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SE-430

Software Project Management

Software Project Selection Methods
Week 7

Objectives of Todays Lecture

• On completion of this lecture we will be able to:
‒ Carry out an evaluation and selection of Projects against strategic, Technical and
economic criteria
‒ Use a variety of cost benefit evaluation techniques for choosing among competing
project proposals
‒ Evaluate the risk involved in a project and select appropriate strategies for minimizing
the potential cost
• Reference:
‒ Chapter 3 – Software Project Management by Bob Hughes

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0.Select
1. Identify project 2. Identify project
project objectives infrastructure

3. Analyse
project
Stepwise refinement of Project Plan

characteristics
Review
4. Identify products
and activities

5. Estimate effort
Lower for activity For each
level activity
detail 6. Identify activity
risks
10. Lower level
7. Allocate
planning
resources

8. Review/ publicize
9. Execute plan plan

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Selection of project approaches

• Concerned with choosing the right approach to a particular project:
‒ also called technical planning, project analysis, methods engineering and methods
tailoring
‒ In-house: often the methods to be used dictated by organizational standards
‒ Suppliers: need for tailoring as different customers have different needs

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Build or buy?

In-house
Outsource?
development?

either

Build Buy

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Off-The-Shelf (OTS) software

Advantages
• Cheaper as supplier can spread development costs over a large number of
customers
• Software already exists
‒ Can be trialed by potential customer
‒ No delay while software being developed
• Where there have been existing users, bugs are likely to have been found and
eradicated

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Off-The-Shelf (OTS) software

Disadvantages
• Customer will have same application as everyone else:
‒ no competitive advantage, but competitive advantage may come from the way
application is used
• Customer may need to change the way they work in order to fit in with OTS
application
• Customer does not own the code and cannot change it
• Danger of over-reliance on a single supplier

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General approach
• Look at risks and uncertainties e.g.
‒ are requirement well understood?
‒ are technologies to be used well understood?
• Look at the type of application being built e.g.
‒ information system? embedded system?
‒ criticality? differences between target and development environments?
• Clients’ own requirements
‒ need to use a particular method

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Selection of project
• Technical Assessment
‒ Technical Assessment of a proposed system consists of evaluating the required
functionality against the hardware/ software available
• Cost benefit analysis
‒ Most common way of carrying out an economic assessment of a proposed system is by
comparing the expected costs of development and operation of the system with the
benefits of having it in place

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Cost benefit analysis

• Common way of carrying out an economic assessment of a proposed IS system
‒ Compare the expected cost of development and operation of the system with benefits
• Standard way of evaluating the economic benefits:
‒ Identifying and estimating all of the costs and benefits of carrying out the project
 This include Development cost, the operating cost and expected benefits
‒ Expressing CBA in common unit:
 Like Rupees
• Development cost: salaries/ employment cost , Development and associated cost
• Setup Cost: Cost of putting the system in use
• Operational Cost
‒ Benefits : Direct Benefit, intangible Benefits, Assessable indirect benefits
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Cost Benefit Analysis (CBA)

• It is usually necessary to ask whether or not the project under consideration is the best of a
number of options
‒ There might be more candidate projects than can be undertaken at any one time
‒ in any case, projects will need to be prioritized so that any limited resources may be allocated effectively
• Standard way of evaluating the economic benefits of any project is to carry out a cost
benefit analysis which consists of following steps:-
‒ Identify all the costs which could be:
 Development costs
 Set-up
 Operational costs
‒ Identify the value of benefits
‒ Check benefits are greater than costs

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Product/ System life cycle cash flows

• The timing of costs and income for a product of system needs to be estimated
‒ Typically product generate a negative cash flow during development followed by A
positive cash flow during operating life
‒ A decommissioning cost t the end of a product’s life

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Cost Benefit Analysis (CBA)

