Newsletter [2]

All of project managers love projects that will employ their knowledge, experience and unique competencies and capabilities and hate projects that don’t. Often a project manager (PM) knows when they are assigned to a good project and when they’re not. PMs hate projects that are “bridges to nowhere”, “solutions looking for a problem to solve” or a manager’s ego trip. Ultimately they want projects that will optimize their skills, enhance their knowledge, and make them more valuable and marketable to executive management or their client. The problem is that they rarely participate in project governance and they rarely get the chance but if the opportunity affords itself, the PM must know something about the governance area. It affords them an opportunity to contribute positively and perhaps influence the choice of projects assigned. 

Participating in governance is venturing into business analysis and if you possess capabilities in that discipline it can expose a PM to a broader view and lead to program and portfolio management.  Finally on this subject there is a need to have experienced PMs in the BA and governance area to squelch irrational exuberance of ill advised management.

If you want to get good projects you have to know how projects are selected and talk the talk that finance folks speak, since they are often decision makers or influencers on which project to select. Projects will be selected, and should be, by the return they provide the company, in tangible and intangible terms.  (Yes you’ll be learning finance, the devil’s own language.)

One can tell if they are assigned to the right projects - let’s call them profitable by evaluating their project ahead of time, before the project governance board begins find out what is the project selection process and review tools such as benefit measurement methods – Net Present Value (NPV), Break-even, Internal Rate of Return (IRR), Return on Investment (ROI), Benefit to Cost Ratio this will help project managers effectively deal with the financial side of project management. And remember to think about the overall project value –short and long term.

Business Analysts are more recently assigned to this work. It is a good idea for PMs to become friendly and remain friendly wit h your resident BAs so you know what projects are coming down the pipeline.

Often, due to the harried nature of our work, we tend to become myopic and don’t perceive what is crucial to our future.  PMs enter their manager’s office accept whatever projects they are handed. This is not to say that we can push back on a direct order but it may be valuable to ask the manager to tell you how this project contributes to the overall strategy of the company.

When I am delivering a BA or a PM course I often make a point to tell students how critical this is and what I see in response is a blank stare. I can appreciate and understand my client’s apathy but I try to shake them from it by telling them a story.  I worked for DEC and upon its demise many consultants, technical and management departed the company to land at professional organizations. There they learned in responding to a RFP they should always determine how a successful project would impact the corporate, division or unit financial statements. Upon project conclusion, the consulting organization would claim either their work increased assets, owner equity, revenues, cash flow or decreased liabilities or expenses. In other words, the companies demonstrated in very tangible terms that any manager could see where the benefits of the project were evidenced.

So when a project manager is composing their portion of their performance appraisal, is it more powerful to write “I completed project X.”  or write “I completed project X and as an outcome it increased corporate revenue by $xx,xxx.” I think you’d agree the later carries more gravity.

This point usually leaves some impression on the attendees.

But how do you know learn what the impact your project has on the business? Well, first it is best to join the governance process when the criteria for project selection is considered and perhaps a PM can get  dibs on what projects to lead. Dibs is old NYese for putting in a claim on something, like your oldest brother’s 45 rpm music records.

To begin, let’s view a time line. It is the end of a financial stage that signals the consideration of new projects. At the end of a financial period, be it yearly, semi-yearly or quarterly, business managers submit their period data and the bean counters go to work. The accountants and financial units create the period’s balance sheet, income statement and the cash flow (sometimes referred to as the sources and uses). The ratios are also created such as: current, acid, return on assets/liabilities, etc. and following their analysis they announce how the prior period performed from the financial. The marketing folks weigh in with their market (a ouija board is the typical tool), customer and competition including a forecast of the future. The economical oracles (the dismal scientists) are consulted for their view. The strategists contemplate and consider. Finally there is a report to the management board. Whew! It’s a wonder anything gets done at all.

