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Unit 3: The Management of Project Cost And Risk

Essential Reading

Field, M. and Keller, L. (2007) Project Management. London: Open University Press (pp. 35 - 48; 123-145;
109-122) Study Guide: pp. 65-87

Additional Reading:

Schwalbe, K. (2009) An Introduction to Project Management. 2nd Ed. Boston: Cengage Learning (pp.147 -151)

Pinto, J.K. (2012) Project Management A Competitive Advantage. 2nd Ed. London: Pearson Education
Limited (pp. 247-266; 219-238)

Maylor, H. (2010) Project Management 4th ed. Edinburgh: Pearson Education Limited (pp. 174-198; 217-225)
Unit Learning Outcome

Upon successful completion of this module, you will be able to:

Analyse the key techniques that enable project managers to


manage finance and project risks.

Be able to explain the key project financial appraisal techniques,


project accounting processes and project business case approval
processes.

Discuss the importance of risk in the management of projects.


The Management of Project Cost
Financial Project Appraisal
Payback
Net Present Value (NPV)
The Internal Rate of Return
Estimating Methods
Putting Together the Detailed Project Budget
Budgeting
Common Causes of Cost Problems
Project Accounting

Managing Risks
Risk Management/Risk Assessment
Summary
References
Clear project objectives and a project definition document are essential to the
success of the project.

Investment decision is a decision on:

Whether or not to undertake an investment.

When there are alternative choices for an investment, selecting which


of the mutually exclusive investment to undertake.

When capital for spending is in short supply, deciding which


investments to undertake with the money that is available.
Investment decisions need to be considered in the light of strategic and
tactical plans of the company.

Most companies have a formal business case system in place that


includes a financial appraisal of the project in one form or another.

Financial appraisal techniques


include: Payback

Net Present Value (NPV) The

Internal Rate of Return

Estimating Methods
i How long will it take to pay back its cost?”

i Calculates the length of time a project will take to recoup the


initial investment.

i Often used as a first screening process.

i Very unsophisticated method.

i Often used payback as a rough guide before a more sophisticated


technique.
' Cash flows may vary:

Year 1 £35,000 £35,000


Year 2 £20,000 £55,000
Year 3 £45,000 £100,000
Year 4 £25,000 £125,000
Year 5 £25,000 £150,000

' In this example, the payback period for a project with an


initial investment of £100,000 is 3 years.

' On the other hand, the payback period will be 5 years if the
initial investment is £150,000.

' (Activity) How do you explain the popularity of the payback method, given
the limitations of this method?
Payback Worked example

Project A
Initial £200,000
investment

Cash inflows
Year 1 £100,000
Year 2 £100,000
Year 3 £100,000
Year 4 £100,000
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Task 2 Smith Company

Project B
Initial £100,000
investment
Cash inflows
Year 1 £10,000

Year 2 £20,000
Year 3 £40,000
Year 4 £40,000
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Advantages & Disadvantages

Method Advantages Disadvantages


Payback Simple and easy to understand Ignores the time value
and of money
use Ignores cash flows
Objective – using cash flows after the payback
Liquidity – commercially period
realistic
Cautious & risk averse –
ignores
later cash flows

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Takes into consideration all the relevant cash flows associated with a
project during its life and also when the cash flows will occur.

Cash flows occurring in future years are then adjusted to a present value.

PV - Receiving a £1000 now, would be worth more than receiving a £1000 in 5


years as this could be reinvested with an additional rate of return being received
over the five years.

FV – Value of cash at a specified date in the future that is equivalent in value to


a specified sum today.

A present value is the amount that would need to be invested now to


earn the future cash flow if the money is invested at the “cost of
capital
The Time Value of Money

What a difference between £1 now and £1 in a year’s time?


Factors change the value of money
Interest cost
Inflation
Other risks to materialise the money

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The Time Value of Money

For example: the annual interest rate is 10%, I lend you £1 now and will get it back
after 1 year, how much worth of that £1 in a year’s time?
? x (1+10%) = £1
? = £0.91
10% is called “cost of capital”; “0.91” is called the “discount factor”

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NPV

Assume that your company’s cost of capital is 10%


Discount factors at 10% are:
Year 1 0.909
Year 2 0.826
Year 3 0.751
Year 4 0.683
Present value table distributed

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Brown Company

Project A Cash flow Disc. Factor (10%) Dis.d cash flow


Year 0 -100,000 1.00 (100,000)
Year 1 45,000 0.909 40,905
Year 2 40,000 0.826 33,040
Year 3 25,000 0.751 18,775
Year 4 50,000 0.683 34,150
NPV £26,870

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Gracie Company

Dis. Factor Dis.d cash


Project B Cash flow
(10%) flow
Year 0 -100,000 1.00 (100,000)
Year 1 30,000 0.909
Year 2 30,000 0.826
Year 3 44,000 0.751
Year 4 66,000 0.683
NPV
• Which project is the better one based on NPV?

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Advantages &
Disadvantages
Method Advantages Disadvantages
NPV Takes account of the time Difficult to be
value of money understood
Concerns of shareholder by managers
wealth Adverse effects on
Takes account of risk accounting profits in the
Looks at the whole life of short run
the How to choose discount
project rate?

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Reverse assumpt io n o f NPV.

Uses the discounting to calculate the return expected


from the project calculated on a discounted cash flow
basis.

