Project Management

Organization Strategy and Project Selection

Organization Strategy and Project Selection Evaluation will be based on Strategic Technical Economic

Organization Strategy and Project Selection

Strategy is implemented through projects. Every project should have a clear link to and contribute value to the organizations strategic plan, which is designed to meet the future needs of its customers. Demands constant attention from top management.

Process is needed to clearly align project selection to the strategic plan of the organization. Otherwise, utilization of resources can be poor. Intended outcomes of alignment process are:
Clear organization focus Best use of resources Improved communication

Project Managers / Understanding of Strategy New school thinking recognizes that project management is at the apex of strategy and operations. Project Managers role has expanded from getting the job done to achieving the business results and winning in the market place.

Project Managers / Understanding of Strategy There are two reasons why project managers need to understand their organizations mission and strategy. So that they can make appropriate decisions pertaining to their projects.

So that they are able to demonstrate to the senior management how their project contributes their firms mission.

Strategic Management Process Strategic management is the process of:

Assessing where we are? Deciding and implementing where we want to go? and Deciding and implementing how we are going to get there?

Strategy describes how and organization intends to compete with the resources available in the existing and perceived future environment.

Strategic Management Process

Two major dimensions of strategic management are:

Responding to changes in the external environment and allocating scarce resources to improve the firms competitive positions. Constant scanning of external environment for change is required to survive in a dynamic competitive environment.
Internal responses to new action programs aimed at enhancing the competitive position of the firm. The nature of responses depends on the type of business, environment volatility, competition and the organization culture.

Strategic Management Process Strategic management process is a continuous, iterative process aimed at developing an integrated and coordinated long term plan of action. With long term position identified, objectives are set, and strategies are developed to achieve objectives and then translated into actions by implementing projects. Strong links are required among mission, goals, strategy and implementation.

Strategic Management Process

What are we now? How are we going to get there? What do we intend to do? Review / revise mission 1 External environment: opportunities and threats New goals and objectives Portfolio of strategic choices Strategy implementation Project selection Internal environment: strengths and weaknesses

4
Projects 1 Review and define organizational mission 2 Set goals and objectives 3 4

Analyze and formulate strategies to reach objectives

Implementing strategies through projects

Project Portfolio Management System - Need Implementing projects without strong priority system linked to strategy creates problems. The implementation gap Organizational politics

Resource conflicts and multitasking

A project portfolio system can go a long way to reduce or even eliminate the impact the impact of these problems.

Project Portfolio Management System - Need

Project Portfolio Management System Benefits

Builds discipline into project selection process. Links project selection to strategic metrics.

Prioritizes project proposals across a common set of criteria, rather than on politics or emotions.
Allocates resources to projects that align with strategic direction. Balances risk across all projects. Justifies killing projects that do not support strategy. Improves communication and supports agreement on project goals.

Project Portfolio Management System Since there are usually more projects clamoring for resources than are available, it is important to follow a logical and defined process for selecting the projects to implement. Design of project portfolio system should include classification of project, selection criteria depending upon classification, sources of proposals, evaluating proposals and managing the portfolio of projects.

Project Portfolio Management System Classification Many organizations find that they have three different kinds of projects in their portfolio:
Compliance/ Emergency Strategic Operational

Compliance / Emergency (Must do) Operational e.g., TQM Strategic Strategic value of the project must be determined before it can be placed in the project portfolio.

Project Portfolio Management System Classification

On February 16, 2005, the Kyoto Protocol came into force, marking an important step forward in the fight against climate change. The Kyoto Protocol is an historic milestone. It is the first, and only, binding international agreement that sets targets to reduce the greenhouse gas emissions that cause climate change.

Case Study

STOP STOP

Project Portfolio Management System Selection Criteria

There can be: Financial Criteria Cost Benefit Analysis Net Profit (NP) Payback Period (PB) Return on Investment (ROI) Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI)

Non Financial Criteria

Projects to support community development. Multi-Weighted Scoring Models

Project Portfolio Management System Selection Criteria

Time Value of Money FV

PV =
Present Value

(1+i)n

Future Value

Y0 Option A Option B $100,000

Y1

Y2

Y3 $100,000 + interest

$100,000 interest

$100,000

PV: Applying an expectation of future interest rate to determine present value of money that will be received at some point in future.