The projects are then proposed and, we hope, something that has the potential to deliver some money is included. But there are many ideas and some are great but the old adage says, some great ideas should remain good ideas. As the list of potential choices narrows the return for the company is a crucial element of the filtering options. Hey, if you want to make it real watch “The Dragon’s Den” (BBC) or “The Shark Tank” to see what venture capitalists consider important. It’s their money and they take these ratios seriously.

The most common approaches to proving a financial case are payback period, NPV, Break-even, IIR, ROI, and Benefit to Cost Ratio. There is also a pro-forma statement that lays the financial benefits to cost ratios in projected financial statements but pro-forma statements are beyond the scope of this humble paper.

Break-even Analysis
Always begin with a simple Break-even statement. I like it because it is self defining. How much will you have to sell in order to cover your fixed assets and the variable assets that accompany each unit of whatever you produce.

Here is an example:                                                                                                                          
Imagine if you are manufacturing widgets, you will have to pay for cost of your widget factory even if you produce no widgets and remain at home like a couch potato.  These are your fixed assets and they include: electricity, plumbing water, taxes, and mortgage or rent, yada yada. If you get off you duff and run the widget producing machine you will have a cost associated with the materials and labor for making them. (Your parents may still not view your labor as worth very much but be sure to pay yourself.) Together the Fixed and Variable assets are your total costs for the period. While manufacturing the widgets hopefully someone is making the effort to sell them. (By the way, sales folks are also a cost.) Another cost associated with running the widget maker is someone will be selling your widgets, unless they can fit in a vending machine. When enough of your widgets pay for all your fixed and variable costs, you have broken even. Yippie!!! Don’t get too excited buckeroo, you haven’t made any profit yet, so your pockets are still empty. However, from now until the end of the month, for every widget you make you will get some bucks to keep while paying for the cost of each widget made. The more you make, the more profit you make. As you make more and more, the amount of profit will increase (This explains the economy of scale which is beyond the scope we’re at here but I must add that it is the only study of economy that isn’t dismal.) There is a caveat, if you make more than you sell you will have to store the excess and this will eat into your profit again. So don’t make too much.

Each period you need to make money so your total revenue needs to exceed your total expenses (Revenue – Expenses). If we attempt to forecast profit for the future, using prior financial data, we call this Future Value.  We hope you're going to make more money not lose money.  Losing money happens commonly in the early stages of any new venture but it shouldn’t go on for many months - unless you are GOOGLE - that is so each period you need to make a profit but you may not, In this case the function (revenue – costs) will be negative. You won’t last too long like that and your enterprise will be short lived.

If you make a forecast of revenue to expenses you are projecting a future value. Remember this is a projection or forecast. You haven’t got the money in the bank, so until it shows up on your balance sheet spend as little as you need.

(The most common reason for a new venture to fail is not mismanagement, it is generally because it runs out of capital. It is why finance folks say “CASH IS KING”.)

Here is the equation you will need to project Future Value:

Payback Period =              Period 1     +     Period 2     +     Period 3     +     Period 4     +     Period 5   FV =                              (Frev – Fexp) + (Frev – Fexp) + (Frev – Fexp) + (Frev – Fexp) + (Frev – Fexp)
Another formula for Future value that is commonly used is: FV = PV ( 1+rⁿ)

Where FV is the future value (what your investment will yield) and PV is the present value (the value of your investment in today’s economic environment). The r represents the interest rate and the exponent refers to the year of the investment.

Payback Period
OK moving right along, if you can estimate the future values for a few periods ahead (usually years but I’ve seen it done in months) you can estimate how many periods it is going to take until you return your initial investment. Now, to many of you this may seem like a pretty primitive investment approach but if you read the Wall Street Journal in 2009 you would discover that many financial firms then, and to a great degree now, have this as a primary investment decision filter. If that doesn’t convince you, then go to the bank and see what it takes to get a loan. The banks want to know first that they are going to secure their loan and they want to know how quickly they will get back their investment. They can tell you, to the penny and the day, when it will happen before they approve your loan request.

