pm chapter 02 organization strategy and project selection

Project Management Organization Strategy

and Project Selection

Organization Strategy and Project Selection

Evaluation will be based on

• Strategic

• Technical

• Economic

Organization Strategy and Project Selection

• Strategy is implemented through projects.

• Every project should have a clear link to and contribute value to the organization’s strategic plan, which is designed to meet the future needs of its customers.

• Demands constant attention from top management.

• Process is needed to clearly align project selection to the strategic plan of the organization. Otherwise, utilization of resources can be poor.

• Intended outcomes of alignment process are:

• Clear organization focus• Best use of resources• Improved communication

Project Managers / Understanding of Strategy

• New school thinking recognizes that project management is at the apex of strategy and operations.

• Project Managers’ role has expanded from getting the job done to achieving the business results and winning in the market place.

Project Managers / Understanding of Strategy

• There are two reasons why project managers need to understand their organization’s mission and strategy.

• So that they can make appropriate decisions pertaining to their projects.

• So that they are able to demonstrate to the senior management how their project contributes their firm’s mission.

Strategic Management Process

• Strategic management is the process of:

• Assessing “where we are?” • Deciding and implementing

“where we want to go?” and • Deciding and implementing

“how we are going to get there?”

• Strategy describes how and organization intends to compete with the resources available in the existing and perceived future environment.


• Two major dimensions of strategic management are:

• Responding to changes in the external environment and allocating scarce resources to improve the firm’s competitive positions. Constant scanning of external environment for change is required to survive in a dynamic competitive environment.

• Internal responses to new action programs aimed at enhancing the competitive position of the firm. The nature of responses depends on the type of business, environment volatility, competition and the organization culture.

• Strategic management process is a continuous, iterative process aimed at developing an integrated and coordinated long term plan of action.

• With long term position identified, objectives are set, and strategies are developed to achieve objectives and then translated into actions by implementing projects.

• Strong links are required among mission, goals, strategy and implementation.



Review / revise mission

Internal environment:strengths and weaknesses

External environment:opportunities and threats

New goals and objectives

Portfolio of strategicchoices

Strategy implementation

Project selection

Projects

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1 Review and define organizational mission

2 Set goals and objectives

3 Analyze and formulate strategies to reach objectives

4 Implementing strategies through projects

• Implementing projects without strong priority system linked to strategy creates problems.

• The implementation gap

• Organizational politics

• Resource conflicts and multitasking

• A project portfolio system can go a long way to reduce or even eliminate the impact the impact of these problems.

Project Portfolio Management System - Need

Project Portfolio Management System - Need

• Builds discipline into project selection process.

• Links project selection to strategic metrics.

• Prioritizes project proposals across a common set of criteria, rather than on politics or emotions.

• Allocates resources to projects that align with strategic direction.

• Balances risk across all projects.

• Justifies killing projects that do not support strategy.

• Improves communication and supports agreement on project goals.

Project Portfolio Management System – Benefits

Project Portfolio Management System

• Since there are usually more projects clamoring for resources than are available, it is important to follow a logical and defined process for selecting the projects to implement.

• Design of project portfolio system should include classification of project, selection criteria depending upon classification, sources of proposals, evaluating proposals and managing the portfolio of projects.

Project Portfolio Management System – Classification

• Many organizations find that they have three different kinds of projects in their portfolio:

• Compliance / Emergency (Must do)

• Operational – e.g., TQM• Strategic

• Strategic value of the project must be determined before it can be placed in the project portfolio.

Compliance/Emergency

Operational

Strategic

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The Kyoto Protocol is an historic milestone. It is the first, and only, binding international agreement that sets targets to reduce the greenhouse gas emissions that cause climate change.

Project Portfolio Management System – Classification

Case Study

STOPSTOP

• There can be:

• Financial Criteria

• Cost Benefit Analysis• Net Profit (NP) • Payback Period (PB) • Return on Investment (ROI)• Net Present Value (NPV) • Internal Rate of Return (IRR)• Profitability Index (PI)

• Non Financial Criteria

• Projects to support community development. • Multi-Weighted Scoring Models

Project Portfolio Management System – Selection Criteria

Time Value of Money


Y0 Y1 Y2 Y3

$100,000Option A $100,000 + interest

$100,000 – interest Option B $100,000

PresentValue

FutureValue

PV = FV

( 1 + i ) n

PV: Applying an expectation of future interest rate to determine present value of money that will be received at some point in future.

+

Cost Benefit Analysis

• Comparing the expected cost of the projectwith the benefits of having it in place.

• Any project requiring an investment must, as a minimum, provide a greater benefit thanputting that investment in, say, a bank.

