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PMP : Quantitative Approach to Selecting the Right Project
We are publishing series of articles on PMP topics to help the PMP exam preparation. In this article we are going to explain you what are the best approaches and methods for choosing a right project for the organizations.
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Even before a project is initiated, there are number of activities that take place. A company’s strategic objectives could drive the initiation of a new project. The reason a project starts could be many but mainly it is to cater to the company’s business needs.
It’s possible that a product requires a change due to customer demands, or the current technology update drives the organization to decommission an old system and roll out a new one, alternatively, a start-up becomes a project in itself in the beginning. We could list out a series of examples of why a project starts, but in most scenarios we’ll find one thing common; Business drives the need for new projects.
What is a Project?
By the definition of a project as stated in the guide for project management PMBOK, 5th edition, a project is a temporary endeavor undertaken to create a unique product, service or result. (Std. Def.)
A project is temporary, which means it has a beginning and an end. A project creates unique results. A need for a project could be of internal or external influence in nature. As per the guide to project management PMBOK 5th edition, some key reasons why a project is created are listed below:
- Organizational need – Sometimes organizations have a problem to solve which gives rise to the initiation of a new project. It can also be termed as Business Need. It is alternatively also a strategic opportunity for the company to grow. Most often these projects solve problems internal to the organization. For e.g. If the company has grown in terms of employees, it may want to transition from a manual HR set-up, to an automated HR system.
- Market Demand – Those projects that a company takes up due to its high market presence in the current stream. This is also external influence to which the organization responds by tapping the opportunity. For e.g., the digital marketing agency decides to launch a new portfolio in E-Commerce due to the booming market of online shopping and e-commerce industry.
- Customer Request – Sometimes the need for a new project arises due to a change request in your product or the users of the product requested some new feature during a survey taken by the organization. For e.g. a banking product being run by a company in Financial technology received a request from the bank to increase the security of product by introducing one more line of verification while the transactions happen online.
- Technological Advance – As the name suggests, this requirement is totally based on the requirement of a company to progress itself with technology. In today’s times of dynamic technology trends the organizations need to be competitive enough to adopt new technologies every few years to keep up with the pace of the market. For e.g. when a company realizes that its user base has increased drastically over the few years, it initiated a project to migrate its data-warehouse project to Big-data technology for more flexibility, more storage and versatility in storing different types of data in one data-lake.
- Legal Requirements – Another external influence that causes an organization to initiate a project that becomes necessary to be carried out due to its legal implications. These kinds of projects are a response to compliance, regulatory or legal issues. For e.g. a company in construction while starting a new project ignored the government compliance policy on leaving a measured amount of space for sewage. Due to the legal constraint, they had to revisit their architecture to initiate a new project in design.
- Ecological impacts – Some companies make sure to follow the environmental safety sincerely. When they initiate a project they keep in mind its ecological impact and work around it to ensure that our environment is not harmed in any way. For e.g. XYZ corporation launched its ‘Go Green’ campaign and to ensure its employees took it seriously, they initiated a new project to go paperless and therefore decided to move all the company’s records and documentation to an organized data center and set-up a centralized server to access it.
- Social needs – The projects initiated due to Social needs. Those projects that are taken up mostly by non-profit organizations or any organization for that matter, to cater to certain social needs. For e.g. a fortune 500 company recently initiated a project to re-habilitate around 500 people who lost their homes in the recent flood.
How to Select the right project?
Feasibility Study: Once the project is in context, we need to understand if it’s feasible to carry out the project. It is termed as Feasibility study. A project requires resources and investment. To analyze if we have or can manage the kind of resources required by the project in context, or that our consideration to investment is in the right direction, feasibility study becomes mandatory. To perform feasibility analysis we must focus of 2 entities- one is the body that will perform the feasibility studies and second is to determine list of criteria for project selection.
