How do project managers choose projects?
There are three non-numeric methods used to predict project selection:
Operating necessity - In this scenario, there is an assumption that the project under consideration is off paramount importance. This leads to the question, ‘Is it worth saving the system or business, at the approximate cos of the project?’ If the answer is yes, then the project will go ahead and it will receive the necessary funds (UONBI, 2021).
Sacred cow - In well established organisations, a boss may suggest to look into certain ideas. This may be to explore new products or markets. This suggestion results in the creation of a project, which is now ‘sacred’, as the boss has suggested it. Such a project will continue on, until it is successfully concluded or until the boss realises that the idea has not been successful and dissolves it (UONBI, 2021).
Competitive necessity - Here, the reason for choosing a project is based solely on the the ability of the projects outcomes to maintain or boost the organisation’s competitive status in the market (UONBI, 2021). Investment, adopting new technologies and restructuring the organisation are some examples of competitive necessity.
There are five numeric methods used to predict project selection:
Cost benefit analysis - First, all project associated costs are evaluated. Secondly, the benefits derived from a successfully completed project are examined. Thirdly, A determination must be made as to whether or not the benefits outweigh the costs. Project approval will only occur if the benefits are greater than the costs (Landau, 2021).
Financing costs - The main question is, ‘How much will the project cost to fund?’
Payback method - The amount of time that is required to gain back the initial investment is looked at.
Average rate of return - is the ratio of the average annual profit to the initial investment (Daniels, 2020)
Discounted cash flow methods - This method is also known as the Net Present Value (NPV) method. According to Daniels (2020), ‘The net present value of all cash flows is determined by discounting them by the required rate of return in this method.’
Let’s examine Cost Benefit Analysis in further detail:
Cost benefit analysis is a process, whereby data is used to make decisions. The aim is to determine whether or not the projected costs of a project outweigh the estimated benefits of the project (Stobierski, 2019). There are four steps in this process:
i.) Establish a framework for your analysis - the specifics of the project determines it’s framework. Goals and objectives must be established and the unit of measure, usually currency, must be chosen to compare costs and benefits
ii.) Identify the costs and benefits - two lists must be drawn up. One containing the totality of projected costs and the other containing the totality of projected benefits. In addition to monetary costs, direct costs, intangible costs and opportunity costs must also be compared.
iii.) Assign a monetary value to each cost and benefit - after the costs and benefits lists have been drawn up, a monetary value must be assigned to each one
iv.) Tally the value of costs and benefits and compare - after a monetary value has been given to each cost and to each benefit, it must be compared (Stobierski, 2019).
A ratio called the Cost Benefit Ratio is used as a tool to determine the feasibility of a project.
Any project that is carried out, whether it be big or small, must be financed. The entirety of the expenses associated with obtaining funds are called financing costs. There are several ways in which a project can be financed. These are:
- Funds already in the business - if money is taken out of the business to fund a new project, then the rate of return of the new project must either equal or surpass the existing rate of return
- Borrowed funds - the interest rate, or cost of borrowing money, must be examined
- Increased capital from shareholders - here, the dividend rate is the financing cost
- Grants - this is a financial award given by a public body or grant making institution to carry out a project. This money does not need to be paid back
- Subsidies - these are given out by the government and includes cash payments or tax breaks
- Donations - this can be described as a gift, where one voluntarily transfers money to the recipient
The time value of money states that money is worth more in the present than in the future (CFI, 2015).
With this in mind it is important to examine the payback period and the average rate of return for a project.
The payback period refers to the length of time needed to regain the cost of the investment. This method is straightforward to calculate and requires the formula below:
A disadvantage of this method is that the return on investment cannot be determined (CFI, 2015)
The average rate of return (ARR) must be used jointly with the payback period. The ARR measures the profitability of various projects over the life of the project. The initial cost of the investment is compared to the average annual profit of an investment (BBC, 2021). The formula is:
The project that has the highest ARR will be chosen and this project’s ARR must be higher than it’s financing costs.
A discounted cash flow (DCF) is a method used to calculate the value of an investment by discounting estimated future cash flows. If the DCF is higher than the initial cost then the project will be profitable (CFI, 2021). The formula is as follows:
Where:
CFt = Cash flow in period t
R = appropriate discount rate given the riskiness of the cash flows
t = life of the asset, which is valued
Net present value (NPV) and Internal rate of return (IRR) are DCF methods.
Net present value determines the profitability of a project by computing the difference between the present value of cash inflows against the present value of cash outflows over a project’s life span. The project is profitable when the difference is positive (Vaidya, 2021). The formula is as follows:
Where:
Xt = total cash inflow for period t
X𝝾 = net initial investment expenditures
R = discount rate, finally
T = total time period count
Internal rate of return is the anticipated compound annual rate of return that a project will earn (CFI, 2021). The formula is:
Great blog Fiona, I had trouble understanding the calculations for DCF & NPV but after reading this I am a lot clearer on it now, you wrote it in a way that makes it easy to comprehend. Thanks. Gary.
Dear Fiona, another concise and well presented Blog. All the fundamentals are covered in relation to the Project selection decision making process. Well done. Take care. Best wishes. Caroline.
I appreciate that the references underneath the pictures and on the body of the blog are visible and easy to access. And as always, very clear and concise blog.