• Consists of two steps:

• Identifying and estimating all of the costs and benefits of carrying out theproject and operating it.

• Express these costs and benefits in some common unit. This common unitis usually money.

• If a proposal shows an excess of benefits overcosts then it is a candidate for further analysis.


Cash Flow Forecasting

• Indicates when expenditure and income will take place and their timing.

• Typically products generate a negative cash flow during their development followed by a positive cash flow over their operating life.

• There may be decommissioning costs at the end of the product’s life.


Expenditure

Income

Time

Net Profit


The difference between the total costs and the totalincome over the life of the project.

Example


Year Project 1 Project 2 Project 3 Project 4

0 (100,000.00) (1,000,000.00) (100,000.00) (120,000.00)

1 10,000.00 200,000.00 30,000.00 30,000.00

2 10,000.00 200,000.00 30,000.00 30,000.00

3 10,000.00 200,000.00 30,000.00 30,000.00

4 20,000.00 200,000.00 30,000.00 30,000.00

5 100,000.00 300,000.00 30,000.00 75,000.00

Net Profit 50,000.00 100,000.00 50,000.00 75,000.00

Four project cash flow projections – figures are end of year totals in $

• Project 2 shows the greatest net profit but at the expense of a large investment of $ 1 Mio.• We can even investment in Project 1, 3 and 4 if we have $ 1 Mio and even greater net profit of $ 175,000. • Does not take into account the timing of cash flows. Project 1 and 3 gives the same net profit of $50,000 and are therefore equally preferable. But Project 3 gives a steady cash flow of $30,000 each year than Project 1 whose bulk of income occurs late in the life of the project.

Payback Period


• Time it will take to recover the investment. • Shorter paybacks are more desirable. • Simplest and widely used model.

Advantages

• Easy to calculate but can lead to wrong decisions. • Put more emphasis to quick return of the invested fund so that they may be put to use in other places or in meeting other needs. • Easy to apply and understand.

Disadvantages

• Does not consider post payback cash flows. • Does not consider time value of money.• Does not explicitly consider risk.

Payback Period


Payback period =(Years)

Estimated project cost

Annual Savings

Project AY0 Y1 Y2 Y3 Y4 Y5

Investment$ 700K

$ 225K $ 225K $ 225K $ 225K $ 225K

Returns

Project BY0 Y1 Y2 Y3 Y4 Y5

Investment$ 400K

$ 110K $ 110K $ 110K $ 110K $ 110K

Returns

Payback period = 700 / 225 = 3.1 yearsROI = 32.1%

$ 450K $ 675K $ 900K $ 1125K

Payback period = 400 / 110 = 3.6 yearsROI = 27.5% $ 220K $ 330K $ 440K $ 550K

Decision Rule: Accept project that has smaller payback period (Project A in our case) .

Example



0 (100,000.00) (1,000,000.00) (100,000.00) (120,000.00)

1 10,000.00 200,000.00 30,000.00 30,000.00

2 10,000.00 200,000.00 30,000.00 30,000.00

3 10,000.00 200,000.00 30,000.00 30,000.00

4 20,000.00 200,000.00 30,000.00 30,000.00

5 100,000.00 300,000.00 30,000.00 75,000.00

Net Profit 50,000.00 100,000.00 50,000.00 75,000.00


• Payback period does not take into account post payback returns. So, the fact that project 2 and 4 are overall more profitable than project 3 is ignored.


Return on Investment (ROI) • Also Known as Accounting Rate of Return (ARR).• Compares the net profitability of the investment

Problems with ROI

• Takes no account of the timing of cash flows.

ROI = Average Annual Profit

Total Investment X 100

Example



0 (100,000.00) (1,000,000.00) (100,000.00) (120,000.00)

1 10,000.00 200,000.00 30,000.00 30,000.00

2 10,000.00 200,000.00 30,000.00 30,000.00

3 10,000.00 200,000.00 30,000.00 30,000.00

4 20,000.00 200,000.00 30,000.00 30,000.00

5 100,000.00 300,000.00 30,000.00 75,000.00

Net Profit 50,000.00 100,000.00 50,000.00 75,000.00


• Project 1: (50000/5) / 100000 x 100 = 10%• Project 2: (100000/5) / 1000000 x 100 = 2%• Project 3: (50000/5) / 100000 x 100 = 10%• Project 4: (75000/5) / 120000 x 100 = 12.5%


Net Present Value • Management’s minimum desired rate of return to compute the present value of all net cash flows. • If the result is positive, the project is accepted. • More realistic because it considers time value of money, cash flows and profitability.

