Project ManagementA Managerial Approach

Project ManagementA Managerial Approach

Chapter 2

Project Selection

Project Selection Procedure: A Cross- Industry Sampler

Hoechst AG, a pharma firm uses a scoring portfolio model with 119 questions in five major categories i.e: business strategy fit, probability of technical success, commercial success, strategic leverage and reward to the company. Within each of these factors there are specific questions which are scored on a 1-10 by the management.

The Royal Bank of Canada uses the foll criteria for portfolio scoring: Project importance( strategic importance, magnitude of impact and economic benefits) ease of doing (cost of development, project complexity and resource availability) Expected annual expenditure and total project spending are then added to this rank ordered list to prioritize project options.

Project Selection

Project selection is the process of evaluating individual projects or groups of projects, and then choosing to implement some set of them so that the objectives of the parent organization will be achieved

Managers often use decision-aiding models to extract the relevant issues of a problem from the details in which the problem is embedded

Models represent the problem’s structure and can be useful in selecting and evaluating projects

Criteria for Project Selection Models (Souder) Realism - reality of manager’s decision

Capability- able to simulate different scenarios and optimize the

decision

Flexibility - provide valid results within the range of conditions

Ease of Use - reasonably convenient, easy execution, and easily

understood

Cost - Data gathering and modeling costs should be low relative to

the cost of the project

Easy Computerization - must be easy and convenient to gather,

store and manipulate data in the model

Key issues in Project analysis

Market factorsProduction Factors /Technical analysisFinancial factorsPersonnel factorsAdministrative factors

Marketing Factors

Size of potential market for output

Probable market share of output

Time until market share is acquired

Impact on current product line

Consumer acceptance

Impact on consumer safety

Estimated life of output

Spin-off project possibilities

Production factors

• Time until ready to install

• Length of disruption during installation

• Learning curve-time until operating as desired.

• Effects on waste & rejects

• Energy requirements

• Facility & other equipment requirements

• Safety of process

• Other applications of technology

• Changes in cost to produce a unit output

PRODUCTION FACTORS (contd.)

• Change in raw material usage

• Availability of raw materials

• Required development time & cost

• Impact on current suppliers

• Change in quality of output

Financial Factors

• Profitability

• Impact on cash flows• Payout periodIn entrepreneurship, a period of time in

which cash flow is negative. This especially applies to an early part of a company's history before it has recovered start up costs and operating expenses.

• Cash requirements

• Time until break-even

• Size of investment required

• Impact on seasonal &cyclic fluctuations

Personnel factors

• Training requirements

• Labour skill requirements

• Availability of required labour skill

• Level of resistance from current work force

• Change in size of labour force

• Inter & intra group communication requirements

• Impact on working conditions

Administrative & Miscellaneous factors

• Meet govt. safety,environmental standards

• Impact on information system

• Reaction of stock holders & securities market

• Patent & trade secret protection

• Impact of image with customers, suppliers & competitors

• Degree to which we understand new technology

• Managerial capacity to direct & control new process

Nature of Project Selection Models

2 Basic Types of ModelsNumericNonnumeric

Two Critical Facts:Models do not make decisions - People do!All models, however sophisticated, are only partial

representations of the reality the are meant to reflect

Nonnumeric Models

Sacred Cow - project is suggested by a senior and powerful official in the organization

Operating Necessity - the project is required to keep the

system running

Competitive Necessity - project is necessary to sustain a

competitive position

Product Line Extension - projects are judged on how they fit

with current product line, fill a gap, strengthen a weak link, or extend the line in a new desirable way.

Comparative Benefit Model - several projects are

considered and the one with the most benefit to the firm is selected

Numeric Models: Scoring

Unweighted 0-1 Factor Model

Unweighted Factor Scoring Model

Weighted Factor Scoring Model

Constrained Weighted Factor Scoring Model

Goal Programming with Multiple Objectives

NUMERIC MODELS-SCORING

UNWEIGHTED 0-1 FACTOR MODEL -A set of relevant factors is selected by management & then listed in a preprinted form. One or more raters score the project on each factor, whether or not it qualifies for an individual criterion.

Qualify Does not qualify

Potential market size *Time to break-even less than 3 years *No quality compromise *Need for external consultants *Impact on work force safety *Estimated annual profits $250,000 *

Total 4 2

Project________

Rater_________

Date__________

UNWEIGHTED FACTOR SCORING MODEL-the earlier model had the drawback of considering all criteria equally important & involves no gradation of the degree to which a specific project meets the various criteria.

This model addresses the second drawback by constructing a simple linear measure of the degree to which the project being evaluated meets each of the criteria contained in the list

Unweighted Factor Scoring model….