Discounted Cash Flow
In the 19th century, the US financial system was based on the gold standard. If you knocked on the door of the Fed you could surrender your paper money and the Fed would give you gold. Year after year the same amount of gold. If that were the case now, then there wouldn’t be any diminishment of your dollar’s value. But as we know that is not the case now. The project is going to last more than one year we have to consider the value of the dollars we will receive in the future. The looming question is:  Is a dollar today worth a dollar tomorrow? All together shout, “NO!!!” Just go to the Fed now and ask for your gold and see the bemused look the Fed. Reserve agent will have before call security to throw you out or cart you to the nearest asylum.

When the newspapers write about inflation they frequently show depictions of $s growing smaller, shrinking with time, so what is that about? Well, as the cost of inflation increases, the value of your dollar decreases. So unless your investment pays off this period you need to consider what inflation will do to your return. (Another choice for non-inflation might be North Korea where bartering is all the rage.) 

To learn what the REAL value of your investment returns over the future periods in today’s dollars, over time, we use the Future Values (FV) and adjust it or as they say in finance discount it for inflation. This method is called discounted cash flow. Each of the period’s FVs are divided by a function that is:  the interest rate raised exponentially to the year (1 + i)ⁿ. So we divide the FV by 1 (which makes it itself) plus the interest rate raised to the exponent of the year.  See here FV/(1 + i)ⁿ

We can apply the function (1 + i)ⁿ to each of the projected FVs in each year to determine the return in TODAYs dollars. (DCF means Discounted Cash Flow)   So let’s see how that looks:

DCF =       FV        +        FV       +      FV        DCF =  (rev – exp) + (rev – exp) + (rev – exp)              -------------      -------------     -------------                    (1 + i)¹          (1 + i)²          (1 + i)³                                                                                                                                                    
After calculating, each of the period Future Cash Flows represents the Present Value (in today's dollars remember) of the return for each of the periods.

It is the denominator function, (1+i)ⁿ that makes the DCF, a DISCOUNTED Cash Flow.

Thus
                                                                                                                                          
DCF =         FV        +        FV       +      FV        DCF =   (rev – exp) + (rev – exp) + (rev – exp)            --------------     --------------    --------------                    (1 + i)¹          (1 + i)²           (1 + i)³          thus

DCF =                  PV1              PV2              PV3              
However, there is something that’s missing in the DCF and that is the value of the investment that was present in the payback period. So if we insert it into the formula above we get the NET Present Value of our investment. One thing we must remember is that the investment is an outflow of money, so the value of the FV in period 0 is negative. Since we calculate the Present Value for each year it is adding the negative investment or outflow of funds that makes this formula a NET. Hence

DCF =        FV         +      FV         +      FV        +       FV        NPV =   (rev – exp) + (rev – exp) + (rev – exp) + (rev – exp)              --------------    ---------------    --------------    --------------                      (1+ i)⁰           (1 + i)¹           (1 + i)²         (1 + i)³                            PV0               PV1               PV2             PV3               
Now what you should notice above is that the denominator of the 0th year is raised to the exponent of 0, which makes the entire function (1+i)⁰ equal to one. To say it another way, the exponent of 0 makes the discount function drop out. So why do I put it in? To show the formula is consistent throughout. This makes sense, doesn’t it? After all, the value of the dollar is equal to its residual value in the year that it was invested, so there should be no change. We pointed out earlier that the FV for year 0 would also be negative because the FV is an outflow. (Are all you scouts with me here? Quick someone do a roll call! )

So now you have a value that is equal to the value of today’s dollars. So again, his net present value tells you the value of the return of your investment over a period of time in TODAYS dollars. This is pretty good information to know right don’t you think? NPV is commonly in companies the information they use to make major decisions.

