AMES, Iowa -- Some managers throw money at a high-priced project in an effort to save it from failure. And while it may seem like they're just throwing money away, they may ultimately produce some of the best business ideas according to research led by an Iowa State University professor of more than 100 major technology companies and 1,000 projects.
The research found that managers who commit greater time and resources to failing high tech projects -- efforts that have long been believed by scholars to be irrational behavior -- can actually be rational efforts to seek creative solutions in some circumstances.
"When you talk about project escalation, the previous thinking was that you were throwing good money at bad (projects)," said Amrit Tiwana, lead researcher and associate professor of logistics operations and management information systems at ISU. "We found that the greater the uncertainty when you're investing in that option, the greater the upside potential."
Tiwana joined with Mark Keil, a professor of computer information systems at Georgia State University; Jijie Wang, a doctoral student at Georgia State; and Punit Ahluwalia, assistant professor of computer information systems and quantitative measures at the University of Texas, Pan American, in authoring a paper on their study titled "The Bounded Rationality Bias in Managerial Valuation of Real Options: Theory and Evidence from IT Projects." It was published in the latest issue of Decision Sciences -- the professional journal of the Decision Sciences Institute.
Paper earns Decision Sciences' Best Article Award
In that same issue, the editorial team of Decision Sciences announced an earlier paper by Tiwana, Keil, and Robert Fichman, associate professor of management at Boston College, was the publication's international Best Article Award for 2006. Published in the August 2006 edition, the study of 123 firms found that some managers escalate their commitment to a troubled project not because they are acting irrationally, but rather as a rational response to real options that may be embedded in a project. Real options are when managers have the opportunity to adjust the future direction of the project -- through such things as investing in a project or property, expanding, downsizing, or abandoning other projects -- in response to external or internal events. They are called "real" options because they pertain to physical or tangible assets, such as equipment, rather than financial instruments.
"Tiwana, Keil, and Fichman break new ground for researchers by providing a complementing theory to explain escalating behavior, while providing managers with valuable insights about their decision-making behavior," wrote the editors in the announcement.
The current research studied managers from 88 large firms, including Japanese technological giants Sony, Toshiba, Hitachi, and IBM Japan. The researchers found that managers only regard real options as valuable when a project's easily measured benefits are low, and fail to do so when they are high and therefore harder to attain.
"Most managers, who come through MBA programs and programs such as those, tend to behave very rationally. So they tend to rationalize their options -- their ability to see or not see options that exist right in front of their eyes," said Tiwana. "They won't think outside the box when everything looks positive based on net present value -- which essentially means when your measurable returns exceed measurable costs. So anytime they're in the positive land (with net present value) they tend to ignore any options that might be present.
"But when you consider the flip side and there is evidence that they're going to lose money on a project, then they systematically explore what options exist and they suddenly begin recognizing options that they otherwise would have completely ignored or neglected," he said.
Only options with the almighty dollar
The new paper is the first to show that a bounded rationality bias exists among managers -- that they exhibit bias in determining value of real options based on the prospects of the benefits. It also is the first to set empirical measures for the six types of real options -- growth, stage, scale, switch, defer and abandon.
Tiwana and his team plan to continue studying large companies that invest in developing new technologies that may or may not be commercially successful.
"Some projects succeed, as you would expect, but the majority of them don't," he said. "But you just need a blockbuster (real option) -- one of those out of the 15-20 products you deal with. That's all it takes to break even.
"A simple example would be the iPod," Tiwana said. "Hitachi was the company that created the hard disc drive that led to the original iPod back in 2001, and it more than broke even on that project."
And based on their recent award, Tiwana and his colleagues are breaking new ground in the area of project escalation decision-making behavior.