Project Portfolio Management System Selection Criteria

Cost Benefit Analysis Comparing the expected cost of the project with the benefits of having it in place. Any project requiring an investment must, as a minimum, provide a greater benefit than putting that investment in, say, a bank. Consists of two steps: Identifying and estimating all of the costs and benefits of carrying out the project and operating it. Express these costs and benefits in some common unit. This common unit is usually money.

If a proposal shows an excess of benefits over costs then it is a candidate for further analysis.

Project Portfolio Management System Selection Criteria

Cash Flow Forecasting Indicates when expenditure and income will take place and their timing.

Typically products generate a negative cash flow during their development followed by a positive cash flow over their operating life.
There may be decommissioning costs at the end of the products life.

Income

Expenditure

Time

Project Portfolio Management System Selection Criteria Net Profit

The difference between the total costs and the total income over the life of the project.

Project Portfolio Management System Selection Criteria

Example
Four project cash flow projections figures are end of year totals in $
Year 0 1 2 3 4 5 Net Profit Project 1 (100,000.00) 10,000.00 10,000.00 10,000.00 20,000.00 100,000.00 50,000.00 Project 2 (1,000,000.00) 200,000.00 200,000.00 200,000.00 200,000.00 300,000.00 100,000.00 Project 3 (100,000.00) 30,000.00 30,000.00 30,000.00 30,000.00 30,000.00 50,000.00 Project 4 (120,000.00) 30,000.00 30,000.00 30,000.00 30,000.00 75,000.00 75,000.00

Project 2 shows the greatest net profit but at the expense of a large investment of $ 1 Mio. We can even investment in Project 1, 3 and 4 if we have $ 1 Mio and even greater net profit of $ 175,000. Does not take into account the timing of cash flows. Project 1 and 3 gives the same net profit of $50,000 and are therefore equally preferable. But Project 3 gives a steady cash flow of $30,000 each year than Project 1 whose bulk of income occurs late in the life of the project.

Project Portfolio Management System Selection Criteria Payback Period

Time it will take to recover the investment. Shorter paybacks are more desirable. Simplest and widely used model. Advantages Easy to calculate but can lead to wrong decisions. Put more emphasis to quick return of the invested fund so that they may be put to use in other places or in meeting other needs. Easy to apply and understand. Disadvantages Does not consider post payback cash flows. Does not consider time value of money. Does not explicitly consider risk.

Project Portfolio Management System Selection Criteria Payback Period

Estimated project cost Payback period = (Years)
Investment $ 700K

Annual Savings

Project A
Y0 Y1 $ 225K Y2 Y3 Y4 Y5 Payback period = 700 / 225 = 3.1 years ROI = 32.1% $ 225K $ 225K $ 225K $ 225K $ 450K $ 675K $ 900K $ 1125K Returns

Investment $ 400K

Project B
Y0 Y1 $ 110K Y2 Y3 Y4 Y5 Payback period = 400 / 110 = 3.6 years ROI = 27.5% $ 110K $ 110K $ 110K $ 110K

$ 220K $ 330K $ 440K $ 550K Returns Decision Rule: Accept project that has smaller payback period (Project A in our case) .

Project Portfolio Management System Selection Criteria

Example
Four project cash flow projections figures are end of year totals in $
Year 0 1 2 3 4 5 Net Profit Project 1 (100,000.00) 10,000.00 10,000.00 10,000.00 20,000.00 100,000.00 50,000.00 Project 2 (1,000,000.00) 200,000.00 200,000.00 200,000.00 200,000.00 300,000.00 100,000.00 Project 3 (100,000.00) 30,000.00 30,000.00 30,000.00 30,000.00 30,000.00 50,000.00 Project 4 (120,000.00) 30,000.00 30,000.00 30,000.00 30,000.00 75,000.00 75,000.00

Payback period does not take into account post payback returns. So, the fact that project 2 and 4 are overall more profitable than project 3 is ignored.

