TA GROUP LIMITED Adding Value Through Technology

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1 TA GROUP LIMITED Adding Value Through Technology 'Newnhams', West Street, Farnham, Surrey, GU9 7EQ Tel: (01252) ; Fax: (01252) Presentation to 14th International Symposium on Military Operational Research Shriven ham September 4th 1997 Gareth Webb John Beasley A FLUOR DANIEL 9 COMPANY Registered in England Number Registered Ollice: 'Newnhams'. West Street. Farnham. Surrey. GU9 7EQ

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3 INVESTMENT APPRAISAL FOR THE HIGHER MANAGEMENT OF DEFENCE By JR Beasley and GA Webb Introduction This paper is intended to provide an insight into the issues and challenges facing the UK MOD in the move towards investment appraisals at the highest levels of defence programming and plans. The paper is based on some work recently undertaken by the TA Group for CDA(Land) and DSc(Land) on balance of investment for the land equipment programme. Eauipment Proyramminp Issues The continued pressure on Government spending, coupled with the drawdown of post Cold War force levels has brought the need for value-for-money ever more into focus for defence procurement. Although there has been an easing of East-West tensions, the world security situation has meant unforeseen demands for British forces and equipment. The present situation offers the planner little in terms of leeway in available resources and the potential short notices of operations offer virtually no time to regenerate manpower, equipment and stocks. This puts even more pressure on peacetime planning to ensure that sufficient response to crises will be effectively immediately available to deal with a range of tasks from humanitarian aid to war fighting. Kev Reauirements for a Hiph Level Balance of Investment Process Given the above issues, there is a very real need for a robust balance of investment process which is not only a decision making aid but also provides a visible mechanism for risk management. The key requirements for such a process include: a. The planning context must be defined to provide sufficient background to illustrate the varying effectiveness of equipments in the possible range of operating environments; this planning context should include the following information: i. the scale of the force to be committed; the particular type of operation, such as war fighting or peacekeeping and assumptions, for example, on intensity and host nation support; iii. distance to deploy; iv. timings for deployments for lead and main elements; v. the capability of fighting elements when they arrive in-theatre. Without these contextual baselines, the uncertainty on contingency operations are too great for any sensible investment appraisal.

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5 b. It must be possible to illustrate the effects on costs of varying equipment programmes over not just the 10 year LTC period but through the life of the equipment. C. Some credible form of value assessment must be available to decision-makers to enable the comparison of the relative worth of equipment programme options and assess what-ifs on programme options. This will typically be in the form of measures which reflect the areas key players are worried about and could include measures such as the risk to successful achievement of military objectives, levels of blue personnel and equipment casualties. Collectively, the probability of achieving these measures come under the umbrella term of operational effectiveness. d. The BO1 process must be able to deal with the large size and complexity of the problem i.e. hundreds of equipments projects at varying stages of development and each project varying enormously in size and cost with the added dimension that separate projects can be highly interdependent and these dependencies do not respect boundaries, budget lines, cap badges or service. e. Decisions made must be fully auditable and as objective as possible such that the risks taken are visible to the key players. This is an extremely important perspective because it will nearly always be the situation that a degree of risk is taken, the key to allowing this risk is to making it visible to the decision makers. Possible influences and effects for OR Clearly, the BO1 process requires cost and effectiveness data and in theory OR is the ideal candidate for supplying effectiveness data. To be readily usable in an absolute sense these data should have the essential characteristics of the following: a. it should be derived from a high level, all arms view of the campaign covering the planning contexts envisaged including humanitarian missions. b. it should be derived from a validated and trusted model and data sources. c. outputs compatible effectiveness measures in a suitable format. A good example of suitable high level OR being implemented is the CDA Assessment of Defence Capability project. There is, of course, a plethora of low level OR data available but the application of low level OR is not straight forward. Low level data will have a direct role to play if the models are consistent and validated or the data lends itself to aggregational summation such as in the case of mines or ammunition. However, generally re-using and aggregating low level OR data will probably not be feasible because of the focused and constrained nature of the studies and models, and the complexities and issues arising from the combining of differing study results.

