Black Swan Farming

The future is cheap — the value of time

Chris Matts recently wrote about the impact of discounting on investments in software development. He showed a comparison between a few different investment options for a software project in order to demonstrate the negligible effect of discounting. Whilst I agree with the conclusion – that discounting is mostly pointless for software — I wanted to add a few thoughts and observations.

  1. The appraisal period matters. When considering investment periods that are short (i.e. only 6 months) it should be obvious that discounting has almost no effect. Of course, if the investment period is longer, the effect of discounting can be much greater. It is spurious to compare various short appraisal periods claiming to show the effect of discounting.
  2. Please don’t forget the benefits. Not only is this the whole point, but when doing investment appraisals it is the benefits side that is typically more affected by discounting. Why? Well, the benefits typically last a lot longer than the initial investment. In some cases, the benefits accrue in perpetuity, so adding up all of the discounted future benefits into today’s money can be important. In particular, if the lion’s share of the benefits are projected to occur a long way into the future, ignoring the effects of discounting can lead to really poor investment decisions.
  3. Always compare options with a “do nothing” scenario.  The “do-nothing” scenario is the base-case (or counterfactual) against which all other options are compared. Sometimes “do-nothing” involves no costs and no benefits – but for software investments, there are often existing manual alternatives or some economic risks to consider in the counterfactual.
  4. The rate reflects the riskiness of the investment. The relatively low interest rate on your mortgage is a reflection of the relative safety that comes from the bank being able to sell the property if you stop paying. Given the risks (and alternative investments that are less risky), we should only invest in more risky options if they are likely to generate higher returns. The most commonly used measure of riskiness for a company is the Weighted Average Cost of Capital (or WACC). None of this is nasty or tricky business though – just ask someone in your Finance department what discount rate to use for your organisation.

When discounting makes sense

So when should you use discounting? There are lots of situations where discounting future costs and benefits makes perfect sense. When the effects of an investment are long and the timing and profile of cost and benefits are very different there is really no other way to fairly compare options. For any large and irreversible capital investment with lots of options, you absolutely should compare options thoroughly. Discounting future cashflows as part of a cost-benefit analysis will help you make a better decision than your gut-feel may suggest to you.

When discounting is mostly nonsense

The sort of decisions described above should be very rare in product development. I’ve seen very few examples where I would recommend applying discounting, for the following reasons:

The point about confusion hints at what is wrong with the mindset that we tend to bring to product development. The need to discount future costs and benefits implies One Big Investment Decision, involving lots of scarce capital. The myth that this perpetuates is that money is the most scarce resource, which is usually not true. Optimising for capital efficiency ignores the significant capacity constraints we have in product development that capital usually cannot solve. Far more important for us to understand is the Cost of Delay – that time is the most scarce resource in product development.

Chris’ post was titled “Duration and the Time Value of Money“. This nicely points out how badly we’ve missed the point, focusing on all the wrong things:

The cost that really matters is the cost of delay. The benefits that really matter are the benefits you get from shortening lead time. Don’t bother with discounting.