allPM.com :: Are you Managing the Right Projects? By Giancarlo Duranti, PMP

Are you Managing the Right Projects? By Giancarlo Duranti, PMP

Published on Thursday, July 01, 2010 - 03:57 PM

Traditional project managers focus on efficiency which means getting the job done successfully balancing the Competing Demands¹ : scope, time, costs, resources, quality and risk. But what about the business results for which the project was created? Projects do not look like investments. They are investments! Why? Because someone put some money into the organization to finance its business strategy, which means money was used to fund those projects that support the business strategy. He, she or they, the investors, as a consequence, would like to receive, at certain point, some money back from their investments. This is called Return On Investment or commonly referred to as ROI. Project Management is supposed to help them to achieve the expected organizational strategic objectives. As a consequence, what happens nowadays is that project managers are asked to be active participants during the projects evaluation and selection process in order to undertake the alternative that brings most benefits to the organization.

Project Selection

Organizations seldom select projects where the costs exceed the benefits. Sometime they do, as investments with the purpose of acquiring future projects in a new or in a very competitive business context. What they do normally instead is to select the project with the purpose of maximizing the profitability according to the organization’s business strategy. Organizations that reached a certain maturity levels employ Portfolio Management technique to select the projects aligned to their business strategy, specifically they:

Develop the discipline, methodology and processes
Establish project/program selection criteria
Conduct financial/strategic value analysis
Establish prioritization of projects and programs, in terms of organizational value
Select among multiple projects/programs, based on strategic alignment

The process of applying economic methods to identify financial benefits is called capital budgeting, which may be defined as: the decision making processes by which organizations evaluate projects.
In this article we will explore the most common techniques of capital budgeting (benefits measurements methods), the sensitivity analysis as a way of assessing risk in project investments and some considerations about the meaning of ROI.

Break-even Analysis

Break-even analysis is a profit planning method that determines the point where the cash outflows and cash in-flow become equal. The objective is to determine at what point in time the cash outflows (the expenditures incurred for implementing the product) will equal the cash in-flows. If the time frame is within the acceptable range for the organization, the project may be selected.

Figure 1 – Break-even Analysis
The Figure 1 illustrates how the Total Costs, the expenditures, balance the Revenues, the cash-inflows. The Total Costs are the amount of variable costs and fixed costs allocated on the project. The term variable refers to the nature of those costs that change, augment and diminish according to the level of production (i.e. the more pieces I build the more raw material and labor work I use). The fixed costs, on the contrary, refer to costs that are not related to the production level (i.e. the rent for a shed will be the same even though I do not build anything).

Payback Period

The payback period is the exact length of time needed for an organization to recover its initial investment as calculated from cash inflows. It ignores cash flow after payback which is needed to determine benefits.

Figure 2 – Payback Period
The Figure 2 shows that it will take three years to recover the initial investment the project start. This method is considered to be a rough method of evaluation because it doesn’t take into consideration that the value of money changes according to the time due to the cost of capital.

Net present value (NPV)

Net present value is a sophisticated capital budgeting method because the calculations are in currency and are adjusted for the time value of money. The time value of money is based on the principle that the value of the currency today is worth more than it will be one year from now.

It equates the discounted cash flow, expressed in terms of the Present Value (PV) against the initial investment. The NPV requires calculating the PVs of the cash in-flows for each year of the project. The PVs are added together to produce a sum of the present values, and then the initial investment is then subtracted to produce the resulting NPV. Ideally, the NPV should be greater than zero. An NPV of less than zero indicates that the investment will actually result in a negative return on the investment. In this case it would be like the organization pays money for the privilege of doing the project. The formulas below show how to calculate the NPV and the PV of the cash inflows.

NPV = II – sum (PVI1..PVIn)
PVI = FVI x Factor [1 / (1 + i)n]
Where:

II = Initial Investment
PVI = Present Value Inflows
FVI = Future Value Inflows
Factor is also called discount factor
i = discount rate per period also referred to as the cost of capital
n = number of periods (i.e. months, years, etc.)

This operation is also called cash inflows discount or normalization. Under this point of view the Initial Investment needs to be discounted if we take into consideration the real cash outflows of the project that is the points in time when the real expenditures will happen. In this case the formula will be as follows:
FVIn - FVOn
NPV = -----------------
(1 + i)n
Where:

FVIn = Future Value Inflows period n
FVOn = Future Value Outflows period n

The Exhibit 1 exemplifies an example of project evaluation. Here the initial investment of $5,000 is compared to the project benefits at the cost of capital of 10%. In the 5 year project the financial benefits will be $3722. A positive NPV indicates the company will earn a return equal to or greater than the cost of capital. A negative NPV indicates the company will not recover the initial investment. Certainly, the higher the NPV the better the investment.

NPV is also used to compare two or more projects to know which one of them will produce the higher financial benefits.

The example in Exhibit 2 shows the financial benefits of two 5 year projects. The one that require less initial investment seems to bring more financial benefits in absolute value.

The general principle is to discount (or normalize) contribution to the corporate “bottom-line” (additional profit or expense reduction) for a project to fairly compare that project with other investment decisions to be made during the budgeting, Portfolio Management, or delivery validation processes.

