Project Selection and Project Portfolio Process

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Project Selection and Project Portfolio Process

© All Rights Reserved

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You are on page 1of 71

PROJECT PORFOLIO PROCESS

2-1

Chapter outline

2.2 Project portfolio process (PPP)

2-2

2.1 PROJECT SELECTION

2-3

Problems With Multiple Projects

Inefficient use of resources

Bottlenecks in resource availability

2-4

Project Results

Over half of completed projects came in

up to190 percent over budget

Over half of completed projects came in

up to 220 percent late

2-5

Challenges

goals and strategy

How to handle the growing number of

projects?

How to make these projects successful?

2-6

Project Management Maturity

the mastery of skills required to manage

projects competently

Number of ways to measure

Most organizations do not do well

2-7

Project Selection and Criteria of Choice

Project selection

Evaluating

Choosing

Implementing

Same process as other business

decisions

2-8

Types of Companies

broad categories:

Companies whose core business is completing

projects

Companies whose core business is something else

They can also be broken down as:

Companies looking at projects to do for others

Companies looking at projects to do for themselves

2-9

Model Criteria

Realism

Capability

Flexibility

Ease of use

Cost

Easy computerization

2-10

The Nature of Project Selection Models

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

2-11

Types of Project Selection Models

Nonnumeric models

Numeric models

2-12

Nonnumeric Models

for a project to 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

2-13

Types of Nonnumeric Models

Sacred Cow

A project, often suggested by the top management,

that has taken on a life of its own

Operating Necessity

A project that is required in order to protect lives or

property or to keep the company in operation

Competitive Necessity

A project that is required in order to maintain the

companys position in the marketplace

2-14

Types of Nonnumeric Models Continued

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

2-15

Numeric Models

project that can be easily compared with

other projects

Two major categories:

Profit/profitability

Scoring

2-16

Profit/Profitability Models

Payback period

Discounted cash flow (NPV)

Internal rate of return (IRR)

Profitability index

NPV and IRR are the more common

methods

2-17

Payback Period

investment has been recouped by the

project

A shorter payback period is better

2-18

Payback Period Example

Project Cost

Payback Period

Annual Cash Flow

2-19

Payback Period Drawbacks

More difficult to use when cash flows

change over time

Less meaningful for longer periods of

time (due to time value of money)

2-20

Discounted Cash Flow

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

2-21

Discounted Cash Flow Continued

future cash flows

This is known as the discount rate

The discount rate may also be known as

a hurdle rate or cutoff rate

There will usually be one overall discount

rate for the company

2-22

NPV Formula

n

Ft

NPV (project) A0

1 k

t

t 1

2-23

NPV Formula Terms

Ft 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

Higher the discount rate lower the NPV

2-24

NPV Example

investment with a net cash inflow of

$25,000 per year for a period of 8 years,

a required rate of return of 15% and an

inflation rate of 3% per year.

8

$25,000

NPV (project) $100,000

t 1 1 0.15 0.03

t

$1,939

2-25

Projects with Unequal Lives

machines of unequal lives. They are

mutually exclusive. How do you decide

which one to purchase?

In this case, if you use NPV, you will

ignore the fact that you need to buy a

new machine sooner in one case than the

other!

Example

Two machines have the following maintenance expenses

during their lives: (r=10%)

0 1 2 3 4

Machine A -500 -120 -120 -120

Machine B -600 -100 -100 -100 -100

Seems like one should choose the 1st machine, since the

PV of its expenses is lower than for the 2nd machine.

.This may be wrong!

Methods to Handle this

Matching Cycle Approach

Annualized NPV approach or The

Equivalent Annual Cost Method (EAC)

Replacement Chains

years, and Machine B has a lifetime of 4 years.

A would have 4 replacement cycles and B would

have 3.

This is tedious! If we were added a machine with

a 5 year lifetime, our chain would be 60 years long.

Matching Cycle Approach

Repeat projects until they end at the

same time

Assumption: the projects can be repeated

The easiest: repeat the projects forever

Compare NPV of the repeated projects

NPV(T) : NPV of the original project of T

years

NPV(T,) = NPV(T) / (1 (1+R)-T) : NPV of

the original project replicated at const scale

to

Annualized NPV approach

(or Equivalent Annual Cost EAC)

annuity that has the same NPV as the

original set of cash flows.

