PM652: Project Selection and Initiation Learning Module 7: Project Selection – Quantitative Decision Approach We make several decisions on a daily basis while managing a project. Some of them are minor, a few major (occasionally), and many of them based on the available information and rationality. It is one of the main responsibilities of a project manager. Decision making analysis is aimed at improving the quality of resulting decisions by approaching complex problems systematically. However, we must recognize that subjective judgments are integral to decision making. We discussed about decisions using AHP process in LM2, which is essentially, a qualitative (information is qualitative) decision approach. In this learning module, we will discuss about quantitative (information is quantitative) decision approach. Decision Analysis Process First, you must identify elements in a problem situation. You can classify them into: - A decision to make Uncertain (or unknown) elements associated with the situation Value of specific outcomes in short-term and long-term Decisions to Make You face the situation of making a decision in every phase of the project management. However, we will consider decisions in the context of project planning with a specific reference to risk management plan. You may ask, why risk management plan? The answer is easy. You, as the project manager, deal with difficult decisions but the one of the most difficult and complex decisions is often associated with managing risk that is associated uncertainties. Let me give you an example: The COVID in 2020 has forced the International Olympic Committee (IOC) on 24 March 2020 to postpone Olympics to 2021, albeit with a reluctance as vaccine was not ready and several national Olympic committees starting announcing that they would pull their athletes from participating in it if held in 2020. Beyond the original cost, the postponement increased the cost at $12.6 billion. But Japan’s National Audit Board has estimated the real cost could be nearly double that, at $22.3 billion as noted in 2020. Source: https://www.forbes.com/sites/michellebruton/2020/04/28/financial-ramifications-of-coronavirus-canceling-tokyo-olympicswould-be-massive/?sh=51a4c7a2772a; retrieved on 20th December 2022. Recognizing that you have to make a decision is an important and critical first step in decision analysis. Usually, it is not a single decision but you will have to make several decisions sequentially. If you review the above example carefully, you will recognize this fact. One decision will lead to another decision. As a decision maker, you will have to consider the consequent decisions for making the immediate decision, which makes it a complex and dynamic decision-making process. PM 652: Project Initiation and Selection Uncertain Events - - Decisions related to risk analysis are complicated because of uncertainties associated with risks. You may end up making these decisions without a detailed knowledge of consequences of the final outcome in future (uncertain). For instance, we make financial investments such as buying stocks; even though you are well versed with the stock market, it is still a calculated risk. Uncertainties associated with decisions will lead to a range of possible outcomes. Usually, you have more than one uncertain event associated with a decision. The complexity of the decision is directly related to the number of uncertain events associated with it. You will have to consider the interdependencies among all these uncertainties. Value of Specific Outcomes - - After you make your final decision by resolving the last uncertain event, you will know the result. The outcome could go either way. The outcome can have more than one dimension. Referring to the Tokyo Olympics example, investments in in the event will have monetary benefits (losses) and several intangible benefits (losses) as well. You will have to decide the planning horizon for your decision, which will determine the value of your decision outcome. You will have to consider the time value of money. Decision Tree Analysis Among many decision tools, I believe Decision Tree Analysis is a simple one and easy to understand. For example, consider that you are a venture capitalist. You have $10 million in your bank that you can set aside for investment. You have two options. You can promote a new technology firm and the investment has 80% chance of success. If it succeeds, you will earn $9 million in five years and the investment salvage value will be $8 million. If it fails, you still can salvage it at $13 million. Alternatively, you may decide not to take risk and keep the money in fixed deposit and at the end of the five years, your amount will be $12 million. All the monetary values are defined in present value. What is your decision? © Master of Project Management, Western Carolina University 2 of 6 PM 652: Project Initiation and Selection The expected monetary value of investing in technology firm is higher ($16.2 million) than investing saving it in a fixed deposit ($12 million). Let us look at the risk profiles of each alternative. Risk Profiles A risk profile is a graphical representation of chances associated with possible outcomes. There are three possible outcomes in this case: Alternative I $17 million (80% probability) and $13 million (20% probability) Alternative II $12 million (100% probability) Risk profiles of these two alternatives are shown in below. Cumulative risk profile Cumulative risk profile is similar to risk profile; it is developed by adding up, or accumulating