Project Portfolio Management System Selection Criteria Return on Investment (ROI)

Also Known as Accounting Rate of Return (ARR). Compares the net profitability of the investment Problems with ROI Takes no account of the timing of cash flows.

Average Annual Profit ROI = Total Investment X 100

Project Portfolio Management System Selection Criteria

Example
Four project cash flow projections figures are end of year totals in $
Year 0 1 2 3 4 5 Net Profit Project 1 (100,000.00) 10,000.00 10,000.00 10,000.00 20,000.00 100,000.00 50,000.00 Project 2 (1,000,000.00) 200,000.00 200,000.00 200,000.00 200,000.00 300,000.00 100,000.00 Project 3 (100,000.00) 30,000.00 30,000.00 30,000.00 30,000.00 30,000.00 50,000.00 Project 4 (120,000.00) 30,000.00 30,000.00 30,000.00 30,000.00 75,000.00 75,000.00

Project 1: (50000/5) / 100000 x 100 = 10% Project 2: (100000/5) / 1000000 x 100 = 2% Project 3: (50000/5) / 100000 x 100 = 10% Project 4: (75000/5) / 120000 x 100 = 12.5%

Project Portfolio Management System Selection Criteria Net Present Value

Managements minimum desired rate of return to compute the present value of all net cash flows. If the result is positive, the project is accepted. More realistic because it considers time value of money, cash flows and profitability.

Decision Rules
Independent Projects: Accept all projects with NPV >= 0, reject otherwise. Mutually Exclusive Projects: Rank projects from highest to lowest NPV and choose the project with the highest (positive) NPV. Problems with NPV Difficult to explain to non-finance people. Solution is not in percentage rate of return but in amount.

Project Portfolio Management System Selection Criteria

Table of NPV Discount Factors
Year 1 2 3 4 5 6 7 8 5% 0.9524 0.9070 0.8638 0.8227 0.7835 0.7462 0.7107 0.6768 6% 0.9434 0.8900 0.8396 0.7921 0.7473 0.7050 0.6651 0.6274 7% 0.9346 0.8734 0.8163 0.7629 0.7130 0.6663 0.6227 0.5820 8% 0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 0.5835 0.5403 9% 0.9174 0.8417 0.7722 0.7084 0.6499 0.5963 0.5470 0.5019 10% 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645 0.5132 0.4665 ... ... ... ... ... ... ... ... ...

9
10 : :

0.6446
0.6139 : :

0.5919
0.5584 : :

0.5439
0.5083 : :

0.5002
0.4632 : :

0.4604
0.4224 : :

0.4241
0.3855 : :

...
... : :

More extensive or detailed tables may be constructed using the formula discount factor = 1 / ( 1 + r) ^ n for various values or r (the discount rate) and t (the number of years from now).

Project Portfolio Management System Selection Criteria Net Present Value

n

NPV = I0 +
i=1

Ft (1+k)t

I0 = Initial Investment (-ve for outflow) Ft = Net cash inflow for a period t k = Required rate of return

Investment $ 700K

Project A
Y0 Y1 $ 225K Y2 Y3 Y4 Y5 $ 225K $ 225K $ 225K $ 225K Returns Investment $ 400K

Project B
Y0 Y1 $ 110K Y2 Y3 Y4 Y5 $ 110K $ 110K $ 110K $ 110K Returns

Project Portfolio Management System Selection Criteria Net Present Value

Project A
Required Rate of Return Outflows Inflows Present Value Net Present Value 15% $(700,000) $225,000 $195,652 $225,000 $170,132 $225,000 $147,941 $225,000 $128,644 $225,000 $111,865 $ (700,000) $1,125,000 $ 754,235 $ 54,235

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Total

Project B
Required Rate of Return
Outflows Inflows Present Value Net Present Value

Year 0
15%
$(400,000)

Year 1

Year 2

Year 3

Year 4

Year 5

Total
$ (400,000)