NPV = ANPV ART

If only costs: EAC (Equivalent Annual Cost)

Compare ANPV (or EAC)

This method requires less restrictive

assumptions

Annualized NPV approach

(or Equivalent Annual Cost EAC)

each piece of equipment. This gives the Equivalent

Annual Cost of each machine.

0 1 2 3 4

Machine A -500 -120 -120 -120

EACa EACa EACa

Machine B -600 -100 -100 -100 -100

EACb EACb EACb EACb

This results in an annual payment on the Machine A of

$321. The Machine B costs $289 per year. (Show this in

excel)

Thus, you should prefer Machine B.

Exercise:

cleaner.

There are two mutually exclusive choices (r =

10%):

The Cadillac cleaner costs $4,000 today,

has annual operating costs of $100 and

lasts for 10 years.

The cheaper cleaner costs $1,000 today,

has annual operating costs of $500 and

lasts for 5 years.

Which one to select?

Solution:

lower NPV:

NPV (Cadillac) = - 4,614.46

NPV (Cheap) = - 2,895.39

This overlooks the fact that the Cadillac

cleaner lasts twice as long => choose

the Cadillac cleaner

Solution: Matching Cycle Approach

time

Assumption: the projects can be repeated

The easiest: repeat the projects forever

Compare NPV of the repeated projects

NPV(T) : NPV of the original project of T years

NPV(T,) = NPV(T) / (1 (1+R)-T) : NPV of the

original project replicated at const scale to

In our example, NPV of the infinitely

repeated project is -$7509.8 for Cadillac

and -$7638 for Cheap

Solution: Annualized NPV approach

ANPV = value of the level payment annuity that

has the same NPV as the original set of cash

flows.

NPV = ANPV ART

If only costs: EAC (Equivalent Annual Cost)

Compare ANPV (or EAC)

This method requires less restrictive assumptions

In our example, the EAC for Cadillac is $750.98

10 10

$100 $750.98

$4,000 t

4,614.46 t

t 1 (1.10) t 1 (1.10)

$763.80 which confirms our earlier

decision to reject it.

Application: Example of Replacement Projects

instruments. He has an old one that is in use, but the

maintenance costs are rising. So he is considering

replacing it.

New Autoclave

Cost = $3,000 today,

Maintenance cost = $20 per year

Resale value after 6 years = $1,200

NPV of new autoclave (at r = 10%):

6

$20 $1,200

$2,409.74 $3,000

t 1 (1.10)t (1.10)6

EAC of new autoclave = -$553.29

6

$553.29

$2,409.74

t 1 (1.10) t

Existing Autoclave

Year 0 1 2 3 4 5

Maintenance 0 200 275 325 450 500

Resale 900 850 775 700 600 500

Total Annual Cost 340 435 478 620 660

Total Cost for year 2 = (850 1.10 775) + 275 = $435

Total Cost for year 3 = (775 1.10 700) + 325 = $478

Total Cost for year 4 = (700 1.10 600) + 450 = $620

Total Cost for year 5 = (600 1.10 500) + 500 = $660

Note that the total cost of keeping an autoclave for the first

year includes the $200 maintenance cost as well as the

opportunity cost of the foregone future value of the $900

we didnt get from selling it in year 0 less the $850 we have

if we still own it at year 1.

Choosing the Moment of Replacement

New Autoclave

EAC of new autoclave = -$553.29

Existing Autoclave

Year 0 1 2 3 4 5

Maintenance 0 200 275 325 450 500

Resale 900 850 775 700 600 500

Total Annual Cost 340 435 478 620 660

new one.

Replace the autoclave after year 3: at that point the new

one will cost $553.29 for the next years autoclaving and the

old one will cost $620 for one more year.

