Chapter 2

Selecting Projects Strategically

Copyright 2009 John Wiley & Sons, Inc.

Problems With Multiple Projects

Delays in one project delays others Inefficient use of resources Bottlenecks in resource availability

Ch #-2

Challenges
Making sure projects closely tied to goals and strategy How to handle growing number of projects How to make sure projects are delivered on time, on budget and with requested functionality

Ch #-3

Project Selection and Criteria of Choice

Project selection Evaluating Choosing Implementing Same process as other business decisions

Ch #-4

Project Selection and Criteria of Choice

Strategic Alignment
Projects that are consistent with the strategic goals of the organization should be selected
Ch #-5

Examples of Project Selection

A manufacturing firm chooses which machine to adopt in a process A TV station selects which comedy show to run A construction firm selects the best subset of potential projects A hospital finds the best mix of beds for a new wing
Ch #-6

Types of Companies Companies considering projects fall into two broad categories:
1.

2.

The ones whose core business is completing projects The others whose core business is something else

Ch #-7

Project Companies

Must select which projects they will bid on Generally based on

Their expertise Resource they have availability Their chance of winning bid

Preparing a bid is expensive They do not want to waste that effort on bids where they are unlikely to be successful
Ch #-8

Non-Project Companies
Must decide which potential projects they will pursue Available capital is the major constraint Profitability is often the major criteria Must evaluate approaches when there is more than one project that can accomplish a goal

Ch #-9

Models
Models are used to select projects All models simplify reality That is, they only look at the key variables involved in a decision The more variables included in a model, the more complex it becomes Simpler models usually work better

Ch #-10

Types of Models

Stochastic/Probabilistic Model

A model that includes the probabilities of events occurring within the model. In other words, the same inputs might yield different outputs at different runs. A model that does not include probabilities. Given the same inputs, the outputs will always be the same.

Deterministic Model

Ch #-11

Criteria For Project Selection Models

Companies only want to undertake successful projects Projects that fail waste resources and hurt profitability and competitiveness Projects that succeed improve profitability and competitiveness It is not possible to know ahead of time if a project will succeed or fail In fact, there is a continuum of possible results from total success through absolute failure
Ch #-12

Criteria

(Continued)

Companies need a way of weeding out the bad projects while keeping the good ones No model can predict with absolute certainty What we want is a model with a good batting average

Ch #-13

Model Criteria
Realism Capability Flexibility Easy to use Inexpensive Easy to implement

Ch #-14

The Nature of Project Selection Models

Models turn inputs into outputs Managers decide on the values for the inputs and evaluate the outputs The inputs and outputs never fully describe the situation Models are just tools Managers are the decision makers

Ch #-15

Different Factors Affecting Outcome

Many factors affect the outcome of a project

Some are one-time factors

The cost of an item to be purchased Maintenance

Others are reoccurring

Not all factors are equally important Critical factors on one project may be trivial on another project
Ch #-16

Predictors of Project Success

Expected profitability Technological opportunity Development risk Appropriateness of the project for the organization

Ch #-17

Project Evaluation Factors

table_02_01

Ch #-18

Types of Project Selection Models

Nonnumeric

models Numeric models

Ch #-19

Nonnumeric Models
Models that do not return a numeric value for a project These are really not models but rather justifications for projects Just because they are not true models does not make them all bad

Ch #-20

Types of Nonnumeric Models

Sacred Cow

A project, often suggested by top management, that has taken on a life of its own. It continues, not due to any justification, but just because. A project that is required in order to protect lives or property or to keep the company in operation. A project that is required in order to maintain the companys position in the marketplace.
Ch #-21

Operating Necessity

Competitive Necessity

Types of Nonnumeric Models

Continued

Product Line Extension

Often, projects to expand a product line are evaluated on how well the new product meshes with existing product line rather than on overall benefits. Projects are subjectively rank ordered based on their perceived benefit to the company. Focuses on long-run profitability rather than shortrun pay-off.
Ch #-22

Comparative Benefit

Sustainability

Numeric Models

Models that return a numeric value for a project that can be easily compared with other projects Two major categories:
1.

