Investments in RFID: A Real Options Approach

Milind Patil

A Patni White Paper

COPYRIGHT
Copyright Patni Computer Systems Ltd. All Rights Reserved. December 2004 Restricted Rights This document may not, in whole or in part, be copied photocopied, reproduced, translated, or reduced to any electronic medium or machine readable form without prior consent, in writing, from Patni Computer Systems Ltd. Information in this document is subject to change without notice and does not represent a commitment on the part of Patni. This document is provided "as is" without warranty of any kind including without limitation, any warranty of merchantability or fitness for a particular purpose. Further, Patni does not warrant, guarantee, or make any representations regarding the use, or the results of the use, of the written material in terms of correctness, accuracy, reliability, or otherwise. All other brand and product names are trademarks of their respective companies.

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Table of Contents

Overview..................................................................................................................................................................2 Introduction ..............................................................................................................................................................2 What is Real Options Theory?..................................................................................................................................2 Strategic Nature of RFID Investment ........................................................................................................................3 Why Real Options Theory? ......................................................................................................................................5 Common Real Options and Scenarios with RFID Investment ...................................................................................5 An illustrative Example .............................................................................................................................................6 Conclusion ...............................................................................................................................................................8 Appendix A ..............................................................................................................................................................9 Appendix B ............................................................................................................................................................10 Appendix C ............................................................................................................................................................11 About the Author ....................................................................................................................................................12 About Patni ............................................................................................................................................................12

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OVERVIEW
Net Present Value (NPV) and Return on Investment (ROI) are commonly used to evaluate investment in initiatives like new technology or any reengineering project. But sometimes measuring the value of investment in technology becomes very difficult due to its wide scope of application coupled with embedded options in its adoption. Projected cash flows seem meager in comparison to the investment required, or the discount rate chosen to compensate for the risk is so high that it renders the NPV unpalatable. RFID being a disruptive technology i.e. it cannot match the performance that customers expect from product and services in the short term, Real Options Analysis should be a better way to evaluate its adoption in the Supply Chain.
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INTRODUCTION
This paper reviews the financial and business logic behind investing in RFID. Managers the world over are facing increasing uncertainty while taking complex strategic decisions, having an enduring impact on organization profitability and sustained growth. Usually, this type of uncertainty erodes real value when such decisions are evaluated using conventional techniques, such as NPV or ROI, since larger discounting rates are applied to riskier projects. We argue that the dominant form of financial analysis, Discounted Cash Flow (DCF) and Net Present Value (NPV) calculations, are too limited a basis on which to make RFID investment decisions because they undervalue returns and focus management attention on short term cash flow when, perhaps, the biggest benefits lie in building a strategic asset. The cash-flow calculations significantly undervalue RFID since it fails to account for all the effects of better customer centric strategies, such as, learning and innovation, reduced risk and improvements in shareholder value. Finance scholars also suggest real options may be a better means of valuing strategic management investments (Copeland and Keenan, 1998; Luehrman, 1998) . To understand these customer-related and business-related benefits more comprehensively, this paper demonstrates how a real options approach builds a stronger business case for RFID investments and focuses managerial attention on the areas of RFID that would perhaps offer the firm greater value than cash flow alone.
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WHAT IS REAL OPTIONS THEORY?

An option represents freedom of choice, after the revelation of information. An option is the act of choosing, the power of choice, or the freedom of alternatives. An option is a right but not an obligation. In financial markets, it is the freedom of choice after revelation of additional information that increases or decreases the value of the asset on which the option owner holds the option. A real option is an option relating to things, as opposed to illusory things. Strategic investment and budget decisions within any organization are decisions to acquire, exercise, abandon or let expire real options. Following table shows the analogy between financial options and real options.

Humberto Moran (2002), "Real Options for strategy development in the introduction of technology for business and process innovation: New applications for the Automatic Identification technology in the Healthcare Industry. Dissertation Project, Judge Institute of Management University of Cambridge. Copeland, T. and Keenan, D. (1998), How much is f lexibility worth? The McKinsey Quarterly, No. 2, pp. 38-49.

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Table 1: Analogy Between Financial and Real Option Financial Options

Call Option Stock Price Exercise Price Time to Expiration Risk Free Rate Volatility of Stock Price Dividends

Real Options
Option to Invest Present Value of Project Present Value of Investment Time to Expiration Risk Free Rate Volatility of Project Value Project Cash Flow

STRATEGIC NATURE OF RFID INVESTMENT

Investment in RFID is of strategic nature since it is clearly linked to business strategy in the following way:

By Process Innovation (positioning of the firm), By importance of its adoption in Business Process Reengineering and By enabling IT Capabilities.
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In short term RFID can be deployed for Focused Differentiation i.e. providing something unique that is valuable to the buyer beyond simply offering a low price. Broad and narrow target especially suggests to focus on particular customer segment based on the contribution margin or the mandate.