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7 b* 3 Even in an ideal case hard OR can only ever supply a sub-set of the data required and soft OR will be required in the form of, for example, formalised judgement processes and lessons leamt from operations and training. In supplying information to feed the balance of investment process it will therefore be essential to use decision-making techniques that utilise data from various sources. Decision-making Techniaues The strategic planning / programming problem is one which is common in many management situations both public and private sector. It is essentially one of choosing between different possible courses of action. In this part of the talk I shall look at how this problem is approached in the commercial world and in doing so identify a number of issues which may be of help to the OR community. There are a number of standard approaches are available to assist in this problem. They include optimisation, systems analysis and what-if analysis. The what-if analysis technique was found to be most comparable with equipment programming. This approach has a number of advantages: a. it provides the decision-maker with the relevant information for him to make a choice; b. it comes closest to the essence of the decision-making process in real life. Whatever the approach, they all require one or more measures of output, some of which has already mentioned in the defence context. In practice, the analyst who is supporting the decision-maker will wish to provide a range of options and associated recommendations rather than a mass of data. In the next section, ways in which options can be ranked or otherwise selected are considered. Capital budgeting The key aspect of capital budgeting in the coqunercial sector is the explicit treatment of costs, benefits and timescale: - investment takes place now, while benefits accrue at some future time. The standard technique to handle this is to use discounted cash flow analysis leading to a net present value for each option under consideration. Different investment options will give rise to different NPVs and, other things being equal, a manager will choose preferentially those options which give rise to the largest (positive) NPV. One method which can avoid the sometimes arbitrary choice of interest rates in NPV calculations is to calculate the interest rate that makes the NPV equal zero. This is known as calculating the Intemal Rate of Retum (IRR). Investment options are then compared in terms of their expected IRR - other things being equal, the higher the better.

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9 The key challenge to the defence OR community is to reach a stage where the benefits arising fiom buying a certain military capability can be expressed in financial terms and so allow standard commercial techniques to be used to inform capital budgeting decisions. Risks and uncertainty An important aspect of the decision-making process is the need to capture the inherent risks and uncertainties. A number of techniques are shown here. Finite planning horizon. The essential idea is that one simply ignores the effects of the distant future by imposing a finite planning horizon. Of course this is simple, but it is essentially an arbitrary choice. The LTC process is based on this finite planning horizon approach. It is clearly not a flawless approach. It also does nothing to deal with uncertainty within the planning period. Sensitivity analysis One could obviously carry out a number of sensitivity analyses to explore different future events, but even though this seems sensible in theory, in such a technique tends to provide results which are lacking in precision and conciseness. Risk discounting If one makes use of an NPV approach, the discount rate that is used can be modified to account for risks. In such a case the discount rate is increased to penalise benefits which are accrued in the far future. The concept is based on the fact that there is a trade-off between risk and retum. The key issue is the form of this trade-off. In most cases this tends to be established subjectively. In some specialised cases, however, this trade-off can be established with respect to previous experience. Once again, this depends on an essentially financial approach where riskheward ratios are clearly visible. Expected value Often people use decision trees which indicate the probability of a future outcome and the value of the option under consideration should this happen. By combining the probabilities and the values one calculates an expectation value. Although it has a role to play, there are some important limitations to the usefulness of the expected value approach. In reality, expected values are meaningful only in a statistical sense - they are after all the average value resulting from a large number of "trials". In most project cases, the project takes place only once. Most decision makers will evaluate the merits of two projects with the same expectation value, but very different standard deviations, in different ways. This indicates that expectation values, despite their widespread use, cannot capture the essence of real decision-making except in special cases. It also illustrates the importance of understanding the spread of possible outcomes for the decision-maker.