To address the first one, one of the two bodies within an organization performs the feasibility study:
- PMO – As per PMI, a group or department within a business, agency or enterprise that defines and maintains standards for project management within the organization is known as a project management office (PMO). This office is also accountable for standardizing and the execution of projects and introducing financial analysis in to projects. PMO has many potential roles to play as a contributor to advancing the areas of project, program and portfolio management. Project selection is one of its responsibilities
- Project Portfolio Committee – is also known as Project selection committee or Project evaluation committee. Just as the name suggests, this committee is responsible selecting new projects, prioritizing projects, making project closure decisions, measuring the existing project’s progress etc. In addition this committee is also responsible for making financial and non-financial analysis contribution towards initiating a project. In some organization, they are also called portfolio steering committee.
Criteria for Project Selection: There are many variables to be considered while selecting a project. The project selection team focuses on the criteria relevant to their organization. They could consider analyzing few of the following or all of the following criteria from the given list:
- Does the project align to company’s strategic alignment
- Environmental Factors to be considered
- Financial benefit that is expected from taking up the project
- Funding available for the project
- Resource availability for the project
- Risks associated with taking up the project
- If the project balances out with the portfolio under which it is being considered
- Volume of the project –Too large or too small or apt.
- Other non-financial benefits, associated with taking up the project
Project Selection Methods
Once the selection team starts their feasibility study, they also focus on quantifying their values of analysis in their presentation. They should be able to provide their findings in terms of financial metrics. They can approach towards this goal using the project selection methods, which helps in measuring the value of what the product, service, or the result of the project will produce.
Before we move on to describing these methods, there are a few finance related terms we should know:
- Present Value – The value of a sum of money in the present, as compared to its value in future, when an interest is charged on it, upon investment. It calculates how much a future sum of money is worth today.
PV = FV/ (1+r)n
FV = cash flow in future period, r = the periodic rate of return or interest (also called the discount rate or or the required rate of return)
n = number of periods
- Opportunity cost – Opportunity Cost is the value of the project given up when choosing another project over it. When an organization chooses between two projects, they are giving up the money that could have been earned on the project they didn’t choose. That’s called opportunity cost. It’s the price we pay for choosing one project over another.
- Sunk cost – Sunk Cost is the cost that has already been spent which cannot be recovered.
- Depreciation - Depreciation is the decrease in value of assets over time. The decrease in value can be attributed to many factors like wear and tear or getting out-dated. For e.g. a manufacturing unit could depreciate for various reasons like loss of efficiency, becoming out of date, new model coming out, etc.
In general there are two categories in which the project selection methods can be divided:
- Mathematical Models – Mathematical models use a set of defined steps to solve a problem. They use Linear, Non-linear, Dynamic, Algorithms and other mathematical formulae to quantify their observations. As this approach requires specialized skills in mathematics or statistics, it has been kept beyond the scope of PMP and the guide to PMBOK.
- Decision Models, alternatively called Benefit Measurement Methods are used in analyzing and comparing project selection decisions. It helps the team focus on calculation expected revenue and benefits generation against the cost incurred by the organization. High complexity projects generally could involve more than one benefit measurement method. The list of techniques that fall under this umbrella is given below:
- Cost-Benefit Analysis – Comparing the rough estimation of expected costs against the tangible benefits for the organization, listed and quantified. Benefit-Cost ratio is the ratio of the benefits expected from the project compared to the costs estimated in terms of Present Value (PV). The higher the BCR value, the better it is for the project. Positive BCR value refers to profit and negative BCR value means loss.
Benefit-Cost Ratio (BCR) = Benefits (in terms of PV) / Costs (in terms of PV)
Interpretation of Benefit-Cost Ratio (BCR):
BCR > 1 — the project is profitable, and the higher the BCR the better
BCR = 1 — the project will break even
BCR < 1 — the project will cause the organization to lose money and is generally considered as not a good investment
- Scoring Models – Scoring models, also known as weighted scoring model calculates by applying weight-age to the scores assigned to a criteria or factor. These factors are weighted and scored depending on most significant to least significant. This technique of scoring is also used in choosing between the bids from 3rd party vendors.