• It is helpful to categorize costs according to where they originate in the life of
the project
‒ Development costs:
 Include the salaries and other employment costs of the staff involved in the development
project and all associated costs
‒ Setup costs:
 Include the costs of putting the system into place
• These consist mainly of the costs of any new hardware and ancillary equipment, but will also
include costs of file conversion, recruitment and staff training

‒ Operational costs:
 Consist of the costs of operating the system once it has been installed

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Cost Benefit Analysis (CBA)

• Benefits, are often quite difficult to quantify in monetary terms even once they have been
identified
• Benefits may be categorized as follows
‒ Direct benefits: These accumulate directly from the operation of the proposed system.
• for example, include the reduction in salary bills through the introduction of a new, computerized system

‒ Assessable indirect benefits: These are generally secondary benefits, such as increased accuracy through the
introduction of a more user-friendly screen design where we might be able to estimate the reduction in errors, and
hence costs, of the proposed system
‒ Intangible benefits: These are generally longer tern’ or benefits that are considered very difficult to quantify
• Enhanced job interest can lead to reduced staff turnover and, hence, lower recruitment costs

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CBA Evaluation Techniques

• Consider proceeding with a project only where the benefits outweigh the costs
• Decide on a consistent and standardized approach for measuring benefits for
the criteria
‒ For instance, for financial return you could use one or more of the following:
 Payback period
 Net Profit
 Return on investment (ROI)
 Net present value (NPV)
 Internal rate of return (IRR)
 Other forms of cost/benefit analysis

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Financial Return Methods

• Payback period
‒ Payback period is the amount of time it takes a company to recoup its initial
investment in the cost of producing a product or service
 Fairly simple to use, but is not as accurate as other methods because it does not
consider how the value of money is affected by interest over time.
• The decision is based on when the payback comes, not on how much the organization will
make after that payback point.

‒ Payback period = Time taken to pay back the initial investment

 Advantage: simple to calculate, not particular sensitive to small forecasting errors
 Disadvantage: ignores any income (or expenditure) after the payback period

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CBA – Cash Flow

‘Year 0’ represents all the Year Project 1 Project 2 Project 3 Project 4

costs before system is
operational 0 100,000 1,000,000 100,000 120,000
1 10,000 200,000 30,000 30,000

2 10,000 200,000 30,000 30,000

3 10,000 200000 30,000 30,000
4 20,000 200000 30,000 30,000

‘Cash flow’ is the value of 5 100,000 300,000 30,000 75,000

income less outgoing Cash Flow 150,000 1,100,000 150,000 195,000

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CBA – Net Profit

• Net profit is the value of all the cash flows Year Cash-flow
for the life time of the project 0 -100,000

• For the project on the right it will be 1 10,000

50,000 2 10,000
3 10,000
4 20,000
5 100,000
Net Profit 50,000
• This can also be calculated as

𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 = 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 − 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

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CBA – Payback period

• This is the time it takes to start Year Cash-flow Accumulated
generating a surplus of income over 0 -100,000 -100,000
outgoings 1 10,000 -90,000
• The payback period would be about 4.5 2 10,000 -80,000
years 3 10,000 -70,000
4 20,000 -50,000
5 100,000 50,000

• This can be calculated as

𝑝𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑
= 𝑡ℎ𝑒 𝑙𝑎𝑠𝑡 𝑦𝑒𝑎𝑟 𝑖𝑛 𝑤ℎ𝑖𝑐ℎ 𝑡ℎ𝑒 𝑎𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑤𝑎𝑠 𝑛𝑒𝑔𝑎𝑡𝑖𝑣𝑒
𝑎𝑏𝑠𝑜𝑙𝑢𝑡𝑒 𝑎𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑡ℎ𝑎𝑡 𝑦𝑒𝑎𝑟
+
𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑛𝑒𝑥𝑡 𝑦𝑒𝑎𝑟

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CBA – Financial Return methods