2.

Profit/profitability Scoring

Ch #-23

Profit/Profitability Models

Models that look at costs and revenues

Payback period Discounted cash flow (NPV) Internal rate of return (IRR) Profitability index

NPV and IRR are more common

Ch #-24

Payback Period
The length of time until the original investment has been repaid by the project A shorter payback period is better

Ch #-25

Payback Period Example

Project Cost Payback Period Annual Cash Flow $100,000 Payback Period 4 $25,000
Ch #-26

Payback Period Drawbacks

1. 2.

3.

4.

Does not consider time value of money More difficult to use when cash flows change over time Less meaningful over longer periods of time Ignores cash flows beyond payback period

Ch #-27

Discounted Cash Flow (NPV)

The value of a stream of cash inflows and outflows in todays dollars Also known as net present value (NPV) or just discounting Widely used to evaluate projects Includes the time value of money Includes all inflows and outflows, not just the ones through payback point
Ch #-28

Discounted Cash Flow

Requires a percentage to use to reduce future cash flows

This is known as the discount rate or hurdle rate or cutoff rate

There will usually be one overall discount rate for the company

Ch #-29

NPV Formula

Ft NPV (project) A0 t 1 t 1 k
n

A0 Initial cash investment Ft The cash flow in time period t (negative for outflows) k The discount rate n The number of years of life
Ch #-30

NPV

A project is acceptable if NPV is positive A higher NPV is better The higher the discount rate, the lower the NPV

Ch #-31

NPV Formula Including Inflation

NPV (project) A0 t 1
n

1 k pt

Ft

pt

Predicted rate of inflation during period t

Ch #-32

NPV Example
A project requires $100,000 investment with a net cash inflow of $25,000 per year for a period of eight years, a required rate of return of 15% and an inflation rate of 3%

per year.

Ch #-33

NPV Example
$25,000 NPV (project) $100,000 t 1 t 1 0.15 0.03 $1,939
8

Ch #-34

NPV Example

table_02_02

Ch #-35

Internal Rate of Return (IRR)

The discount rate (k) that causes the NPV to be equal to zero The higher the IRR, the better Finding the IRR requires a financial calculator or computer IRR can also be found by trial and error In Excel =IRR(Series,Guess)

Ch #-36

Profitability Index
a.k.a. Benefit cost ratio NPV of all future cash flows divided by initial cash investment Ratios greater than 1.0 are good

Ch #-37

Advantages of Profitability Models

Easy to use and understand Based on accounting data and forecasts Familiar and well understood Give a go/no-go indication Can be modified to include risk

Ch #-38

Disadvantages of Profitability Models

Ignore non-monetary factors Some ignore time value of money Discounting models (NPV, IRR) are biased to the short-term Payback models ignore cash flow after payback Sensitive to error in data

Ch #-39

Scoring Models
Unweighted factor model Weighted factor model

Ch #-40

Unweighted Factor Models

Each factor is weighted the same Easy to compute Just total or average the scores

Ch #-41

Unweighted 0-1 Factor Model Example

Figure 2-2
Ch #-42

Unweighted Factor Scoring Model

Give a score (point) to each criterion and sum them up Select the project with the highest total score Generally a five-point scale is used

Ch #-43

Unweighted Factor Scoring Model Example

Criterion: Estimated annual profits Score Performance level 5 Above $1,100,000 4 $750,001 to $1,100,000 3 $500,001 to $750,000 2 $200,000 to $500,000 1 Less than $200,000
Ch #-44

Unweighted Factor Scoring Model Example

Criterion: No decrease in quality of the final product Score Performance level The quality of the final product is 5 significantly and visibly improved 4 significantly improved but not visible to buyer 3 not significantly changed 2 significantly lowered but not visible to buyer 1 significantly and visibly lowered