Decision Rules

• Independent Projects: Accept all projects with NPV >= 0, reject otherwise. • Mutually Exclusive Projects: Rank projects from highest to lowest NPV and choose the project with the highest (positive) NPV.

Problems with NPV

• Difficult to explain to non-finance people. • Solution is not in percentage rate of return but in amount.

Year 5% 6% 7% 8% 9% 10% . . .

1 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 . . .

2 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264 . . .

3 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513 . . .

4 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830 . . .

5 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209 . . .

6 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645 . . .

7 0.7107 0.6651 0.6227 0.5835 0.5470 0.5132 . . .

8 0.6768 0.6274 0.5820 0.5403 0.5019 0.4665 . . .

9 0.6446 0.5919 0.5439 0.5002 0.4604 0.4241 . . .

10 0.6139 0.5584 0.5083 0.4632 0.4224 0.3855 . . .

: : : : : : : :

: : : : : : : :


Table of NPV Discount Factors

More extensive or detailed tables may be constructed using the formula discount factor = 1 / ( 1 + r) ^ nfor various values or r (the discount rate) and t (the number of years from now).

Net Present Value


NPV = I0 + ∑


Investment$ 700K

$ 225K $ 225K $ 225K $ 225K $ 225K

Returns


Investment$ 400K

$ 110K $ 110K $ 110K $ 110K $ 110K

Returns

i = 1

n Ft

( 1 + k ) t

I0 = Initial Investment (-ve for outflow) Ft = Net cash inflow for a period tk = Required rate of return


Project A Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Total

Required Rate of Return 15%

Outflows $(700,000) $ (700,000)

Inflows $225,000 $225,000 $225,000 $225,000 $225,000 $1,125,000

Present Value $195,652 $170,132 $147,941 $128,644 $111,865 $ 754,235

Net Present Value $ 54,235

Project B Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Total

Required Rate of Return 15%

Outflows $(400,000) $ (400,000)

Inflows $110,000 $110,000 $110,000 $110,000 $110,000 $ 550,000

Present Value $ 95,652 $ 83,176 $ 72,327 $ 62,893 $ 54,689 $ 368,737

Net Present Value $ (31,263)

Select Project A as it has positive NPV and reject Project B as it has negative NPV

Net Present Value


Net Present Value


0 (100,000.00) (100,000.00) (1,000,000.00) (1,000,000.00) (100,000.00) (100,000.00) (120,000.00) (120,000.00)

1 10,000.00 9,090.91 200,000.00 181,818.18 30,000.00 27,272.73 30,000.00 27,272.73

2 10,000.00 8,264.46 200,000.00 165,289.26 30,000.00 24,793.39 30,000.00 24,793.39

3 10,000.00 7,513.15 200,000.00 150,262.96 30,000.00 22,539.44 30,000.00 22,539.44

4 20,000.00 13,660.27 200,000.00 136,602.69 30,000.00 20,490.40 30,000.00 20,490.40

5 100,000.00 62,092.13 300,000.00 186,276.40 30,000.00 18,627.64 75,000.00 46,569.10

Net Profit 50,000.00 620.92 100,000.00 (179,750.51) 50,000.00 13,723.60 75,000.00 21,665.06


Example

A large manufacturing firm is considering improving its computer facility. The firm currently has a computer which can be upgraded at a cost of $200,000. The upgraded computer will be useful for 5 years and will provide cost saving of $75,000 per year. The current market value of the computer is $100,000. The cost of capital is 15%. Should the computer be upgraded.

Answer

Year Project's Cost &

Returns NPV

0 $ (200,000.00) $(200,000.00)

1 $ 75,000.00 $ 65,217.39

2 $ 75,000.00 $ 56,710.78

3 $ 75,000.00 $ 49,313.72

4 $ 75,000.00 $ 42,881.49

5 $ 75,000.00 $ 37,288.26

Total $ 51,411.63


Example

(a) A firm is considering an investment of $300,000 in an asset with a useful life of 5 years. The firm estimates that the annual cash revenues and expenses will be $140,000 and $40,000, respectively. The annual depreciationbased on the historical cost will be $60,000. The required rate of return on the project of this risk is 13%. The marginal tax rate is 34%. What is theNPV of this project?

(b) The 13% required rate of return is the nominal required return including inflation. Suppose the firm has forgotten that revenues and expenses are likely to increase with inflation at 5% annual rate. Recalculate the NPV. Isthis a more attractive proposal now that the inflation has been taken into account.