Year Project 1 Project 2 Project 3 Project 4
0 -100,000 -1,000,000 -100,000 -120,000
1 10,000 200,000 30,000 30,000
2 10,000 200,000 30,000 30,000
3 10,000 200,000 30,000 30,000
4 20,000 200,000 30,000 30,000
5 100,000 300,000 30,000 75,000
Net Profit 50,000 100,000 50,000 75,000
Payback Period 5 yrs 5 yrs 4 yrs 4 yrs

• (negative values represent net expenses, positive values represent net incomes),
Assumptions:
1. Cash flow take place at the end of each year
2. The year 0 figure represents the initial investment made at the start of the project
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CBA – Average Annual Profit

Project 1 Project 2 Project 3 Project 4
Investment 100,000 1,000,000 100,000 120,000
Cash Flow 150,000 1,100,000 150,000 195,000
Net Profit 50,000 100,000 50,000 75,000
Payback 5 yrs 5 yrs 4 yrs 4 yrs
Avg Annual Profit 10,000 20,000 10,000 15,000

𝑵𝒆𝒕 𝑷𝒓𝒐𝒇𝒊𝒕 = 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 – 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝑷𝒆𝒓𝒊𝒐𝒅 = 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑚𝑜𝑛𝑒𝑦 𝑠𝑡𝑎𝑟𝑡𝑠 𝑝𝑟𝑜𝑓𝑖𝑡
𝑨𝒗𝒈 𝑨𝒏𝒏𝒖𝒂𝒍 𝑷𝒓𝒐𝒇𝒊𝒕 = 𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 / 𝑝𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑
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CBA - ROI
• Return on investment (ROI) a.k.a accounting rate of return (ARR) provides a way of comparing
the net profitability to the investment required
Project 1 Project 2 Project 3 Project 4
Investment 100,000 1,000,000 100,000 120,000
Net Profit 50,000 100,000 50,000 75,000
Payback 5 yrs 5 yrs 4 yrs 4 yrs
Avg Annual Profit 10,000 20,000 10,000 15,000
ROI (%) 10 2 10 12.5

𝑅𝑂𝐼 = (𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡 / 𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡) × 100

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CBA – ROI
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡
𝑅𝑂𝐼 = × 100
𝑡𝑜𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
• Advantage:
‒ ROI provides a simple, easy to calculate measure of return on capital and is therefore
quite popular
• Disadvantages:
‒ It takes no account of the timing of the cash flows
‒ Comparing ROI with current interest rates is potentially misleading because it takes no
account of compounding of interest

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Net Present Value

• The difference between the market value of a project and its cost
• How much value is created from undertaking an investment?
‒ The first step is to estimate the expected future cash flows.
‒ The second step is to estimate the required return for projects of this risk level.
‒ The third step is to find the present value of the cash flows and subtract the initial
investment.

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Net Present Value (NPV)

• The calculation of NPV is a project evaluation technique that takes into
account the profitability of a project and the timing of the cash flows that are
produced
‒ It determines the current value of all future cash flows generated by a project by
discounting them to the present point in time
 It is the sum of present values of all future amounts
‒ Present value is the value which a future amount is worth at present
 If financial value is a key criterion, projects with positive NPV should be considered
• The higher the NPV, the better

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NPV

If It means Then
the investment would add value to the
NPV > 0 the project should be accepted
firm
the investment would subtract value
NPV < 0 the project should be rejected
from the firm
the project could be accepted as this project adds
the investment would neither gain nor
NPV = 0 no monetary value. Decision should be based on
lose value for the firm
other criteria, e.g. strategic positioning.

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NPV – Calculating Present Value

• Would you rather I gave you Rs100 today or in a year’s time?
‒ You could invest the Rs100 and get 1 year’s interest say @10%
• Present value of Rs100 in an year’s time can be calculated using discount
rate:
𝑣𝑎𝑙𝑢𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟 𝑛
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 =
(1 + 𝑟)
… where r is the discount rate & n is the number of years
• Thus PV of Rs100 will with required return @10% i.e. 𝑟 = 0.1 will be
100
𝑃𝑉 100 = = 90.9
(1 + 0.1)
• Thus ~Rs 91 today are worth Rs100 in an year’s time if we consider r=10%