Ch #-45

Weighted Factor (Scoring) Model

Each factor is weighted relative to its importance

Weighting allows important factors to stand out

A good way to include non-numeric data in the analysis Factors need to sum to one All weights must be set up so higher values mean more desirable Small differences in totals are not meaningful
Ch #-46

Weighted Factor Model

Si sij w j
j 1

Si sij wj

Total score of the ith project Score of the ith project on the jth criterion Weight of the jth criterion

0 w j 1 and j w j 1
Ch #-47

Weighted Factor Model Example Automobile Selection

Table A
Ch #-48

Weighted Factor Model Example Automobile Selection

Table B

Ch #-49

Weighted Factor Model Example Automobile Selection

Figure A Ch #-50

Weighted Factor Model Example Automobile Selection

Figure B Ch #-51

Advantages of Scoring Models

Multiple criteria can be used Simple and easy to understand Direct reflection of managerial policy Easily altered to accommodate changes Weights of criteria Easy sensitivity analysis

Ch #-52

Disadvantages of Scoring Models

Scores may not directly represent the value or utility Elements are assumed to be independent Unweighted models assume equal importance of all criteria

Ch #-53

Other Numeric Models

Real Options Window-of-Opportunity Analysis Discovery-Driven Planning

Ch #-54

Risk Considerations
Uncertainty about timing and future cash flows Uncertainty about expected outcome / benefits Unforeseen consequences

Ch #-55

Project Portfolio Process (PPP)

Links projects directly to the goals and strategy of the organization Means for monitoring and controlling projects

Ch #-56

Project Portfolio Process (PPP)

Benefits:

Identify non-projects Prioritize the available projects Limit the number of projects Identify the projects that best fit the organizations strategy Identify interdependencies among projects Eliminate projects that incur high cost/risk Keep from overloading the resource availability Balance resources with needs

Ch #-57

PPP Steps
Step 1. Establish a project council Step 2. Identify project categories and criteria Step 3. Collect project data Step 4. Assess resource availability Step 5. Reduce the project and criteria set Step 6. Prioritize the projects within categories Step 7. Select projects to be funded and held in reserve Step 8. Implement the process

Ch #-58

Step 1: Establish a Project Council

Senior management The project managers of major projects The head of the Project Management Office Particularly relevant general managers Those who can identify key opportunities and risks facing the organization Anyone who can derail the PPP later on
Ch #-59

Step 2: Identify Project Categories and Criteria

Derivate

projects Platform projects Breakthrough projects R&D projects

Ch #-60

Step 3: Collect Project Data

Assemble the data Update previous data Document assumptions Screen out weaker projects The fewer projects that need to be compared and analyzed, the easier the work

Ch #-61

Step 4: Assess Resource Availability Assess both internal and external resources Assess labor conservatively Timing is particularly important

Ch #-62

Step 5: Reduce the Project and Criteria Set

Organizations goals Have competence Market for offering How risky Potential partner Right resources Good fit

Use strengths Synergistic with other projects Dominated by another Has slipped in desirability

Ch #-63

Step 6: Prioritize the Projects Within Categories Apply the scores and criterion weights Consider in terms of benefits first, resource costs second Summarize the returns from the projects

Ch #-64

Step 7: Select the Projects to be Funded and Held in Reserve Determine the mix of projects across the categories Leave some resources free for new opportunities Allocate the categorized projects in rank order

Ch #-65

Step 8: Implement the Process

Communicate results Improve process

Ch #-66

Project Proposals

Project proposal is essentially a project bid Putting together a project proposal requires a detailed analysis of the project Project proposals can take weeks or months to complete A more detailed analysis may result in not bidding on the project

Ch #-67

Project Proposal Contents

Cover letter Executive summary Technical approach Implementation plan Plan for logistic support & administration Past experience

Ch #-68