The internal rate of return of a project is the discount rate at which


the project NPV is zero. Internal Rate of Return (IRR) is that rate of
return at which the NPV from the above investments will become
zero. It is that rate of interest that makes the sum of all cash flows
zero, and is useful to compare one investment to another.
Brown Company IRR

Project A Cash flow Disc. Factor (10%) Dis.d cash flow


Year 0 -100,000 1.00 (100,000)
Year 1 45,000 ? ?
Year 2 40,000 ? ?
Year 3 25,000 ? ?
Year 4 50,000 ? ?
NPV £0

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Brown Company IRR using 23%

Project B Cash Dis. Factor Dis.d cash


flow (10%) flow
Year 0 -100,000 1.00 (100,000)
Year 1 45,000 0.813 36585
Year 2 40,000 0.661 26440
Year 3 25,000 0.5374 13435
Year 4 50,000 0.4369 21845
NPV (1695)/0

Which project is the 20


better?
The process of gathering data to develop an estimate for the
project.
Estimating methods include:

Parametric Modeling: Uses mathematical techniques to help with


costing estimates; for example, in the building industry square foot (£ per
square foot) metrics are used.

Bottom up: Estimates the activities at the bottom of the WBS first and
then works up through the WBS.

Analogous Method: Looks at the costs of similar projects and


other historical information.

Simulation : Used on large or complex projects, software calculates


many costs or durations with different assumptions, the most common
is known as Monte Carlo Analysis.
' Detailed estimation of cost is called budgeting and is the process of
allocating the cost estimates to the activities.
' To prepare a project budget do the following: Total

the personnel costs from each activity.

Total the direct costs from each activity estimate sheet. Remember to include
project management costs.

Total indirect costs (overhead costs if your organisation requires they


be included in your budget).

Total cumulative costs.


The process of allocating the cost estimates to work items to establish a cost
baseline for measuring project performance.

Top-Dow n Budgeting:

Based on collective judgments and experiences of top and middle


managers.
Overall project cost estimated by estimating costs of major tasks.
Bottom-Up Budgeting:

WBS or action plan identifies elemental tasks.

Those responsible for executing these tasks estimate resource


requirements.
i Basing estimates on poor information rather than detailed specifications of the
project at hand.

i Failure to allow contingency, failure to correctly estimate research and


development activities.

i Indiscriminate use of the contingency budget by activities or people, who overrun


their budget.

i Receiving information too late to take corrective action.


within the approved budget

Processes and methods that make up project accounting:

Financial accounting

Management accounting

Project accounting
i Risk management is all about deciding what to do about risk.

i Techniques that help control and reduce risk include:

risk reduction

risk avoidance

risk acceptance

risk transfer

i All projects have a certain degree of risk that needs to be managed.

i Risk management can be defined as:


“the systematic processes of identifying, analysing and responding to project
risk through out the project life cycle”
PMBOK Handbook, Burke (2003)
http://www.youtube.com/watch?v=LDc4xzK9esA

“Risk is an inherent - and inevitable - characteristic of projects risk represents the chance
of adverse consequences or loss occurring” (Field and Keller, 2007. p.109)

Risks may result in (amongst others):

-Loss of image, reputation and market share

-Litigation

-Complaints, loss of business

-Financial Loss

-Health and safety breaches


Risk Assessment

The Process

Clear definition of risks - Identify

How important the risk is -Prioritise

What the severity of the risk would be -Impact

Likelihood of risk occurring - Estimate probability, respond

Monitor

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Risk Assessment

Identifies risks

Analyses these in terms of their impact on performance, cost, schedule, and


quality

Estimates their probability of occurrence

Prioritises the risks according to exposure, effect and problems


with compounding risk
Enables management to monitor risk factors and
take action during the execution of the project

Probability /Impact
Low/high- Low /high
Risk Assessment of 25 metre swimming pool

Risk Description Probability (1-5) Impact ( 1-5)

5 5
People diving into swimming pool
Drowning 5 5
Slipping on Pool Side 5 5

Eating drinking at pool side 3 2

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Depth Case

Managing the previously identified risks

Risk Description Probability (1-5) Impact ( 1-5) Management

5 5 Avoid – Diving not permitted


People diving into swimming pool
Drowning 5 5 Reduce - Lifeguards
Reduce – signage, no running,
games etc.
Slipping on Pool Side 5 5
Staff encouragement
Signage no food or drink
People eating drinking on poolside 3 2 Staff encouragement

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Risk Management

To manage the risks identified in the (risk) assessments:

- Avoid the risk

- Reduce the risk: likelihood or impact

- Transfer the risk

- Contingency plans

- Accept the risk and monitor


Technical: new technology, design error

Environmental: Culture of the organisation, change in management

Financial: budget cuts, cash flow problems

Human: human error, poor work performance, personality conflict

Resources: Specialised skills or critical equipment not available

Logistical : material supply problem

Government: g overnmental reg ulations

Market : Product fails in marketplace, new competitor products


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R isk Manag ement Planning

R isk I d entifica t i on

Qualitat i ve R isk Analysis

R isk R esp onse Planning

R isk Monit or ing and Control


List ways project might fail

Evaluate severity (S) of each failure

Estimate likelihood (L) of each failure occurring

Estimate ability to detect each failure (D)

Calculate Risk Priority Number (RPN)

Sort potential failures by their RPNs

http://www.youtube.com/watch?v=qKFrhYJvlc8&feature=related
i Clear project objectives are essential to the success of the project.

i If the objectives are unrealistic or not written down then the project is in
serious trouble before it has started.

i Financial viability of the project must be carried out.

i Risk management is all about deciding what to do about risk.


i Field, M., Keller, L. (2007) Project Management. Open University
i Maylor, H. (2010) Project Management. Prentice Hall

i Burke, R. (2003) Project Management, Planning and Control Techniques.


John Wiley and Sons.

i PMBOK Handbook (1992). Volume 6, Project and Program Risk


Management.