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189
Project Evaluation and Selection
189.1 Quantitative Approaches to Project Evaluation and Selection 189.2 Qualitative Approaches to Project Evaluation and Selection
Collective Multifunctional Evaluations Net Present Value (NPV) Comparison Return-on-Investment Comparison Pay-Back Period (PBP) Comparison Pacifico and Sobelman Project Ratings Limitations of Quantitative Methods
Hans J. Thamhain
Bentley College
For most organizations, resources are limited. The ability to select and fund the best projects with the highest probability of success is crucial to an organization's ability to survive and prosper in today's highly competitive environment. Project selections, necessary in virtually every business area, cover activities ranging from product developments to organizational improvements, customer contracts, R&D activities, and bid proposals. Evaluation and selection methods support two principal types of decisions: 1. Judging the chances of success for one proposed project 2. Choosing the best project among available alternatives Although most decision processes evaluate projects in terms of cost, time, risks and benefits, such as shown in Table 189.1, it is often extremely difficult, if not impossible, to define a meaningful aggregate measure for ranking projects regarding business success, technical risks, or profit. Managers can use traditional, purely rational selection processes toward "right," "successful," and "best" only for a limited number of business situations. Many of today's complex project evaluations require the integration of both analytical and judgmental techniques to be meaningful. Table 189.1 Typical Criteria for Project Evaluation and Selection
The criteria relevant to the evaluation and selection of a particular project depend on the specific project type and business situation such as project development, custom project, process development, industry and market. Typically, evaluation procedures include the following criteria: Development cost Development time Technical complexity
Risk Return on investment Cost benefit Product life cycle Sales volume Market share Project business follow-on Organizational readiness and strength Consistency with business plan Resource availability Cash flow, revenue, and profit Impact on other business activities Each criterion is based on a complex set of parameters and variables.
Although the literature offers a great variety of project selection procedures, each organization has its own special methods. Approaches fall into one of three principal classes: 1. Primarily quantitative and rational approaches 2. Primarily qualitative and intuitive approaches 3. Mixed approaches, combining both quantitative and qualitative methods
0 0 0 0 0 0 0
*Assuming an MARR of i = 10% Note: The first line of negative numbers represents the initial investment at the beginning of the life cycle.
P W (A j i; n) = A
1 = P Wn (1 + i)n
Net present value of a series of revenues or costs, An, over N periods of time is as follows:
NPV(An j i; N ) =
N X n=1
X 1 An = P Wn (1 + i)n n=1
Table 189.2 applies these formulas to four project alternatives, showing the most favorable 5-year net present value of $3192 for project option P4. (There are three special cases of net present value: (1) for a uniform series of revenues or costs over N periods, NPV(Anj i, N) = A[(1+i)N 1]/i(1+i)N; (2) for an annuity or interest rate i approaching zero, NPV = A N; and (3) for the revenue or cost series to continue forever, NPV = A/i.)
Return-on-Investment Comparison
Perhaps one of the most popular measures for project evaluation is the return on investment (ROI):
ROI =
It calculates the ratio of net revenue over investment. In its simplest form it entails the revenue on a year-by-year basis relative to the initial investment (for example, project option 2 in Table 189.2 would produce a 20% ROI). Although this is a popular measure, it does not permit a comparative evaluation of alternative projects with fluctuating costs and revenues. In a more sophisticated way we can calculate the average ROI per year # " N X An =N ROI(An ; In j N ) = In
n=1
and compare it to the minimum attractive rate of return. All three project options, P2, P3 and P4, compare favorably to the MARR of 10%, with project P3 yielding the highest average return on investment of 54%. Or we can calculate the net present value of the total ROI over the project lifecycle, also known as cost-benefit (CB). This is an effective measure of comparison, especially for fluctuating cash flows. (Table 189.2 shows project 3 with the highest 5-year ROINPV of 108%.) " N # " N # . X X ROINPV (An ; In j i; N ) = NPV(An j i; N ) NPV(In j i; N )
n=1 n=1
NPV(An j i)
N X n=1
NPV(In j i)
assessing chemical products, and the project value factor (z), developed by Sidney Sobelman for new product selections:
PR =
pT pC R TC
z = (P TLC ) (C TD )
Pacifico's formula is in essence an ROI calculation adjusted for risk. It includes probability of technical success [.1 < pT < 1.0], probability of commercial success [.1 < pC < 1.0], total net revenue over project life cycle [R], and total capital investment for product development, manufacturing setup, marketing, and related overheads [TC]. The Sobelman formula is a modified cost-benefit measure. It takes into account both the development time and the commercial life cycle of the product. It includes average profit per year [P], estimated product life cycle [TLC], average development cost per year [C], and years of development [TD].
