copyright 2009 john wiley & sons, inc. chapter 2 strategic management and project selection

Copyright 2009 John Wiley & Sons, Inc.

Chapter 2

Strategic Management and Project Selection

Problems With Multiple Projects

1. Delays in one project delays others

2. Inefficient use of resources

3. Bottlenecks in resource availability

Project Results

30 Percent lateOver half 190 percent over budgetOver 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 measureMost 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. Companies whose core business is completing projects

2. Companies whose core business is something else

They can also be broken down as:1. Companies looking at projects to do for others2. Companies looking at projects to do for

themselves

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 constraintProfitability is often the major criteriaMust evaluate approaches when there

is more than one project that can accomplish a goal

Models

Models are used to select projectsAll models simplify realityThat is, they only look at the key

variables involved in a decisionThe more variables included in a

model, the more complex it becomesSimpler 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

RealismCapabilityFlexibilityEasy to use InexpensiveEasy 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 firm’s 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– Some are one-time factors

The cost of an item

– 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 modelsNumeric 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– 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 company’s position in the marketplace.

Types of Nonnumeric Models Continued

Product 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. Profit/profitability

2. 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

4000,25$

000,100$PeriodPayback

FlowCash Annual

CostProject PeriodPayback

Payback Period Drawbacks

1. Does not consider time value of money

2. More difficult to use when cash flows change over time

3. 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 today’s 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 Continued

Requires 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

n

t tt

k

FA

101

(project) NPV

NPV Formula Terms

A0 Initial cash investmentFt The cash flow in time period t (negative for

outflows)k The discount rateT The number of years of life

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

NPV

NPV Example

939,1$

03.015.01

000,25$000,100$ (project) NPV

8

1

t

t

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 IRR’s, 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 ratioNPV divided by initial cash investmentRatios greater than 1.0 are good

Advantages of Profitability Models

Easy to use and understandBased on accounting data and

forecastsFamiliar and well understoodGive a go/no-go indicationCan be modified to include risk

Disadvantages of Profitability Models

Ignore non-monetary factorsSome ignore time value of moneyDiscounting models (NPV, IRR) are

biased to the short-termPayback models ignore cash flow after

payback

Scoring Models

Unweighted factor modelWeighted factor model

Unweighted Factor Model

Each factor is weighted the sameLess important factors are weighted the

same as important onesEasy to computeJust 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

A 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 Uncertainty—The 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 doesWhat nature does

Uncertainty

1. Pro forma financial statements

2. Risk analysis

3. Simulation (requires detailed probability information)

Comments on the Information Base for Selection

1. Accounting data

2. Measurements

3. Uncertain information

Accounting Data

1. Cost and revenue are linear

2. Cost-revenue data derived using standard cost standardized revenue assumptions

3. Costs may include overhead

Measurements

1. Subjective versus objective

2. Quantitative versus qualitative

3. Reliable versus unreliable

4. Valid versus invalid

Uncertain Information

Must estimate inputs for risk analysisThese 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. Establish a project council2. Identify project categories and criteria3. Collect project data4. Assess resource availability5. Reduce the project and criteria set6. Prioritize the projects within categories7. Select projects to be funded and held in reserve8. 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. Derivate projects

2. Platform projects

3. Breakthrough projects

4. R&D projects

Step 3: Collect Project Data

Assemble the dataDocument assumptionsScreen out weaker projectsThe 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 conservativelyTiming is particularly important

Step 5: Reduce the Project and Criteria Set

Organization’s 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 weightsConsider in terms of benefits first,

resource costs secondSummarize 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 resultsRepeat regularly Improve process

Project Proposals

The project proposal is essentially a 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

Project Proposal Contents

Cover letterExecutive summaryThe technical approachThe implementation planThe plan for logistic support and

administrationPast experience