Score Performance level

5 Very good Grows by 40%

4 Good Grows by 25%

3 Fair Grows by 10%

2 Poor Not affected at all

1 Very Poor Negatively affected

Eg: Potential market size: Total score should exceed some set critical value

WEIGHTED FACTOR SCORING MODEL

Numeric weights reflecting the relative importance of each individual factor are added.

It is the sum of products of scores and weights on each criterion.

It is also useful for improvement of the project.

The weight may be generated by any of the following techniques:

1. Delphi technique (developing numerical values which are equivalent to subjective , verbal measures of relative value.)

2. Analytical hierarchy process

3. Successive comparison / pair wise comparisons

Exercise

Use a weighted scoring model to chose an automobile. The performance measures and scores, as also the relative weights of each criterion are shown in the following table.

Performance measures and scores for automobile selection

Criteria 1 2 3 4 5

Appearance Ugh Poor Adequate Good Wow

Braking >165 165-150 150-140 140-130 <130

Comfort Bad Poor Adequate Good Excellent

Cost (Operating) >$2.5 2.1-2.5$ 1.9-2.1$ 1.6-1.9$ <1.6$

Cost (Original) >$32.5 26-32.5$ 21-26$ 17-21$ <$17

Handling <45 45-49.5 49.5-55 55-59 >59

Reliability Worst Poor Adequate Good Excellent

The criteria and weights for automobile purchase are given below.

----------------------------------------------------Criteria Weight A B C D------------------------------------------------------------------------Appearance .1 3 3 2 5Braking .07 1 3 1 4Comfort .17 4 2 4 3Cost, operating .12 2 5 4 2Cost, original .24 1 4 3 2Handling .17 2 2 1 5Reliability .12 3 4 3 2------------------------------------------------------------------------Develop a weighted scoring model for making an automobile choice.

Scores for automobilesA=2.23B=3.23C=2.68D=3.10B is the best option

Sensitivity analysis

A weighted scoring model can also be used for project improvement.

For any given criterion, the difference between the criterion’s score and the highest possible score on that criterion , multiplied by the weight of the criterion , is a measure of the potential improvement in the project score that would result, were the project’s performance on the specific criterion sufficiently improved.

It may be that such an improvement is not feasible. Such an analysis yields valuable statement of

comparative benefits of project improvements. By adding resources we can study the degree to which a

project’s score is sensitive to attempts for improvement.

CONSTRAINED WEIGHTED FACTOR SCORING MODEL-

• Involves constraints representing project characteristics that must be present or absent in order for the project to be acceptable.

•In is the sum of products of scores and weights on each criterion, multiplied by a value of 1(if the ith project satisfies the kth constraint & 0 if it does not)

• Other elements in this model are the same as in the previous model . A company may have decided that they would not undertake any project that would significantly lower the quality of the final product.

Profit / profitability

Pay back periodAverage Rate of returnDiscounted cash flowInternal rate of returnProfitability Index

Payback period

Payback Period=

Initial fixed investment/estimated annual net cash inflow

It is the no. of years required for the project to repay the initial fixed investment.

The faster the investment recovered , the less the risk.

Average Rate of Return

Average rate of return=

Average Annual Profit/initial or avg. investment

Does not take into account the time value of money.

Exercise

Initial fixed investment=$5,00,000Annual net cash inflow=$1,00,000Average annual profits=$70,000

Calculate the payback period & Average Rate of return.

NPVNPV = - I = - IO O FFtt

(1 + k)(1 + k) tt

nn

t=1t=1

Discounted Cash Discounted Cash flow/NPVflow/NPV

Determines the NPV of all cash Determines the NPV of all cash flows byflows by discounting them by required rate discounting them by required rate of return.of return.Ft=net cash flow in period tFt=net cash flow in period tk=required rate of returnk=required rate of returnII00=Initial cash investment=Initial cash investment

n

t=1IRR: = IO CFt

(1 + IRR) t

Internal Rate of Return (IRR)Internal Rate of Return (IRR)

IRR=discount rate that equates IRR=discount rate that equates the presentthe presentvalues of the cash inflows and values of the cash inflows and outflows. outflows. IRR is simply the rate of return IRR is simply the rate of return that thethat the firm earns on its capital firm earns on its capital budgeting projects.budgeting projects.

Profitability index

Present value of all future expected cash flows divided by initial cash investment.

Question-

Consider the following 2 projects-

Project A Project B

Initial value of investment Rs. 5,00,000 Rs.11,00,000

Present value of cash inflowsRs.6,00,000 Rs. 12,50,000

NPV Rs.1,00,000 Rs. 1, 50,000

Which model will you chose to evaluate the 2 projects. Why?

Solution-

Comparing NPV, project B will score high. However, NPV is only an absolute figure. For an investment of 5Lakh, Project A offers

NPV of Rs. 1 lakh, whereas for investment of 11 lakh, B offers NPV of 1.5 lakh.