Limitations: Many success factors are nonquantifiable Probabilities and weights change True measures do not exist Analysis and conclusions are often misleading Methods mask unique problems and opportunities Stifle innovative decision making Lack people involvement, buy-in, commitment Do not deal well with multifunctional issuesand dynamic situations Pressure to act prematurely
Evaluations based on predominately quantitative criteria should at least be augmented with some expert judgment as a "sanity check." 6. Condense criteria list. Combine evaluation criteria, especially among the judgmental categories, to keep the list manageable. As a goal, try to stay within 12 criteria. 7. Communicate. Facilitate communications among evaluators and functional support groups. Define the process for organizing the team and conducting the evaluation and selection process. 8. Ensure cross-functional cooperation. People on the evaluation team must share a strategic vision across organizational lines. They also must sense the desire of their host organizations to support the project if selected for implantation. The purpose, goals, and objectives of the project should be clear, along with the relationship to the business mission. 9. Don't lose the big picture. As discussions go into detail during the evaluation, the team should maintain a broad perspective. Two global judgment factors can help to focus on the big picture of project success: (1) overall benefit-to-cost perception and (2) overall risk-of-failure perception. These factors can be recorded on a ten-point scale: 5 to +5. This also leads to an effective two-dimensional graphic display of competing project proposals. 10. Do your homework between iterations. As project evaluations are most likely conducted progressively, action items for more information, clarification, and further analysis surface. These action items should be properly assigned and followed up, thereby enhancing the quality of the evaluation with each consecutive iteration. 11. Stimulate innovation. Senior management should foster an innovative ambience for the evaluation team. Evaluating complex project situations for potential success or failure involves intricate sets of variables, linked among organization, technology, and business environment. It also involves dealing with risks and uncertainty. Innovative approaches are required to evaluate the true potential of success for these projects. Risk sharing by senior management, recognition, visibility, and a favorable image in terms of high priority, interesting work, and importance of the project to the organization have been found strong drivers toward attracting and holding quality people to the evaluation team and gaining their active and innovative participation in the process. 12. Manage and lead. The evaluation team should be chaired by someone who has the trust, respect, and leadership credibility with the team members. Further, management can positively influence the work environment and the process by providing some procedural guidelines, charters, visibility, resources, and active support to the project evaluation team.
A Final Note
Effective project evaluation and selection requires a broad-scanning process that can deal with the risks, uncertainties, ambiguities, and imperfections of data available at the beginning of a project cycle. It also requires managerial leadership and skills in planning, organizing, and
communicating. Above all, evaluation team leaders must be social architects in unifying the multifunctional process and its people. They must share risks and foster an environment that is professionally stimulating and strongly linked with the support organizations eventually needed for project implementation. This is an environment that is conducive to cross-functional communication, cooperation, and integration of the intricate variables needed for effective project evaluation and selection.
Defining Terms
Cross-functional: Actions that span organizational boundaries. Minimum attractive rate of return (MARR): The annual net revenue produced on average by projects in an organization as a percentage of their investments. Sometimes MARR is calculated as company earnings over assets. Net worth: Discounted present value of a future revenue or cost. Phase management: Projects are broken into natural implementation phases, such as development, production, and marketing, as a basis for project planning, integration, and control. Phase management also provides the framework for concurrent engineering and stage-gate processes. Project success: A comprehensive measure, defined in both quantitative and qualitative terms, that includes economic, market, and strategic objectives. Stage-gate process: Framework for executing projects within predefined stages (see also phase management) with measurable deliverables (gate) at the end of each stage. The gates provide the review metrics for ensuring successful transition and integration of the project into the next stage. Weighing of criteria: A multiplier associated with specific evaluation criteria.
References
Brenner, M. 1994. Practical R&D project prioritization. Res. Technol. Manage. 37(5):3842. Bulick, W. J. 1993. Project evaluation procedures. Cost Eng. 35(10):2732. Menke, M. M. 1994. Improving R&D decisions and execution. Res. Technol. Manage. 37(5):2532. Obradovitch, M. M. and Stephanou, S. E. 1990. Project Management: Risk and Productivity. Daniel Spencer, Bend, OR. Remer, D. S., Stokdyk, S. B., and Van Driel, M. 1993. Survey of project evaluation techniques currently used in industry. Int. J. Prod. Econ. 32(1):103115. Schmidt, R. L. 1993. A model for R&D project selection. IEEE Trans. EM. 40(4):403410. Shtub, A., Bard, J. F., and Globerson, S. 1994. Project Management: Engineering, Technology, and Implementation. Prentice Hall, Englewood Cliffs, NJ. Skelton, M. T. and Thamhain, H. J. 1993. Concurrent project management: a tool for technology transfer. Proj. Manage. J. 26(4):4148. Ward, T. J. 1994. Which product is BE$T? Chemical Eng. 101(1):102107.
Further Information
The following journals are good sources of further information: Engineering Management Journal (ASEM), Engineering Management Review (IEEE), Industrial Management (IIE), Journal of Engineering and Technology Management, Project Management Journal (PMI), and Transactions on Engineering Management (IEEE). The following professional societies present annual conferences and specialty publications that include discussions on project evaluation and selection: American Society for Engineering Management (ASEM), Rolla, MO 65401, (314) 341-2101; Institute of Electrical and Electronic Engineers (IEEE), East 47 St., New York, NY 10017-2394; and Project Management Institute (PMI), Upper Darby, PA 19082, (610)734-3330.