Figure 1: Path to Cost Leadership

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Porter, M.E. (1985), "Competitive advantage: creating and sustaining superior performance", The Free Press, New York.

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For example, this can be done by deploying RFID technology exclusively in a Warehouse or Distribution center and only for some class of items in compliance to Wal-Marts mandate. The key is creating value for few customers and subsequently be utilized for Full Differentiation to Cost Leadership through staged investment approach (Figure-1). This staged investment approach makes RFID a good case of Real Options Analysis. The scope of RFID technology adoption is limited to Organizational Resources Control. Broadly these resources can be of five types: (1) People, (2) Material, (3) Time, (4) Knowledge and (5) Brand Equity. RFID tag or reader can only be applied to tangible resources like People and Material but other remaining resources get indirectly benefited from RFID application. For People and Material type of resources, RFID application scope can be widened slowly from Class A items to Class B items in the same facility. Then, after availability of some concrete information about the results and further developments in technology and cost, it can be extended to other facilities as well. Similarly there are several opportunities to extend this technology to multiple applications as well as multiple resources at multiple facilities to achieve cost leadership. Refer to Appendix A that illustrates sample option that are available with, RFID investment of pallet level tagging of Class B items. According to Davenport and Shorts methodology of Process Innovation, Information Technology's capabilities involve improving coordination mechanism and information access across organizational units, thereby facilitating more effective management of task interdependence. In general RFID satisfies all the requirements of IT capabilities in some way or other as shown in the table below.
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Table 2: RFID Capabilities (Adopted and Modified from Davenport and Short, 1990) Capability
Transactional Geographical Automational Analytical Informational Sequential Knowledge management Tracking Disintermediation

Organizational Impact/Benefit
It can transform unstructured processes into routinized transactions It can transfer information with rapidity and ease across large distances, making processes independent of geography It can replace or reduce human labor in a process It can bring complex analytical methods to bear on a process It can bring vast amounts or detailed information into a process It can enable changes in the sequence of tasks in a process, often allowing multiple tasks to be worked on simultaneously It allows the capture and dissemination of knowledge and expertise to improve the process It allows the detailed tracking of task status, inputs, and outputs It can be used to connect two parties within a process that would otherwise communicate through an intermediary (internal or external) It allows to build security and safety in Process as well as Product

Security/Safety

Benefits from few Capabilities like Automational, Tracking and Transactional can be reaped in a very short time but other Capabilities need some stabilization of the technology and further integration and investment.
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Davenport, Thomas H.; Short, James E. (1990), "The New Industrial Engineering: Information Technology", Sloan Management Review, 31(4), 11-28.

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WHY REAL OPTIONS THEORY?

For the purpose of valuation, one should view RFID Technology as a bundle of functions that can serve as the basis of certain applications whose value changes over time. While these bundles of enabling functions cannot be adjusted in the short run, one can decide on the basket of applications to be developed, implemented and operated on the basis of the respective costs and benefits after proper observation. In other words, RFID not only generate value directly but also enables different value generating applications to be implemented. Traditional tools neglect the value of flexibility thorough RFID. We argue that these profound changes require a new logic for investment in IT and other similar strategic assets. A typical RFID investment project requires significant initial outlay and is generally irreversible or partially irreversible. In addition, RFID investments usually have huge business and technological uncertainties. All these characteristics make Real Option Theory an appropriate approach in evaluating RFID investment projects . The real value of the real options approach is that it shows how uncertainty creates value. Managers must recognize that the uncertainty associated with current strategic business opportunities is different because flexibility can be used to both avoid losses and to tap upon opportunities that unexpectedly emerge. Uncertainty is the driver of upside potential and the real options approach captures this value-creating aspect of RFID investments.
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COMMON REAL OPTIONS AND SCENARIOS WITH RFID INVESTMENT

Waiting-To-Invest Options: The value of waiting to adopt RFID, till better market information becomes available, may exceed the value of its immediate adoption. The option to postpone can be applied when current investment decisions would impede or hurdle future ones. An early adoption of the wrong RFID technology or substituting it could increase future costs of adopting a more appropriate one. Similarly, in applications where standards are important, there is a clear value in the option of waiting to see which technology becomes the industry standard. Growth Options: An entry investment may create opportunities to pursue valuable followon projects. The most obvious options in RFID implementation projects are the future possibilities of using infrastructure to further applications. This is particularly evident in a ubiquitous technology like the RFID, in which existing tags and readers can be used for multiple purposes. For example, from Pallet level to Item level tracking. Flexibility Options: An option to reallocate resources or switch has a value. For example, adopting at two locations instead of one to serve need-based requirements by switching the resources (e.g. reader) as conditions dictate. Reader, which is used at the checkout process, can be utilized for cycle counting operation when there is no rush in the retail store. Exit (or Abandonment) Options: The option to walk away from a project in response to new information increases the value of the project. Similarly to the flexibility options, the options to disinvest are related with technology failures. The possibility of selling the RFID infrastructure and partially recovering investment in case of adoption failure has to be considered and valued in early adoption decisions.