So why all this effort? Here’s the bottom line. If we have two investments of near or the same amount then when we run their FVs through the NPV we can determine, IN TODAY’s dollars which is better. We would pick the investment with greater return. (I am also assuming both investments carry the same risk. If they do not we have to discount the NPV further to adjust for it as well. Say one of the investments is overseas and we can foresee the possibility of a currency change. .

But there is another tool that can supply valuable knowledge when considering alternative options.

OK. We have a little further along to travel but hang in there!

Here’s a questions? What are the two options are of different amounts? And they have returns of different values? How do we make a choice between these? To help that situation we use the NPV formula as well. The Internal Rate of Return will help by determine the rate or percent of return each option provides and we will choose the one with the greater return. This is the method we all use at present to choose the funds we invest in for our retirement accounts.

Internal Rate of Return
I can inform you of two things that will make your life easier concerning IRR. First, don’t ever try to calculate IRR alone, have someone spot you, you can hurt yourself. It is a very long and tedious calculation. Did I say long and tedious?  Let me repeat. It is a very looooong and teeeeedious calculation. Always use a business calculator or a spreadsheet or better still a friend – one of those dorks you knew from high school.

Second, IRR tells you the same information as the NPV, except it’s a rate, a percent. So if it tells you the same information why do I care? Why not just use the NPV?

Here is why you want the IRR. The NPV is great if two investment options are the same investment amount but what if there are two different investment options with different initial investment amounts and different returns. Which will provide the more profitable r return given the investment? Well the IRR can tell you. When you consider which funds to invest in with your IRA or 401k dollars you don’t look at what money the fund made previously, you view the returns they showed for the previous 1, 5 or 10 years; at least I hope you do. We are applying the same principal here.

The formula for IRR is the same as the NPV shown above. So once you have calculated NPV using the appropriate interest rate, you increment the value of “i”, until NPV diminishes to zero. That is the IRR for each investment. This is the painful part. Just know that you choose the investment with the highest IRR, same for the NPV.

1. Easy, right!

Of this information supplies a thread starting with a simple consideration of breaking even to determining a rate of return for choosing among different projects. The degree of rigor you apply is predicated on the amount of the investment and the degree of risk.  In fact, sometime a risk factor is applied to the NPV for each year’s projected FV with the risk factor increasing with each year.

Assemble all these values in a table and it will provide important input to the consideration of different projects. But I must add this. First, most projections are made from a record of the past. Remember monkeys on Wall Street have done as well in predicting stocks as the best traders. The quality of the conclusion is based on the quality of the estimates for the FVs. Remember the old adage GIGO, garbage in, garbage out.

In this paper, I have attempted to show all the different approaches to determining the value of an investment. Often these methods are taught as discrete methods. Actually there is a thread that binds them all and I think that it is valuable for the reader to see that. You be the judge of my effort and let me know.

Remember, the best project for your organization may not have the best numbers and a project that improves the performance of your staff may propel your organization pass competitors although there is no financial return that may projected.  Don’t get lost in numbers. Take in the big picture.

Now go see your project governance board and dazzle them with your brilliance.

© 2010 allPM.com

Anselm E. Begley, PMP, CBAP, PRINCE2, MBA, is Sr. Consultant and Lead Trainor for PRINCE2 at  International Institute for Learning [3]. Anselm spent 30 years in the IT industry as a business and project manager. He retired from Hewlett-Packard in 2007 and has been teaching project management, business analysis and soft skills courses internationally. Anselm is especially interested in synergies; most especially synergies between business, businesss analysis, enterprise analysis, program mgt. , operations/production as the keystone of strategic planning success. Anselm views  multi-cultural awareness, which includes corporate, industry culture with racial and national culture as the fiber that permits elasticity for change. As a HP manager, Anselm mentored many of his colleagues and reports to achieve professional, academic and personal success and he has a reputation for educating professionals in project management to ensuring their success at professional certification examinations on the first pass. In the past, he has given technical instruction at NYU and City University of NY. Contact Anselm at anselm.begley@iil.com [4].