$110,000 $ 95,652

$110,000 $ 83,176

$110,000 $ 72,327

$110,000 $ 62,893

$110,000 $ 54,689

$ 550,000 $ 368,737 $ (31,263)

Select Project A as it has positive NPV and reject Project B as it has negative NPV

Project Portfolio Management System Selection Criteria Net Present Value

Year 0 1 2 3 4 5 Net Profit Project 1 (100,000.00) 10,000.00 10,000.00 10,000.00 20,000.00 100,000.00 50,000.00 (100,000.00) 9,090.91 8,264.46 7,513.15 13,660.27 62,092.13 620.92 Project 2 (1,000,000.00) 200,000.00 200,000.00 200,000.00 200,000.00 300,000.00 100,000.00 (1,000,000.00) 181,818.18 165,289.26 150,262.96 136,602.69 186,276.40 (179,750.51) Project 3 (100,000.00) 30,000.00 30,000.00 30,000.00 30,000.00 30,000.00 50,000.00 (100,000.00) 27,272.73 24,793.39 22,539.44 20,490.40 18,627.64 13,723.60 Project 4 (120,000.00) 30,000.00 30,000.00 30,000.00 30,000.00 75,000.00 75,000.00 (120,000.00) 27,272.73 24,793.39 22,539.44 20,490.40 46,569.10 21,665.06

Project Portfolio Management System Selection Criteria Example

A large manufacturing firm is considering improving its computer facility. The firm currently has a computer which can be upgraded at a cost of $200,000. The upgraded computer will be useful for 5 years and will provide cost saving of $75,000 per year. The current market value of the computer is $100,000. The cost of capital is 15%. Should the computer be upgraded.

Answer
Year 0 1 2 3 4 5 Total Project's Cost & Returns $ (200,000.00) $ $ $ $ $ 75,000.00 75,000.00 75,000.00 75,000.00 75,000.00 NPV $(200,000.00) $ 65,217.39 $ 56,710.78 $ 49,313.72 $ 42,881.49 $ 37,288.26 $ 51,411.63

Project Portfolio Management System Selection Criteria Example

(a) A firm is considering an investment of $300,000 in an asset with a useful life of 5 years. The firm estimates that the annual cash revenues and expenses will be $140,000 and $40,000, respectively. The annual depreciation based on the historical cost will be $60,000. The required rate of return on the project of this risk is 13%. The marginal tax rate is 34%. What is the NPV of this project?

(b) The 13% required rate of return is the nominal required return including inflation. Suppose the firm has forgotten that revenues and expenses are likely to increase with inflation at 5% annual rate. Recalculate the NPV. Is this a more attractive proposal now that the inflation has been taken into account.

Project Portfolio Management System Selection Criteria Answer (a)

Year 0 Cost Cash Revenue (A) Cash Expenses (B) Depreciation (C) Taxes Paid (D = (A-B-C)*0.34) After-tax Cash (E = A-B-C) $300,000 $140,000 $ 40,000 $ 60,000 $ 13,600 $ 86,400 $ 76,460 NPV $300,000 $140,000 $ 40,000 $ 60,000 $ 13,600 $ 86,400 $ 67,664 $140,000 $ 40,000 $ 60,000 $ 13,600 $ 86,400 $ 59,880 $ 303,889 $ 3,889 $140,000 $ 40,000 $ 60,000 $ 13,600 $ 86,400 $ 52,991 $140,000 $ 40,000 $ 60,000 $ 13,600 $ 86,400 $ 46,894 Year 1 Year 2 Year 3 Year 4 Year 5

Project Portfolio Management System Selection Criteria Answer (b)

Year 0 Cost Cash Revenue (A) Cash Expenses (B) Depreciation (C) Taxes Paid (D = (A-B-C)*0.34) After-tax Cash (E = A-B-C) $300,000 $ $ $ $ $ $ NPV $300,000 147,000 42,000 60,000 15,300 89,700 79,381 $154,350 $ 44,100 $ 60,000 $ 17,085 $ 93,165 $ 72,962 $162,068 $ 46,305 $ 60,000 $ 18,959 $ 96,803 $ 67,090 $ 337,938 $ 37,938 $170,171 $ 48,620 $ 60,000 $ 20,927 $100,623 $ 61,714 $178,679 $ 51,051 $ 60,000 $ 22,994 $104,635 $ 56,791 Year 1 Year 2 Year 3 Year 4 Year 5

Proposal is more attractive now.