Answer (a) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cost $300,000

Cash Revenue (A) $140,000 $140,000 $140,000 $140,000 $140,000

Cash Expenses (B) $ 40,000 $ 40,000 $ 40,000 $ 40,000 $ 40,000

Depreciation (C) $ 60,000 $ 60,000 $ 60,000 $ 60,000 $ 60,000

Taxes Paid (D = (A-B-C)*0.34) $ 13,600 $ 13,600 $ 13,600 $ 13,600 $ 13,600

After-tax Cash (E = A-B-C) $ 86,400 $ 86,400 $ 86,400 $ 86,400 $ 86,400

NPV

$ 76,460 $ 67,664 $ 59,880 $ 52,991 $ 46,894

$300,000 $ 303,889

$ 3,889


Answer (b) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cost $300,000

Cash Revenue (A) $ 147,000 $154,350 $162,068 $170,171 $178,679

Cash Expenses (B) $ 42,000 $ 44,100 $ 46,305 $ 48,620 $ 51,051

Depreciation (C) $ 60,000 $ 60,000 $ 60,000 $ 60,000 $ 60,000

Taxes Paid (D = (A-B-C)*0.34) $ 15,300 $ 17,085 $ 18,959 $ 20,927 $ 22,994

After-tax Cash (E = A-B-C) $ 89,700 $ 93,165 $ 96,803 $100,623 $104,635

NPV

$ 79,381 $ 72,962 $ 67,090 $ 61,714 $ 56,791

$300,000 $ 337,938

$ 37,938

Proposal is more attractive now.


Net Present Value

• The main difficulty with NPV is selecting an appropriate discount rate.

• Some organizations have standard rate but, where this is not the case, then the discount rate should be chosen to reflect available interest rates (borrowing costs where the project must be funded loans) plus some premium to reflect the face that projects may have risks then lending money to a bank.

• The exact discount rate is normally less important than ensuring that the same discount rate is used for all projects being compared.

• Alternatively, the discount rate can be thought of as a target rate of return. If for example we set a target rate of return of 15%, we would reject that would not display a positive NPV using a 15% discount rate.


Internal Rate of Return (IRR)

• The discount rate that makes the present value of a project’s cash flow equal to its initial investment.

• Hurdle rate is considered the firm’s required rate of return on investment projects of average risk. If the Project’s IRR >= hurdle rate, it should be accepted, otherwise, it should be rejected.

0 = - I0 + ∑ i = 1

n Ft

( 1 + R ) t

I0 = Initial InvestmentFt = Net cash inflow for a period tR = Internal rate of return

I0 = ∑ i = 1

n Ft

( 1 + R ) t

Internal Rate of Return (IRR)



Investment$ 700K

$ 225K $ 225K $ 225K $ 225K $ 225K

Returns


Investment$ 400K

$ 110K $ 110K $ 110K $ 110K $ 110K

Returns

IRR = 18%

IRR = 12%

Accept project that has higher IRR (Project A in our case) .


Profitability Index (PI)

• Some times called Benefit Cost Ratio or Present Value Index.

• Calculated by taking the PV of cash inflows divided by the PV of cash outflows.

• The decision criteria is to accept project with PI > 1.0

PI =PV of Cost Inflows

=

∑ i = 1

n Ft

( 1 + k ) t

Cost or Initial Outflow I0


Weighted Average Scoring Models

• Typically uses several weighted selection criteria to evaluate a project proposal

• Generally include qualitative and quantitative criteria

• Each selection criterion is assigned a weight and a score

• Weights and scores are multiplied to get a total weighted score of the project

• Projects can be compared using the weighted score

• Projects with higher weighted scores are considered better

• Selection criteria need to mirror the critical success factor of an organization.


Weighted Average Scoring Models

Project 1

Project 2

Project 3

Project 4

Project 5

Project 6

Weight Sta

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2.0

1

3

9

3

1

6

Strate

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3.0

8

3

5

0

10

5

Urgen

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2.0

2

2

2

10

5

0

25%

of s

ales f

rom

new p

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2.5

6

0

0

0

10

2

Reduc

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to

less t

han

10%

1.0

0

0

2

0

0

0

Impr

ove

Custo

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loyalt

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1.0

6

5

2

6

8

2

ROI 18%

Plus

3.0

5

1

5

0

9

7

Wei

ghted T

otal

66

27

56

32

102

55

Rank

2

6

3

5

1

4

Example Calculation for Project 1

Weighted Total = ( 2.0 x 1 ) + ( 3.0 x 8 ) + ( 2.0 x 2 ) + ( 2.5 x 6 ) + ( 1.0 x 0 ) + ( 1.0 x 6 ) + ( 3.0 x 5 ) = 66

If the resources available create a cutoff threshold of 50 points, the priority team would eliminate projects 2 and 4.

Tip!!

