The Option Value of Modularity in Design : An Example From Design Rules, Volume 1: The Power of Modularity

When the design of an artifact is quot;modularized,quot; the elements of the design are split up and assigned to modules according to a formal architecture or plan. Some of the modules are quot;hidden,quot; meaning that design decisions in those modules do not affect decisions in other modules; some of the modules are quot;visible,quot; meaning that they embody quot;design rulesquot; that hidden-module designers must obey if the modules are to work together. Modular designs offer alternatives that non-modular (quot;interdependentquot;) designs do not provide. Specifically, in the hidden modules, designers may replace early, inferior solutions with later, superior solutions. Such alternatives can be modeled as quot;real options.quot; In Design Rules, Volume 1: The Power of Modularity (MIT Press, 2000) we sought to categorize the major options implicit in a modular design, and to explain how each type can be valued in accordance with modern finance theory. This paper provides an example of the valuation of the modular options quot;splittingquot; and quot;substitution.quot;We show that the key drivers of the quot;net option valuequot; of a particular module are (1) its quot;technical potentialquot; (labeled s, because it operates like volatility in financial option theory); (2) the cost of mounting independent design experiments; and (3) the quot;visibilityquot; of the module in question. The option value of a system of modules in turn can be approximated by adding up the net option values inherent in each module and subtracting the cost of creating the modular architecture. A positive value in this calculation justifies investment in a new modular architecture