Project Portfolio Management System Selection Criteria Net Present Value

The main difficulty with NPV is selecting an appropriate discount rate. Some organizations have standard rate but, where this is not the case, then the discount rate should be chosen to reflect available interest rates (borrowing costs where the project must be funded loans) plus some premium to reflect the face that projects may have risks then lending money to a bank.

The exact discount rate is normally less important than ensuring that the same discount rate is used for all projects being compared.
Alternatively, the discount rate can be thought of as a target rate of return. If for example we set a target rate of return of 15%, we would reject that would not display a positive NPV using a 15% discount rate.

Project Portfolio Management System Selection Criteria Internal Rate of Return (IRR)
The discount rate that makes the present value of a projects cash flow equal to its initial investment. Hurdle rate is considered the firms required rate of return on investment projects of average risk. If the Projects IRR >= hurdle rate, it should be accepted, otherwise, it should be rejected.
n

0 =

- I0 +
i=1 n

Ft (1+R)t Ft

I0 =

i=1

(1+R)t

I0 = Initial Investment Ft = Net cash inflow for a period t R = Internal rate of return

Project Portfolio Management System Selection Criteria Internal Rate of Return (IRR)
Investment $ 700K

Project A
Y0 Y1 $ 225K Y2 Y3 Y4 Y5 IRR = 18% $ 225K $ 225K $ 225K $ 225K Returns Investment $ 400K

Project B
Y0 Y1 $ 110K Y2 Y3 Y4 Y5 $ 110K $ 110K $ 110K $ 110K Returns IRR = 12%

Accept project that has higher IRR (Project A in our case) .

Project Portfolio Management System Selection Criteria Profitability Index (PI)

Some times called Benefit Cost Ratio or Present Value Index.

Calculated by taking the PV of cash inflows divided by the PV of cash outflows.

The decision criteria is to accept project with PI > 1.0

PV of Cost Inflows PI = = Cost or Initial Outflow

i=1

Ft (1+k)t I0

Project Portfolio Management System Selection Criteria

Weighted Average Scoring Models

Typically uses several weighted selection criteria to evaluate a project proposal

Generally include qualitative and quantitative criteria

Each selection criterion is assigned a weight and a score

Weights and scores are multiplied to get a total weighted score of the project Projects can be compared using the weighted score Projects with higher weighted scores are considered better Selection criteria need to mirror the critical success factor of an organization.

Project Portfolio Management System Selection Criteria

Weighted Average Scoring Models

2.0 Project 1 Project 2 1 3

3.0 8 3

2.0 2 2

2.5 6 0

1.0 0 0

1.0 6 5

3.0 5 1 66 27 2 6

Project 3
Project 4 Project 5 Project 6

9
3 1 6

5
0 10 5

2
10 5 0

0
0 10 2

2
0 0 0

2
6 8 2

5
0 9 7

56
32 102 55

3
5 1 4

Example Calculation for Project 1

Weighted Total = ( 2.0 x 1 ) + ( 3.0 x 8 ) + ( 2.0 x 2 ) + ( 2.5 x 6 ) + ( 1.0 x 0 ) + ( 1.0 x 6 ) + ( 3.0 x 5 ) = 66

If the resources available create a cutoff threshold of 50 points, the priority team would eliminate projects 2 and 4.

Tip!!

While selection models like the one above may yield numerical solutions to project selection decisions, models should not make the final decisions the people using the model should.

Applying the Selection Model

Project classification
Experience shows most organizations use similar criteria across all types of projects, with perhaps one or two criteria specific to the type of project, such as, strategic breakthrough versus operational. The most important criterion for selection is the projects fit to the organizations strategy.

