Suppliers at lower cost.
2. Client would demand transformation of their IT services/model/organizations leading to higher efficiency and effectiveness of IT support function at lower cost.
3. Client would expect suppliers to bring innovations to life through IT services to businesses earlier, and faster than their competitors at lower cost.
4. Higher performance/productivity levels (enforced through stringent SLAs) for thier businesses than before at lower cost.
5. Better resources (may I call them Super-humans: higher talent, highly flexible, having shorter learning curves, working longer, etc.) at lower cost.
Now if you do not understand whats and how of lower cost, it is immaterial you are best in any other tenet. Remember you still cant get a dime for your organization and find yourself running around amidst headless chickens or Heady humans ;-)...
What has been your experience regarding these heads and your predictions on the other side of this event horizon?
1. The scope of coverage (includes all the industries)
2. The scale (effects felt globally) unlike the prior Japanese, Argentinian currency crisis, Russian bond market initiated crash or the East Asian BoP crisis
3. The intensity/depth of effect it has had on the industry
4. The speed at which it propogated; virtually in 6-9 months timeframe it had affected the scope and scale
What lies on the other side of the unprecedented economic event horizon...No brownies for guessing it for the Financial industry as almost every one has seen and will see in terms of regulation, infusion and bailouts by governments, recapitalization, more stringent monitoring of risk exposure...read more of it in RGE Monitor an article written by NY Stern school of business. Lets look at our IT outsourcing market alone for a moment. I just happened to come out of a leadership meeting at work and was quiet amazed that every one claiming that the other side of the event horizon will be fundamentally different from what we have witnessed in the past...But no one knew what exactly what it really means :-)...either they thought we may not understand it or they themselves were not so sure.... I for one believe that they might've thought we would not understand it.
The IT outsourcing industry has witnessed just one such downturn in Year 2000 & 2001 (Popularly called DotCom Crash) when the Telecom & Technology industry led downturn had immense impact on us (we will compare and contrast this in a separate post) . Having seen through that downturn and journeying through several organizations and roles, here are my insights:
1. Client will demand more value (one can define it in many ways) to be delivered by Suppliers at lower cost.
2. Client would demand transformation of their IT services/model/organizations leading to higher efficiency and effectiveness of IT support function at lower cost.
3. Client would expect suppliers to bring innovations to life through IT services to businesses earlier, and faster than their competitors at lower cost.
4. Higher performance/productivity levels (enforced through stringent SLAs) for thier businesses than before at lower cost.
5. Better resources (may I call them Super-humans: higher talent, highly flexible, having shorter learning curves, working longer, etc.) at lower cost.
Now if you do not understand whats and how of lower cost, it is immaterial you are best in any other tenet. Remember you still cant get a dime for your organization and find yourself running around amidst headless chickens or Heady humans ;-)...
What has been your experience regarding these heads and your predictions on the other side of this event horizon?
Subscribe to:
Posts (Atom)