Internal Rate of Return (IRR)

The Internal Rate of Return of an investment, like a project, is the discount rate where the present value of the cash inflows equals the present value of the cash outflows. Looking at the picture from a different angle we can say that the IRR is the discount rate that makes the NPV equal to zero. The IRR is a synthetic financial performance information of an investment. The higher it is the better (between two projects the one with the higher IRR is the more profitable). The method to calculate it is the trial-and-error routine. Starting from a random rate value, trial by trial the process gets to the result making the NPV = 0.

Projects can be compared using the results of IRR to make accept/reject decisions or as a key for prioritization.

The example in Exhibit 3 shows how the IRR is calculated in five iterations.

Depreciation Value

Depreciation is another method that is often used when making a determination on project selection. Depreciation is an allocation of the remaining value or the useful life of an asset over a predetermined period of time, the period when it is supposed to use the asset in the project life cycle. Since depreciation is a portion of the cost of the asset allocated in a period of time that generally matches with the fiscal period it may affect an organization’s tax position and calculation of cash flow over time. A salvage value or remaining value of the asset, after depreciation, is also determined.

Sensitivity Analysis

Sensitivity Analysis is a method to assess risks. Capital budgeting risks analysis refers to the level of probability according to which we can predict cash inflows since the initial investment of a project is typically known.

Normally we use sensitivity analysis to compare different alternatives of investment like projects. However, in portfolio management we use sensitivity analysis with the purpose of maximizing the portfolio expected value. Since the expected value is a combination of project technical success and a product commercial success, we start evaluating the risk related to the project technical success and the risk related to the product commercial success. The Expected Commercial Value (ECV) comes from the following formula:
ECV = [(PV x Pcs – C) x Pts] – D

The following table represents an example of Project Portfolio with the application of this method.

Where:

Project name.
PV of the expected cash inflows
Project technical probability of success (Pts).
Product commercial probability of success (Pcs).
Project implementation costs (D).
Product commercialization costs(C).
Project Expected Commercial Value (ECV)

The exhibit above shows how the Expected Commercial Value of each project contributes to the overall portfolio value taking into consideration the probability of project and product success. With the purpose of optimizing the portfolio we need now to relate the potential projects to the resources available in the organization. In order to do that we need to know a performance indicator that measures the proportion of the project benefits versus the project costs: the Costs/Benefits ratio.

This Key Performance Indicator (KPI) is helpful to rank the more suitable projects for the organization.

If we suppose for example to have €15M resources available in the organization, the ranking of the projects in the portfolio is as follows:

Values in M€
It is reasonable for the organization to undertake the projects that fall over the bold line (bottom line) because, other than having the resource requirement satisfied, they are expected to be the most performing in the rank. The ones below the line will be considered on hold by the organization waiting, if feasible, for resource availability.

Beyond the ROI

We said that ROI stands for Return On Investments and at its most fundamental level it is an economic metric which means that it is tied to money. A broader and better view of ROI allows discovering more meaning of it. Under the straightforward number that means the money returned on the investment done, for organizations there are also some “soft” features that need to be take into consideration every time we refer to it. Beyond profit, also customer satisfaction, employees satisfaction and the increase of intellectual capital are aspects embedded into the ROI. Customer satisfaction can bring in more projects from that client other than very good references, and we all know how important references from a satisfied client are nowadays. Satisfied workers tend to generate more positive results in term of output, quality and costs. Increasing intellectual capital means how to become a better company raising the level of capabilities, enlarging the level of expertise. Sometimes the “pure” ROI will not be very attractive on a project because it is the first one, but the experience acquired allows for an outstanding performance in the following projects. The real ROI is a combination of the hard component, the financial benefits and the soft ones, the intangible benefits that an organization may achieve.

Conclusion

Even though projects end successfully, meaning that the expected product was successfully delivered according to specifications, the budget deemed necessary to create that product was spent according to forecasts and the project delivered the product on time as predicted by a detailed scheduling plan, but the business results are not able to cover the investments made and cover the expected margin of the investments. On the other side, some projects completed not so successfully according to the project management criteria, turn out to be a success, in terms of strategic objectives.

In any case an extended concept of project management requires project managers to have a wider background to support organizations in their project selection process helping them to avoid possible future project failures. The transition towards an extended vision of project management requires a kind of cultural change from top management support, to modified processes, to new training paths. Even more so, the project manager has to represents the core of project coordination, not only regarding the operations but also taking into consideration actions from his or her own business vision.

References
Harold Kerzner (2009). Project Management: A Systems Approach to Planning, Scheduling, and Controlling. Wiley (10th Edition).
Project Management Institute (2008). A Guide To The Project Management Body Of Knowledge (PMBOK® GIUDE) Fourth Edition.
R.G. Cooper, S.J. Edgett, E.J. Kleinschmidt (2001). Portfolio Management for New Products. Basic Books (2nd Edition).

© 2010 allPM.com

Giancarlo Duranti is a Project Manager Practitioner, PMP certified. He has been working in the Communication Wire-line & Wireless industry for over 20 years and he is well experienced in managing projects in different international and national business contexts. Giancarlo has consulted for overseas companies in Brazil, Cuba and US. His international experience, perception and sensitivity to other cultures gave him the opportunity to understand insights about managing multicultural team issues. He is also a trainer for project management certification programs and soft skills. He contributes in budding project management culture supporting the develop of new PMI standards, giving speeches on project management topics at congresses and other professional events, writing articles and being an active member of the local PMI Rome Italy Chapter.

¹ PMBOK® Guide – Fourth Edition, p. 37

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