- Return on Investment – It’s the benefit generated by the investment compared against profits in relation to the invested capital. The higher the Return on Investment, the better is the project financially to the organization.
Return on Investment = Net profit / Capital Invested
Net profit is generally represented as net present value [NPV]
If ROI is larger than 1, the project is deemed to be profitable.
If ROI is smaller than 1, the project loses money.
- Cash-flow analysis techniques – The process of examining the financial statement which reflects the total cash in-flow and cash out-flow of a business in a particular accounting period is known as Cash-flow analysis. A cash flow statement is one of the most important financial statements of a company. The balance on the statement is the net cash flow at a specific point in time. Some cash-flow analysis techniques are listed below:
- Payback-period – The length of time required by the organization to recover the cost of an investment made in to a project. This method compares the initial investment to the cash inflows expected over the life of the project. The payback period is not as precise as other cash flow calculations. Shorter the Payback Period, the project is financially better to the organization.
Payback Period = Investment / Cash-flow (Periodic)
- Discounted Cash flows – There is a time value associated with money. To clearly explain, if you received some money today, that money’s worth is higher than the money you receive in future. The worth of money that we receive in future can be termed as Future Value (FV).
Where ‘I’ is for rate of interest on present value and n is the number of time periods for which the FV is being calculated
- Net Present Value (NPV) – This is the actual value of the project, at a given time minus all of the costs incurred. This includes the time and effort cost of building it as well as the materials cost. Net Present Value is the sum of all cash inflows of the project minus the initial cost. The larger the Net Present Value, the project is profitable to the organization. This is the total capital invested minus all expenditure.
PV (benefits) – PV (costs)
NPV > 0 — the project is profitable
NPV = 0 — the project will break even
NPV < 0 — the project will lose money
- Internal Rate of Return (IRR) – The interest rate at which the cash inflow and cash outflow of the project equals zero is the internal rate of return. It refers to the amount of money the project has to return to the company that is funding it. It shows the amount of money a project is making for the company. It’s usually expressed as a percentage of the funding that has been allocated to it.
0 = F0 + F1/ (1+IRR) + F2/ (1+IRR) 2+ F3/ (1+IRR) 3+ . . . +Fn/ (1+IRR)
N is number of periods; F is cash flow.
It’s complicated to initially get a hang of this calculation; however, once you get a hang of it, it is easier. Besides for the PMP exam purposes, there are 3 major pointers of IRR that we must remember:
- We must choose projects with highest IRR value
- When NPV=0, IRR is the discount rate
- Cash-inflows are invested at the IRR value.
Some of the non-financial metrics that we consider while selecting a project are Customer satisfaction, employee satisfaction and retention, organizational learning, continuous improvement.
- You are given to choose between a Project ABC, with a payback period of 1 yr and another Project XYZ with a payback period of 3 yrs, which one should you consider choosing?
- Project ABC
- Project XYZ
- Let the board members choose
- None of the Above
- The PMO of your organization has received three project proposals. However, due to the constraints of costs, only one project can be chosen. Project A would have a NPV of US$200,000, Project B would have a NPV of US$220,000 while Project C would have a NPV of US$50,000. What is the opportunity cost of choosing the project with the highest NPV?
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In this article we have explained what is a project, how to select a right project and what are the different models to measure and choose the right project. I hop this article would have given good idea on project initiation concepts that are tested in PMP exam. However, this is only the basic details and you have to go through the complete chapter in PMBOK to get more understanding on the concepts.
If you have any questions, please write it in the comments section.
- PMBOK 5th Edition – (Project Management Body of Knowledge) – PMI
- Project Management Professional Exam study Guide- 5th Edition – Kim Heldman
- PMP Certification- ALL-IN-ONE for Dummies (a wiley brand) – Cynthia Snyder
- PMP Headfirst- 3rd Edition- O’Reilly- Jennifer Greene and Andrew Stellman
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