In such a situation, PI is a better indicator. PI=PV of cash flow/Initial cash outflow. PI for A=1.200 and PI for B=1.136 Since PI of A is more than that of B, A is a better

project.

Advantages of Numeric Model

Simple to use and understand. Readily available accounting data to determine

cash flow. Direct reflection of managerial policy. Easily altered to accommodate changes in

environment or managerial policy. Can assess project risk. Weighted scoring models allow for the fact that

some criteria are more important than the others. Allow sensitivity analysis. The tradeoffs between

different criteria are readily available.

Disadvantages

It ignores qualitative aspects The output of a scoring model is strictly a

relative measure. Project scores do not represent the value or utility associated with a project and thus do not indicate whether or not the project should be supported

Biased Other limitations of individual profitability

models

Risk Versus Uncertainty

Analysis Under Uncertainty - The Management of Risk The difference between risk and uncertainty

Risk - when the decision maker knows the probability of each and every state of nature and thus each and every outcome. An expected value of each alternative action can be determined

Uncertainty - when a decision maker has information that is not complete and therefore cannot determine the expected value of each alternative

Involved at all stages of project management

What is risk?an event about which we are uncertain and the possibility of the result is unfavourable.

If it is favourable, it turns out to be an opportunity.

PROJECT RISK is the cumulative effect of the chances of an uncertain occurrence adversely affecting the project objectives. Or, the degree to which project objectives are exposed to negative events and their probable consequences, as expressed in terms of scope, quality, time & cost.

Risk

Types of risk

1. Project –specific risk- the earnings & cash flows of the project may be lower than expected due to an estimation error or lower quality of management

2. Competitive risk -the earnings & cash flows of the project may be effected by some unanticipated actions of the competitors

3. Industry -specific risk-unexpected technological developments & regulatory changes that are specific to the industry to which the project belongs ,will have an impact on the earnings & cash flows of the project as well

.

4. Market risk-unanticipated changes in macroeconomic factors like GDP growth rate, interest rate, inflation etc. have an impact on all projects in varying degrees.

5. International risk-in case of foreign projects exchange rate risk /political risk may effect cash flows.

An evaluation of potential risks can show at an early stage whether or not a proposal is worth pursuing.

The risks can be---

1) the project will fail completely

2) The project will be compromised on time, cost or both.

Comments on the Information Base for Selections

Accounting DataMeasurements

Subjective vs. ObjectiveQuantitative vs. QualitativeReliable vs. UnreliableValid vs. Invalid

Technological Shock

Project Portfolio Process

An 8 step procedure for selecting , implementing and reviewing projects that will help an organization achieve its goals.

Project Portfolio Process

Establish a project council Identify project categories and criteria

Derivative projects-are projects with objectives or deliverables that are only incrementally different in both product and process from existing offerings.

Platform projects-The planned outputs of these projects represent major departures from existing offerings in terms of either the product/service itself or the process used to make and deliver it or both.

Breakthrough projects-These projects typically involve a newer technology than platform projects. It may be a “disruptive” technology that is known to the industry or something proprietary that the organization has been developing over

R&D Projects-are visionary endeavors oriented toward using newly developed technologies, or existing technologies in a new manner.

Collect Project DataAssess Resource AvailabilityReduce the project and criteria setPrioritise the projects within categoriesSelect the projects to be funded and held

in reserve.Implement the process.

Project Proposals

Which projects should be bid on?How should the proposal-preparation

process be organized and staffed?How much should be spent on preparing

proposals for bids?How should the bid prices be set?What is the bidding strategy? Is it ethical?

Project ProposalContents

Executive Summary Cover Letter Nature of the technical problem Plan for Implementation of Project Plan for Logistic Support & Administration of the

project Description of group proposing to do the work Any relevant past experience that can be applied

Discussion…

In the next 2 years a large municipal company must begin gas storage facilities as per new govt. regulations. The V.P. incharge of the project feels there are 2 options. One-underground deep storage facility (UDSF) and two-Liquified natural gas facility (LNGF). The V.P has developed a project selection model.

Option Initial cost Operating cost Exp Life Salvage valueUDSF 10 L $ $.004 20 yrs 10%LNGF 25L$ $.002 15 yrs 5Use Souder’s criteria to evaluate this model.(Realism, Capability, flexibility, ease of use, cost, computerization)

Discussion…

In the next 2 years a large municipal company must begin gas storage facilities as per new govt. regulations. The V.P. incharge of the project feels there are 2 options. One-underground deep storage facility (UDSF) and two-Liquified natural gas facility (LNGF). The V.P has developed a project selection model.

Option Initial cost Operating cost/cu.ft Exp Life Salvage value

UDSF 10 L $ $.004 20 yrs 10%LNGF 25L$ $.002 15 yrs 5%Use Souder’s criteria to evaluate this model.(Realism, Capability, flexibility, ease of use, cost, computerization)