Applying the Selection Model

Selecting a Model
Multiple criteria in project selection Senior Management is interested in identifying the potential mix of projects that will yield the best use of human and capital resources to maximize return on investment in the long run. Factors such as researching new technologies, public image, ethical position, protection of the environment, core competencies, and strategic fit might be important criteria for selecting projects.

Sources and Solicitation of Project Proposals

Project should come from anyone who believes that the project will add value to the organization. Encourage and keep solicitations open to all sources internal and external sponsors.

Sources and Solicitation of Project Proposals

Major Project Proposal
Date Project Title Responsible Manager Project Manager General Support Quality Cost Reduction Yes Yes Yes No No No Legal Replacement New Product Capacity _____________ _____________ Number

Risk Analysis
What are the three major risks for this project? 1. 2. 3.

What is the probability of above risk occurring? 0.0 (none) to 1.0 (high)

1. 2. 3. 1.

Project will take more than 500 labor hours? Project is a one time effort? Project proposal is reviewed by product manager.

What is the impact on project success if these risks do occur? 0.0 (none) to 1.0 (high)

2. 3.

Yes

No Resource Available?

Problem definition: Describe problem / opportunity.

Current project status Start Date _____________ Est. Finish Date _____________ Status Active On hold Update:

Goal definition: Describe the project goal.

Objective Definition: Performance: Quantify the savings/benefits you expect.

Cost: Labor hours, materials, methods, equipment, etc.

Accepted Returned Priority Team Action: Discovery project not defined Operational proposal not a project Need more information to prioritize project Duplicate to: ______________

Schedule: Overall duration in months.

Sources and Solicitation of Project Proposals

Project Screening Process
Project Proposal Idea

Data collection and backup

Need strategic fit (ROI / Payback, Risk)

Abandon Periodic reassessment of priorities Reject

Self Evaluation of Project By criteria Pursue Priority team evaluates proposal and reviews portfolio for risk balance. Accept

Return for more information

Hold for resources

Assign priority, resources and Project manager

Evaluate Progress

Managing the Portfolio System

Merits of a particular project are assessed within the context of the existing projects. Involves monitoring and adjusting selection criteria to reflect the strategic focus of the organization.

Senior Management Input Provide guidance in establishing selection criteria How they wish to balance existing resources among different projects.
Priority Team Responsibility Publishing the priority of every project and ensuring the process is open and free of power politics.

Sources and Solicitation of Project Proposals

Priority Analysis An Example
Must Objectives All activities meet current legal, safety, and environmental standards. All new products will have a complete market analysis : : Want Objectives Provide immediate response to field problems. Create $5 Mio. in new sales by 2010
Relative Importance 1 - 100

Must Meet if impacts Yes Meets objectives No Does not meet objectives N/A No Impact Yes Meets objectives No Does not meet objectives N/A No Impact

P1

P2

P3

P4

P5

N/A

N/A

99 88

Improve external customer service

: :

83

Single project impact Definitions 0 <= Does not address 1 = Opportunity to fix 2 >= Urgent problem 0 <= $ 100,00 1 = $ 100,000 500,000 2 >= $ 500,000 0 <= $ 100,00 1 = $ 100,000 500,000 2 >= $ 500,000

Weighted Score

Weighted Weighted Score Score

Weighted Score

Weighted Score

99 0

166

Total Weighted Score Priority

Balancing Portfolio for Risks and Types of Projects David and Matheson studied R&D Organizations and developed a matrix that could be used for assessing a project portfolio.
High Bread and butter Pearl Organizations have too many while elephants and too few oysters and pearls. To maintain strategic advantage organizations must capitalize on pearls, eliminate or reposition white elephants and balance resources devoted to bread-and-butter and oyster projects to achieve alignment with overall strategy.

Probability of Success

Evolutionary improvements to current products and services. White Elephants

Revolutionary commercial advances using proven technology advances Oyster

Low

Projects that one time showed promise but are not viable anymore Low

Technological breakthroughs with high commercial payoffs.

Potential Commercial Value

High