While selection models like the one above may yield numerical solutions to project selection decisions, models should not make the final decisions – the people using the model should.

Applying the Selection Model

• Project classification

• Experience shows most organizations use similar criteria across all types of projects, with perhaps one or two criteria specific to the type of project, such as, strategic breakthrough versus operational.

• The most important criterion for selection is the project’s fit to the organization’s strategy.

Applying the Selection Model

• Selecting a Model

• Multiple criteria in project selection

• Senior Management is interested in identifying the potential mix of projects that will yield the best use of human and capital resources to maximize return on investment in the long run.

• Factors such as researching new technologies, public image, ethical position, protection of the environment, core competencies, and strategic fit might be important criteria for selecting projects.

Sources and Solicitation of Project Proposals

• Project should come from anyone who believes that the project will add value to the organization.

• Encourage and keep solicitations open to all sources – internal and external sponsors.


Major Project Proposal

Date Number

Project Title Responsible Manager

Project Manager

General SupportQuality

Cost Reduction

LegalReplacement

New Product

Capacity

_____________

_____________

Yes No Project will take more than 500 labor hours? Yes No Project is a one time effort?

Yes No Project proposal is reviewed by product manager.

Problem definition: Describe problem / opportunity.

Goal definition: Describe the project goal.

Objective Definition:Performance: Quantify the savings/benefits you expect.

Cost: Labor hours, materials, methods, equipment, etc.

Schedule: Overall duration in months.

Risk Analysis

What are the three major risks for this project?

What is the probability of above risk occurring?0.0 (none) to 1.0 (high)

1.

2.

3.

2.

3.

1.

What is the impact on project success if these risks do occur?

0.0 (none) to 1.0 (high) 2.

3.

1.

Yes No

Current project statusStart Date Est. Finish Date_____________ _____________

Resource Available?

Active On holdStatus

Update:

Priority Team Action: Accepted Returned

Discovery – project not defined

Operational – proposal not a project

Need more information – to prioritize project

Duplicate to: ______________


Project Screening Process

Project Proposal Idea

Data collection and backup Need strategic fit (ROI / Payback, Risk)

Self Evaluation of ProjectBy criteria

Abandon

Priority team evaluates proposal and reviews portfolio

for risk balance.

Pursue

Return for more information

Periodic reassessment of priorities

Reject

Hold for resources

Accept

Assign priority, resources and Project manager

Evaluate Progress

• Merits of a particular project are assessed within the context of the existing projects.

• Involves monitoring and adjusting selection criteria to reflect the strategic focus of the organization.

• Senior Management Input • Provide guidance in establishing selection criteria• How they wish to balance existing resources among different projects.

• Priority Team Responsibility • Publishing the priority of every project and ensuring the process is open and free of power politics.

Managing the Portfolio System


Priority Analysis … An Example Must Objectives Must Meet if impacts P1 P2 P3 P4 P5

All activities meet currentlegal, safety, andenvironmental standards.

Yes – Meets objectivesNo – Does not meet objectivesN/A – No Impact

N/A

All new products will have a complete market analysis

Yes – Meets objectivesNo – Does not meet objectivesN/A – No Impact

N/A

::

Want ObjectivesRelative

Importance1 - 100

WeightedScore

WeightedScore

WeightedScore

WeightedScore

WeightedScore

Single project impact Definitions

Provide immediateresponse to fieldproblems.

99

0 <= Does not address1 = Opportunity to fix2 >= Urgent problem

99

Create $5 Mio. in new sales by 2010 88

0 <= $ 100,00 1 = $ 100,000 – 500,0002 >= $ 500,000

0

Improve external customer service 83

0 <= $ 100,00 1 = $ 100,000 – 500,0002 >= $ 500,000

166

::

Total Weighted Score

Priority

• David and Matheson studied R&D Organizations and developed a matrix that could be used for assessing a project portfolio.

Balancing Portfolio for Risks and Types of Projects

Low Potential Commercial Value High

Low

P

roba

bili

ty o

f S

ucce

ss

Hig

h

Bread and butter

Evolutionary improvements to current products and services.

Pearl

Revolutionary commercial advances using proven technology advances

White Elephants

Projects that one time showed promise but are not viable anymore

Oyster

Technological breakthroughs with high commercial payoffs.

Organizations have too manywhile elephants and too few oysters and pearls.

To maintain strategic advantageorganizations must capitalize on pearls, eliminate or reposition white elephants and balance resources devotedto bread-and-butter and oysterprojects to achieve alignment with overall strategy.

pm chapter 02 organization strategy and project selection

Documents

project selection strategy

senior management

project selection evaluation

project managers role

apex of strategy

organizations strategic

environment volatility

organization culture