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NPV – Formula
𝑅
𝑁𝑃𝑉 =
(1 + 𝑟)
where 𝑅 = 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤 − 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠 𝑑𝑢𝑟𝑖𝑛𝑔 𝑠𝑖𝑛𝑔𝑙𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 𝑛
𝑟 = 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒
𝑡 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑡𝑖𝑚𝑒 𝑝𝑒𝑟𝑖𝑜𝑑𝑠

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NPV – Example
• A project costs Rs1,000 and will provide three cash flows of Rs 500, Rs 300,
and Rs 800 over the next three years. What will be the NPV of the project if the
required rate of return (discount factor) is 8%
−1000 500 300 800
𝑁𝑃𝑉 = + + +
(1 + 0.08) (1 + 0.08) (1 + 0.08) (1 + 0.08)
= 355.23
• NPV of the project is therefore Rs 355.23
• Whereas 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 = −1000 + 500 + 300 + 800 = 𝑅𝑠 600

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Example - II
• Let us say a company wants to expand its business and so it is willing to invest Rs
10,00,000.
‒ The investment is said to bring an inflow of Rs. 100,000 in first year, 250,000 in the second
year, 350,000 in third year, 265,000 in fourth year and 415,000 in fifth year.
‒ Assuming the discount rate to be 9%. Let us calculate NPV using the formula.
‒ Reference: https://www.calculatestuff.com/financial/npv-calculator
Formula for NPV
Year Flow Present value Computation
0 -1000000 -1000000 NPV = (Cash flows)/( 1+r)^t
1 100000 91743 100000/(1.09)
Cash flows= Cash flows in the
2 250000 210419 250000/(1.09)^2 time period
3 350000 270264 350000/(1.09)^3 r = Discount rate
t = time period
4 265000 187732 265000/(1.09)^4
5 415000 269721 415000/(1.09)^5
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Exercise
• consider two potential projects for company ABC:
‒ Project X requires an initial investment of $35,000 but is expected to generate
revenues of Rs10,000, Rs27,000 and Rs19,000 for the first, second, and third years,
respectively.
‒ The target rate of return is 12%.
 Since the cash inflows are uneven, the NPV formula is broken out by individual cash flows.

NPV of Project – X = + + −35000 = NPV X (8,977)

. ( . ) ( . )

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Exercise
• consider two potential projects for company ABC:
‒ Project Y also requires a $35,000 initial investment and will generate $27,000 per
year for two years. The target rate remains 12%. Because each period produces equal
revenues, the first formula above can be used.
‒ The target rate of return is 12%.
 Since the cash inflows are uneven, the NPV formula is broken out by individual cash flows.

NPV of Project – Y = + −35000 = NPV X (10,631)

. ( . )

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Hands-on Practice
• Suppose you as the investor are looking at investing in a project for your company that would
extend to you the ownership of a new piece of machinery that may help your business
produce widgets more efficiently.
• This new piece of machinery costs Rs 500,000 for a three-year lease, but your hope is that
your company will operate more efficiently and generate higher cash flows as a result of this
new machine.
‒ This machine operates differently than the one your company currently uses to produce widgets, so it may
take time for your employees to get used to operating the new equipment. Thus, you expect cash flows to
increase over time as your employees become more familiar with the equipment.
‒ Your analysts are projecting that the new machine will produce cash flows of $210,000 in Year 1,
$237,000 in Year 2, and $265,000 in Year 3.
• The rate of return of an alternative project is 6%.
• What is the net present value of your potential investment?
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Calculation
Rate 0.06
Year 0 1 2 3
CF (500,000) 210,000 237,000 265,000

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Reference
• Project Management Body of Knowledge
‒ Chapter 7
• Software Project Management – Bob Hughes & Mike Cotterell
‒ Chapter 3

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Reference
• Project Management Body of Knowledge
‒ Chapter 7
• Software Project Management – Bob Hughes & Mike Cotterell
‒ Chapter 3

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