Xiaotong Li and John D Johnson (2002), "Evaluate IT investment opportunities using real options theory", Information Resources Management Journal. 15(3), 32-47.

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Innovation and Learning Options: An initial investment creates better information about the market opportunity. This is one interesting options available to the management. As RFID makes it possible to gather information from moving objects, decisions in RFID implementations would enhance information collection possibilities. Whether this information will be useful or not or reveal areas of improvement is uncertain. However having the information would provide managers with the flexibility to undertake future correcting projects and improve value, if needed. For example data collected from tracing and tracking of products will give important information about new changes required in planning and scheduling mechanisms.

With regard to RFID implementation decision; arriving at the different types of applications (usages), options and, opportunities and risks associated with each option is a very complex procedure and takes most of the time in a RFID implementation project. Entire Supply Chain spectrum has different types of applications of RFID technology. Available budget and time are the most important factors to be considered while embarking on a RFID implementation projects. Strategic Value Grid and RFID Application Decision Tree (see appendix B and C) can be used to arrive at the appropriate value by deploying RFID in the Supply Chain.

AN ILLUSTRATIVE EXAMPLE
Following example of growth option/expansion option explains one simple case of how Real Options Valuation will help organization to arrive at a decision to invest into RFID technology if they consider the embedded options available in future (i.e. active management perspective). Consider, for example, a European call option, which offers its holder the right but not obligation, to buy at maturity the underlying share of stock for a specified strike price. Similarly, an application that can be implemented using RFID technology offers the firm the opportunity (but not obligation) to obtain the benefits of the application (underlying asset) by investing a given implementation cost (strike price) at certain implementation decision points (maturity). So the NPV with options value taken into account will be: Expanded NPV = (Ordinary NPV of Expected Cash Flows) + (Value of Options from Active Management) In a particular RFID case it will be:

Value of RFID Implementation =

(NPV of Applying Only at Pallet Level in a Warehouse Class B Items) + (Option Value of Extending to Case Level Class B Items) + (Option Value of Extending to Cycle Counting Application)

If we consider only the investment in Time T=0 and benefits for the same time period the NPV is negative, on the basis of which the decision of investing in RFID should be rejected (Refer to Table3).

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Table 3: Base-line NPV Investment Cost (Time T=0)

Hardware Software Labor Training Total Benefits (Time T=0) Inventory Reduction Labor Reductions Shrinkage Reduction Total Net Present Value 30,000 20,000 20,000 70,000 - 150,000

PV
100,000 100,000 10,000 10,000 220,000

But considering further expansion opportunities and calculating the option value using Black Scholes Model (for simplicity) for the expansion decision the expanded NPV will be positive. Following steps will show how to calculate the option value for above example. Lets assume that: S 2 K t C r = The present value of expansion potential (as assessed today) = $750,000 = The annualized standard deviation in ln (present value of CF) = 34.64% = The initial investment needed for expansion option (in PV $) = $1,000,000 = The number of years you have rights to project = 5 years = The cost associated with waiting an extra year to expand = 0.00% = The risk-less rate that corresponds to the option lifetime = 6.50%
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So in terms of option pricing: Stock Price = $750,000.00 Strike Price = $1,000,000.00 Expiration (in years) = 5

T-Bone rate = 6.50% Variance = 0.12 Cost of delay = 0.00%

Value of Option = SN ( d 1 ) Ke rt N ( d 2 )
Where,

2 S t ln + r+ 2 K d1 = t

d 2 = d1 t
(.) = Cumulative Normal Distribution

ln(.) = Natural Logarithm

So, Value of the option = $235,938.60 Expanded NPV = ($235,938.60 - $150,000.00) = $85938.60
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Damodaran, Aswath (2004), Option Pricing Theory and Applications, Lecture Notes

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CONCLUSION
Though NPV and DCF are not useful in presence of high uncertainty, it will always be useful for basic analysis. The Real Options theory gives us a better structured decision making process for complex and interdependent investment decisions. As investment in RFID is of very complex nature due to its application scope, compound real options is the right methodology for valuation.

