Chapter 2

Strategic Management and Project Selection

Copyright 2009 John Wiley & Sons, Inc.

Problems With Multiple Projects

1. 2. 3.

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

Project Results
30

Percent late Over half 190 percent over budget Over half 220 percent late

Challenges
Making

sure projects closely tied to goals and strategy How to handle growing number of projects How to make projects successful

Project Management Maturity

Project

management maturity refers to mastery of skills required to manage project competently Number of ways to measure Most organizations do not do well

Project Selection and Criteria of Choice

Project

selection

Evaluating Choosing Implementing

Same

process as other business decisions

Types of Companies

Companies considering projects fall into two broad categories:

1. 2.

Companies whose core business is completing projects Companies whose core business is something else Companies looking at projects to do for others Companies looking at projects to do for themselves

They can also be broken down as:

1. 2.

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

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

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

Types of Models
Stochastic

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. Also known as a probabilistic model.

Deterministic

Model

A model that does not include probabilities. Given the same inputs, the outputs will always be the same.

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

Criteria

(Continued)

Companies

need a way of weeding out the bad projects while keeping the good ones No model can predict with absolute certainty No model could predict

The Exxon Valdez wreck The explosion of the Challenger

What

we want is a model with a good batting average

Model Criteria
Realism Capability Flexibility Easy

to use Inexpensive Easy to implement

Realism
Needs

to include all objectives of the firm Needs to include the firms expertise as well as its limitations Needs to report results in a fashion that allows different projects to be compared, e.g. how do we compare a project to lower production cost and one to raise market share

Capability
Model

needs to be sophisticated enough to deal with all projects

Varying resource requirements Varying time periods Varying probabilities of success

Needs

to be able to select the optimum projects among all contenders

Flexibility
Needs

to be able to work with all projects Needs to be updated as the firm and its environment evolves

Easy to Use
Needs

to be quick to gather the data and easy to use Easy to be able to fit the project in the model

Inexpensive
Do

not want the model to eat up all the savings that result from using the model Expenses include the cost of writing and maintaining the model Also includes the expense of gathering the data needed by the model

Easy to Implement
This

is less of an issue with modern spreadsheets However, a model to be used to evaluate all the firms projects should be centrally maintained

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 never fully describe the situation The outputs never fully describe the expected results Models are tools Managers are the decision makers

Different Factors Affecting Outcome

Many

factors affect the outcome of a project

cost of an item

Some are one-time factors

The

Others are reoccurring

Maintenance

Not

all factors are equally important Critical factors on one project may be trivial on another project

Types of Project Selection Models

Nonnumeric

models Numeric models

Nonnumeric Models
Models

that do not return a numeric value for a project that can be compared with other projects These are really not models but rather justifications for projects Just because they are not true models does not make them all bad

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.

Operating

Necessity Necessity

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.

Competitive

Types of Nonnumeric Models

Product

Continued

Line Extension

Often, projects to expand a product line are evaluated on how well the new product meshes with the existing product line rather than on overall benefits.

Comparative

Benefit

Projects are subjectively rank ordered based on their perceived benefit to the company.

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

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 the more common

Payback Period
The

length of time until the original investment has been recouped by the project A shorter payback period is better

Payback Period Example

Project Cost Payback Period = Annual Cash Flow $100,000 Payback Period = =4 $25,000

Payback Period Drawbacks

1. 2. 3.

Does not consider time value of money More difficult to use when cash flows change over time Less meaningful over longer periods of time (due to time value of money)

Discounted Cash Flow

The

value of a stream of cash inflows and outflows in todays dollars Also know as discounted cash flow 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

Discounted Cash Flow

Requires

Continued

a percentage to use to reduce future cash flows

This is known as the discount rate

The

discount rate may also be know as a hurdle rate or cutoff rate There will usually be one overall discount rate for the company

NPV Formula

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

NPV Formula Terms

A0 Initial cash investment Ft The cash flow in time period t (negative for outflows) k The discount rate T The number of years of life

A higher NPV is better The higher the discount rate, the lower the NPV

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

Internal Rate of Return [IRR]

The

discount rate (k) that causes the NPV to be equal to zero The higher the IRR, the better

While it is technically possible for a series to have multiple IRRs, this is not a practical issue

Finding

the IRR requires a financial calculator or computer In Excel =IRR(Series,Guess)

Profitability Index
a.k.a.

Benefit cost ratio NPV divided by initial cash investment Ratios greater than 1.0 are good

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

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

Scoring Models
Unweighted

factor model Weighted factor model

Unweighted Factor Model

Each

factor is weighted the same Less important factors are weighted the same as important ones Easy to compute Just total or average the scores

Unweighted Factor Model Example

Figure 2-2

Weighted Factor Model

Each

factor is weighted relative to its importance

Weighting allows important factors to stand out

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

Weighted Factor Model Example

Figure B

Analysis Under UncertaintyThe Management of Risk

Everything

to do with projects is risky Some projects, like R&D, are more risky than others, like construction Risks include

The timing of the project and its associated cash flow Risk regarding the outcome of the project Risk about the side effects

Risk and Uncertainty

What

the decision maker does What nature does

Uncertainty
1. 2. 3.

Pro forma financial statements Risk analysis Simulation (requires detailed probability information)

Comments on the Information Base for Selection

1. 2. 3.

Accounting data Measurements Uncertain information

Accounting Data
1. 2.

3.

Cost and revenue are linear Cost-revenue data derived using standard cost standardized revenue assumptions Costs may include overhead

Measurements
1. 2. 3. 4.

Subjective versus objective Quantitative versus qualitative Reliable versus unreliable Valid versus invalid

Uncertain Information
Must

estimate inputs for risk analysis These inputs cannot be known exactly Inputs must be adjusted over time

Project Portfolio Process (PPP)

Links

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

PPP Steps
1. 2. 3. 4. 5. 6. 7. 8.

Establish a project council Identify project categories and criteria Collect project data Assess resource availability Reduce the project and criteria set Prioritize the projects within categories Select projects to be funded and held in reserve Implement the process

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

Step 2: Identify Project Categories and Criteria

1. 2. 3. 4.

Derivate projects Platform projects Breakthrough projects R&D projects

Step 3: Collect Project Data

Assemble

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

Step 4: Assess Resource Availability

Assess

both internal and external resources Assess labor conservatively Timing is particularly important

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 Dominated by another Has slipped in desirability

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

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

Step 8: Implement the Process

Communicate

results Repeat regularly Improve process

Project Proposals
The

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

project proposal is essentially a project

Project Proposal Contents

Cover

letter Executive summary The technical approach The implementation plan The plan for logistic support and administration Past experience