Chapter 43. Keep Your Options Open: Extreme Programming and the Economics of Flexibility

Hakan Erdogmus and John Favaro

Financial evaluation and strategic analysis have long been considered two distinct approaches to evaluating new capital initiatives. An emerging valuation approach, known as real options, attempts to align finance and strategy through a new perspective: The value of an asset lies not only in the amount of direct revenues that it is expected to generate, but also in the options that it creates for flexible decision making in the future. In general, the more uncertain the future is, the higher the value of flexibility embedded in an asset, whether financial or real. This perspective has significant implications for the economics of flexible processes. Applied to software development, it could imply that a lightweight process that is well positioned to respond to change and future opportunities creates more value than a heavy-duty process that tends to freeze development decisions early. Thus, the feasibility of Extreme Programming (XP) can be supported by the option value of flexibility inherent in it. What is the theory that underlies this statement? How does it relate to the fundamental assumptions of XP? How does it impact the value of an XP project? What are the implications of such value propositions for project decisions. If you are curious, read on …