Internal Rate of Return [IRR]

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)

2-40

Profitability Index

NPV divided by initial cash investment

Ratios greater than 1.0 are good

2-41

Advantages of Profitability Models

Based on accounting data and forecasts

Familiar and well understood

Gives a go/no-go indication

Can be modified to include risk

2-42

Disadvantages of Profitability

Models

Some ignore time-value of money

Biased toward the short-term

Payback ignores cash flow after payback

IRR can have multiple solutions

All are sensitive to errors

Nonlinear

Dependent on determination of cash flows

2-43

Scoring Models

Unweighted factor model

Weighted factor model

2-44

Unweighted 0-1 Factor Model

Factors selected

Listed on a preprinted form

Raters score the project on each factor

Each project gets a total score

Main advantage is that the model uses

multiple criteria

Major disadvantages are that it assumes

all criteria are of equal importance

2-45

Unweighted 0-1 Factor Model Example

Unweighted Factor Scoring Model

Typically a 1-5 scale

Column of scores is summed

Projects with high scores are selected

2-47

UnWeighted Factor Model

Less important factors are weighted the

same as important ones

Easy to compute

Just total or average the scores

2-48

Weighted Factor Model

importance

Weighting allows important factors to stand out

A good way to include nonnumeric 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

2-49

Weighted Factor Model Example

Weighted Factor Model Example

Advantages of Scoring Models

Structurally simple

Direct reflection of managerial policy

Easily altered

Allow for more important factors

Allow easy sensitivity analysis

2-52

Disadvantages of Scoring Models

Relative measure

Linear in form

Can have large number of criteria

Unweighted models assume equal

importance

2-53

Risk Considerations in Project Selection

Benefits are more uncertain

There are many ways of dealing with risk

Can make estimates about the probability of

outcomes

Subjective probabilities

Uncertainty about:

Timing

What will be accomplished?

Side effects

Pro forma (expected) documents

2-54

2.2 PROJECT PORTFOLIO PROCESS

(PPP)

2-55

The Project Portfolio Process (PPP)

strategy of the organization

Means for monitoring and controlling

projects

2-56

Symptoms of a Misaligned Portfolio

More projects

Inconsistent determination of benefits

Projects that dont contribute to the

strategy

Competing projects

Costs exceed benefits

No risk analysis of projects

Lack of tracking against the plan

No client for project 2-57

Purpose of Project Portfolio Process

Identify nonprojects

Prioritize list of projects

Limit number of projects

Identify the real options for each project

Identify projects with good fit

Identify co-dependent projects

2-58

Purpose of Project Portfolio Process

Continued

Eliminate projects that skip the formal

selection process

Keep from overloading the organization

To balance the resources with needs

To balance returns

To balance short-, medium-, and long-

term returns

2-59

Project Portfolio Process Steps

2. Identify project categories and criteria

3. Collect project data

4. Assess resource availability

5. Reduce the project and criteria set

6. Prioritize the projects within categories

7. Select the projects to be funded and held in

reserve

8. Implement the process

2-60

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

2-61

Step 2: Identify Project Categories and

Criteria

Derivate projects

Platform projects

Breakthrough projects

R&D projects

2-62

Step 3: Collect Project Data

Document assumptions

Screen out weaker projects

The fewer projects that need to be

compared and analyzed, the easier the

work of the council

2-63

Step 4: Assess Resource Availability

resources

Assess labor conservatively

Timing is particularly important

2-64

Step 5: Reduce the Project and Criteria

Set

Have competence Synergistic

Market for offering Dominated by

How risky the project is another

Potential partner Has slipped in

desirability

Right resources

Good fit

2-65

Step 6: Prioritize the Projects Within

Categories

Consider in terms of benefits first and

resource costs second

Summarize the returns from the projects

2-66

Step 7: Select the Projects to be Funded

and Held in Reserve

categories

Leave some resources free for new

opportunities

Allocate the categorized projects in rank

order

2-67

Step 8: Implement the Process

Communicate results

Repeat regularly

Improve process

2-68

Project Proposals

project 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

2-69

Project Proposal Contents

Cover letter

Executive summary

The technical approach

The implementation plan

The plan for logistic support and

administration

Past experience

2-70

END OF CHAPTER 2 !!!

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