Wednesday, November 14, 2007

Follow up 1: Software as an asset

I don’t know how many readers this blog has but I don’t think it s many. In fact I tend to think I know them all. Well, that’s a illusion I can be pretty certain to dispel. I know the ones I know, because they comment on the blog, or they tell me that read it, but by definition I can’t know who I don’t know - if you get my drift. If I now find someone who reads my blog who I didn’t know read it I still don’t know how many reads I have, I just know more of them.

What is gratifying is that although the reader base may be quite small I get quite a few comments. And sometimes I get comments in e-mail not as comments on the blog. So it was that Mick Brooks e-mailed to point out an ambiguity in my blog posting, Software as an Asset, I wrote:

“Your software is worth $10,000,000. Next year, with inflation and depreciation the software may only be worth $9,000,000. So there is an incentive to invest up to $1,000,000 in improving the software, increasing functionality, or code quality, or making it easier to use.”

And Mick asked:

“I don't understand why there is an incentive to invest *up to* $1,000,000 - why
not twice that, or more?”

Well he’s right, I my thinking was sloppy. I skipped several steps in and jumped to a conclusion. The nature of blogging is that it is meant to be fast, what you think of now, not too polished. Anyway, let me think about this a bit slower...

What I was trying to say is: if your software depreciates by $1,000,000 over the course of a year there is a strong incentive to invest in it. At the moment software isn’t carried as an asset on the books, therefore it is worth $0 this year and $0 next year. Therefore, why invest in it?

Now suppose we wish to keep the software worth $10,000,000 each year. We now have to do something to add 10% value to the software just to stand still. Therefore, anything we can do that costs less than $1,000,000 is worth considering. What we really want to do is spend as little as possible to increase the value by as much as possible, i.e. maximise our rate of return.

There are two possible ways value the software. Firstly, remember I imagined a tool that could value our software? Well, what we need to know is what parameters that tool looks at, then by targeting those parameters we can increase the value.

For example, from a product perspective: if adding some new functionality to the system will add value we might do that. Or, from a programmer perspective, if improving the code quality, increasing cohesion and reducing coupling say, will increase the value we could do that. In this way the parameters the tool uses will guide us what changes we make.

The second way we might value the improvements to the software is to look at the effort expended in enhancing it. It is already possible to capitalise the cost of research and development projects, i.e. show expenditure on R&D as an investment on the balance sheet. So, we could argue that spending $100,000 on a programmer to make changes to the software increases the value of the software by $100,000.

We have to be careful with this line of arguing because we could end up counting every bug fix as an asset. WorldCom did something similar with their telephone network and look what happened to them.

Which ever way we value the software the trick is to find the way of increasing the value as much as possible by paying as little as possible - the rate of return. Once you know this you can compare such a project against others in your organization. So, if spending $100,000 to improve the software results in an extra $1,000,000 of asset on the balance sheet it has paid back 10 times.

Conversely, if spending $5,000,000 on a replacement piece of software results in an asset worth $10,000,000 (and the old software is binned) the return is only twice.

But, doing nothing, let the software stand still looks less attractive than it did when the software was not counted as an asset.

Thus, valuing software as an asset gives us a new way of thinking about how we manage the lifetimes of our software.

Back to Mick’s point: my example was a little brief. The real test is whether we can see the value of our software asset increasing faster than other assets. If it is then it is worth investing in. Whether this is a $100,000, $1m a $2m investment.