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RFID Needs a New Justification Model

Manufacturing Insights' Bob Parker explains a new approach to the measurement of ROI with respect to RFID deployments.
Aug 04, 2005This article was originally published by RFID Update.

August 4, 2005—The progress of RFID adoption is confronting many obstacles. Some of these obstacles are technology related, others educational, but by far the most prevalent and daunting is procedural – the inability to create a business justification. My father used to tell me, "It's a poor craftsman who blames his tools," but in this case it is appropriate to blame the ROI-based tools that are being applied to evaluating RFID investment. Companies must look at any RFID investment as a platform, not an individual pilot or compliance exercise, and traditional justification methods just don't capture and communicate the value well enough to inspire management approval.

Discounted cash flow techniques yielding a measure of ROI were developed to help companies assess the investment in incremental assets like production equipment and copy machines. These traditional models abhor uncertainty and will over penalize risk when calculating ROI. They also work best when there is a single positive benefit (e.g. produce more product, save time) rather than many possibilities. RFID, with a high level of uncertainty (e.g. tag prices, standards – although these uncertainties are more "when" than "if") and a number of possible applications, is unfairly treated by ROI tools, but is there a workable alternative?

Enter Real Option Theory. The methodology, popularized by Boston University professors Martha Amram and Nalin Kulatilaka, seeks to apply the option valuation techniques developed by the financial services industry to corporate investments that are characterized by high uncertainty and many possible outcomes. Further work by Robert Fichman of Boston College applied the approach to technology investments with RFID being a common example. Under this approach, the value of being in a position to take advantage of RFID-based opportunities when the technology is ready (the option) is given a value and taken into consideration when evaluating the return on investment.

Real Option Theory is not without its detractors. There are two common criticisms. Many believe that evaluations, although dealing better with uncertainty, are too generous in the results and, second, that the mathematical models (e.g. Black-Scholes) used to calculate option value are too complex for corporate communication.

To address these issues, Manufacturing Insights recommends that companies follow an approach that is a hybrid of Real Option Theory and traditional discounted cash flow techniques. The first thing to do is to not view the investment as an RFID project, but the establishment of a data acquisition platform, one that includes identification, sensors and actuators. The next step is to look at how this automated platform can make existing data collection processes more efficient, which usually yields a benefit stream that has a modest (usually below corporate hurdle rates) return and a payback between three and four years. On top of this base level of benefits, the company would then add the value of the options that are created based on when they could be exercised (e.g. when tag prices are at x, or read rates are y) and the value those additional processes represent. Those option benefits are then discounted to the current year and added to the base-level benefits, which is likely to create more than sufficient justification for investment.

Applying this alternative justification is only the first step. Successfully executing will involve having the discipline to recognize when it is time to exercise the options and having the resources to implement the solution. To this end, Manufacturing Insights recommends that a program management office be formed specifically to oversee activity involving a company's data acquisition platform. Companies that have invested more aggressively in data acquisition technology like RFID have done so with an intuitive understanding of the option value. It is time to formalize the approach because the companies that make these investments will create a distinct competitive advantage for themselves.
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