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11 This has led us to consider the use of a game theory type of approach to handle risk and uncertainty in a more acceptable manner. Game Theory Unlike the preceding techniques, Game Theory allows one to set up a problem in which a variety of outcomes may be possible, but without (in the first instance) assigning probabilities to them. At its simplest level, one needs to establish a pay-off matrix which sets out, for each option being considered, the "value" (for example cost-benefit or NPV, etc) of that option under one or more scenarios. Game theory then is used to give a rational method of choosing which option is most appropriate. A number of rules can be applied to the payoff matrix. These include: a. Bayes; b. Maximin; c. Maximax. However the Minimax regret rule is often used. Here one has to construct a regret matrix based on the pay-off matrix. Each entry in the regret matrix is the amount by which the actual pay-off could have been improved, had the best option (for a given scenario) been selected - essentially the opportunity cost. To translate this to a defence context by way of illustration, this selection rule ensures that even if the likelihood of general war is assessed as being rather small, options which would be disastrous in a general war context are avoided. Accuracv and value So far it has been assumed that the data used in the decision-making process is entirely accurate, whether it be in terms of the measures of effectiveness or in terms of costs. In practice this will not be the case for a variety of reasons: a. future costs can at best be estimated, rather than guaranteed; b. models which provide measures of effectiveness will have some inherent inaccuracy; c. actual equipment may or may not perform in line with that predicted by modelling; d. scenarios used as test cases may or may not prove to be realistic in practice. Estimates of the accuracy of the input data is therefore vital if one is to be able to set accuracy limits on the output of the decision-making methodology. Such estimates are also important to guide the required level of accuracy of the various sources of data which contribute to the decision-making process. For example, if a benefithost ratio is required there is little point in achieving an accuracy for the benefit element of *lo%, if the accuracy of the cost element is *loo%.

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13 There is a further consequence of the less than perfect accuracy of the input data. This is that although there will be cases where a methodology will be able to distinguish between options, there will also be cases where the error budgets are such that no distinction is possible - one should be bold enough to point this out to the decision makers. Summarv In summary, the paper has outlined the issues facing equipment programming and identified the need for a robust investment process. The key requirements to support investment appraisal and strategic decision-making have been highlighted. A central element to this is the definition of the planning context for contingency operations. High level OR was seen as a possible effectiveness data source although the utility of low level OR data was not seen as being straight forward. Any decision making techniques would therefore need to utilise data from a number of other sources to fill gaps in the data. Strategic decision making and capital budgeting are common tasks in the business world. The techniques available require that costs and benefits be expressed financially. Risks and uncertainties can be accommodated in these techniques. There is a variety of methods of selecting options in a rational way in particular Game Theory offers a rational way of choosing options which is relevant to defence equipment programming. But perhaps most importantly, an understanding of the error budgets should be used to inform what spending on OR is justified in a given case. A balanced approach by the OR community, which integrates benefit analysis and cost analysis, is required to ensure that decision-makers are getting value for money from their OR spending.

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15 TA Group Ltd Presentation to 14 ISMOR 4th September 1997 Investment Appraisal for the Higher Management of Defence Gareth Webb John Beasley Equipment Programming and Balance of Investment 9 Programming Issues. Key Requirements OR: possible effects & influences. - Strategic Decision-making. Summa y Y 1

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17 Current global situation Balancing the programme Other issues - Tri-service issues - Balance between Manpower, Training, Sustainability - Costings - Business processes Contributing Military Capability Planning Context -Scale of Force - -Demand /Distance -Timings / Operational capability Costings over Equipment Life Value assessment Size and complexity Decision visibility? 0 2

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19 J Low \ * OR as a data source - High / all arms / Campaign level modelling, planning context ~ ' I. - trusted models compatible outputs / detailed modelling - Aggregation - Feeding / validating 3 Longer term change Strategic Decision-making Strategic planning * ' Investment and risk Information & accuracy Summay 3

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21 9 Optimisation * System analysis What-ifanalysis * All require defined output measures 0. Discounted cash IO04 I 60 flow PCF) 80 NPVandIRR Requirement to 0 express benefits in -20 r i a l terms Need to use whole 40 life costs

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23 -9 Risk and uncertainty L ~ 4 Finite planning horizon * Sensitivity analysis * Risk discounting a Expected value * Gametheory Selection criteria - Bayes - -Maximax - Hurwicz -Minimaxregret Option 2 Option 3 5

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25 * Programme options * strategicscenarios * Timeframes Measures of effectiveness Military judgement Expert panels Delphi History and trend analysis Is it worth it? I 6

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27 - Sources of error - Estimates vs actual - Models - Unrealistic scenarios 3 Erroranalysis - costs - Benefits Essential BO1 requirements Strategic decision making and capital budgeting in the business world Costs and benefits expressed financially Techniques to handle risks and uncertainties Rational selection of options Error budgets 7

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29 TA Group Ltd Newnhams, West Street, Farnham, surrey GU9 7EQ Tel: l14l4 Gareth Webb John Beasley P 8