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APPENDIX A
RFID Application Tree with Options

Resources

People

Material

Time

Knowledge

Brand

Employees 12

Customers 13

Suppliers
Indirect Application

Procurement OR Manufacturing OR

Warehouse

OR Retail Store

Capital Inventory

Revenue Inventory

Spares (Internal) 11

Class A Items 3 Stationary Non-Stationary

Class B Items

Class C Items 4

Returns 5

Machines 6

Racks 7

Pallets

Recycled Pallets 8
Warehouse

Forklifts 9 10 OR Retail Store

Cranes

SKU 2

Case 1

Pallet

Procurement OR Manufacturing OR

Procurement OR Manufacturing OR

Warehouse

OR Retail Store

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APPENDIX B
Strategic Value Grid for RFID Application (Adopted and Modified from Humberto Moran, 2000)
Implementation Decisions
Deferral of Alternative Implementations Versatility of Technology Standard Adoption Type & Placement of Readers Type & Placement of Tags

Uncertain Outcomes
Standard Emergence Pace & Success Lack of Investment & Commitment Complementary Technologies Surge Inter-Application Dependence Critical Mass Achievement Technological Competition Surge RFID Technology Success Industry Inertia Regulations Cost Increase/Decrease

Applications
Direct Identification of Product Inventory Management & Control Tracing Transportation/Movement Storage Display Spares Management Critical Asset Management Staff Access & Control Customer Service Dynamic Pricing Security Counterfeit Tracking

Managerial Flexibility
Extend to Other Applications Connect With Other Technologies Inter-Organizational Interchange Adapt to Future Standards Disinvest Switch to Alternative Usage Adopt Future Better Technologies $ $ $ $ $ $ $ $ $ $

$ $

$ $

$ $

$ $

$ $

$ $

$ $

$ $

$ $

$ $

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Strategic Value

Risks/Opportunities

APPENDIX C
RFID Application Decision Tree

Employees

People

Customers

Invest Now in RFID

Which Resource?

Suppliers

Procurement Capital Equipments Pallet Level

Manufacturing Material Where? Warehouse Replace Barcode With RFID When to Adopt RFID? Invest Now in Barcode

Retail Store

Inventory Items

Case Level

Active

SKU Level Keep Barcode As It Is

What Type of Tag? Passive

Implement RFID Wait and See What Happens With RFID Implement Barcode

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ABOUT THE AUTHOR

Milind Patil
Milind has over 6 years of experience in the Automobile Industry. He has worked in the areas of Manufacturing, Production Planning and Control, Process Planning and Product Engineering. He has also worked in the areas of Advanced Supply Chain Planning and Scheduling. He holds a Masters degree in Business Management from XLRI Jamshedpur and is also a doctoral student of XLRI. He has presented papers at national and international conferences.

ABOUT PATNI
Patni Computer Systems Limited is a global IT Services provider servicing Global 2000 clients in the Manufacturing, Insurance, Banking & Financial Services, Retail, and Energy & Utilities industries. With an employee strength of over 8,000; multiple offshore development facilities across seven cities; and 22 international offices across the Americas, Europe and Asia-Pacific; Patni has registered revenues in excess of US $250 million for the year 2003. Patni's technology focus spans e-business solutions, enterprise applications, embedded technology solutions and enterprise systems management. Its service offerings include application development and reengineering, application management and business process outsourcing. Committed to quality, Patni adds value to its client's businesses through well-established and structured methodologies, tools and techniques. Patni is an ISO 9001:2000 certified and SEI-CMMi Level 5 organization, assessed enterprise wide at P-CMM Level 3. In keeping with its focus on continuous process improvements, Patni adopts Six Sigma practices as an integral part of its quality and process frameworks. Patni is one of the Top 6 Indian-based companies who operate optimized global delivery models for customers, fronted by a strong local consulting capability. As industry leaders, Patni introduced Offshore Development Centers, and pioneered 'follow the sun' development and support frameworks.

Patnis RFID Expertise

Patni's dedicated RFID practice offers a complete range of RFID services as part of its Enterprise Application solutions. Patni, with its unique combination of internal strengths and external partnerships, is well placed to address this emerging market for RFID adoption. Patni strengths are derived from domain expertise and service competencies in the areas of ERP, SCM, CRM, Retail, eBusiness, Data Synchronization, Embedded Technologies and Application and Systems Integration. Patni has strategic alliances with a number RFID middleware and hardware vendors like Manhattan Associates, OATSystems Inc, PowerPaper and Lowry. Patni is also the first Indian company to become a member of EPCglobal India, the Indian arm of EPCglobal, Inc, the global body working for standards generation for RFID. To understand the physics and impact of RFID, Patni has setup a multi-vendor RFID Lab, manned by dedicated expert teams. This lab allows clients to understand the impact/benefits of RFID on their business processes, develop a prototype or simply enhance their understanding during the various phases of RFID adoption. Patni offers a range of solutions spanning impact assessments, readiness assessments, 'proof of concepts', and full-fledged implementation, enabling RFID adoption with minimal disruptions. For more information, visit http://www.patni.com or contact rfid@patni.com

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