the chances of individual payoffs. The above example is simple and each outcome has a unique value. However, it is possible that you may have more than one outcome from an alternative (or from total alternatives combined) with the same amount. In that case, you will have to add up all the chances for that amount to represent it in the cumulative chart. Cumulative risk profile is also shown below. After reviewing the cumulative risk profile, it becomes obvious that fixed deposit alternative fetches you $12 million whereas you could do no worse than $13 million if you invest in technology firm. © Master of Project Management, Western Carolina University 3 of 6 PM 652: Project Initiation and Selection Therefore, you should reject the fixed deposit alternative and invest in technology firm. This is known as deterministic dominance, “which signifies that the dominating alternative pay off at least as much as the one that is dominated.” (Clemen, 1986). Clemen stated, “Deterministic dominance can be noticed in cumulative risk profiles charts by comparing the value at which one cumulative risk profile of an alternative reaches 100% with the value at which another cumulative risk profile begins.” Cost-benefit Analysis Introduction Cost-benefit analysis is another useful technique for project selection. Cost-benefit analysis is the investment decision technique for economic evaluation of federal government programs and projects. The reason is simple. It is a comprehensive approach and considers different types of benefits and costs, whether you can translate them into monetary terms or not. Using cost-benefit analysis, you can allow for full range of effects of a program or project. Principles of Cost-Benefit Analysis - - - - Both costs and benefits must be measured with a common unit (money) at a specific time for two different reasons. § It is not due to the effect of inflation alone. § A dollar value today is not same as the one which is available five years from now. You can invest and earn interest. Estimation of benefits should not reflect what analysts think or consumers say. The estimate should reflect actual behavior. § You have a choice of doing your tax return or hire a CPA to do it. Let us assume that it takes 10 hours for you to do your tax. If you decide not to hire CPA who charges $100 to file your return, then your time value is $10 per hour or less. If you are indifferent about the choice, your time value is exactly $10 per hour. § It is important that the cost in the analysis should reflect your chosen behavior. Benefits are usually measured by market choices. § When you buy an item, the value of the item is equivalent to the money you will give up. You increase the consumption of the item to a point where the benefit of additional unit (marginal benefit) is equal to the additional unit cost (marginal cost), which is the market price. Double counting of benefits or costs must be avoided. § The impact of a project can affect project costs or benefits in two or more ways. We will have to consider the most important and obvious one. Cost-benefit analysis is defined in the context of a geographic region, be it a state, or country. Otherwise, conclusions may not be valid. Cost-benefit analysis should include comparison of impact with a project and without it. OMB Guidelines OMB circular A-94 provides the following guidelines for implementing cost-benefit analysis: - Underlying assumptions to arrive at future benefits and costs must be stated explicitly. Cost-benefit analysis should also consider all possible alternatives for analysis. In the case of adding a new capital asset, you must consider the following: • Do nothing • Direct purchase • Upgrade, or renovate existing property © Master of Project Management, Western Carolina University 4 of 6 PM 652: Project Initiation and Selection • Lease or contract - Periodic retrospective study to determine whether anticipated benefits and costs have been realized or not The last issue is important because costs and benefits are determined based on the information available at the time of analysis. The benefits and costs may or may not apply to any other time (Carlin 205). It is quite possible that new evidence would surface after the decision is made to initiate a project. And this new evidence may negate some of the benefits and/or costs during the project execution. How to make a decision using cost-benefit analysis? To consider a project for implementation, it has to meet two conditions. - Discounted benefits should exceed discounted costs in order to arrive at a net benefit. - Value of ratio between benefit and cost should be more than 1. When you have more than one project, which meets these two conditions, you should select the one with higher net benefit value. Cost-benefit Analysis Example You are considering a project of building a new facility to develop a new product. The initial cost will be $300,000. You will be able to build the new facility and introduce the new product into the market within three months. The product is expected to earn $40,000 revenue every year. Operating and maintenance costs of the new facility are $10,000 per year. After ten years, the salvage value of the new facility will be $200,000. A discount rate 7% is applied for investment decisions. What is your decision? Benefits - Present value of revenue @ $40000 per year Salvage value of the facility $280,943.26 $101,869.86 Costs - Operating and maintenance costs @ $10000 per year Initial investment Benefit-cost ratio $70,235.82 $300,000 $382813.1/$370235.8 (1.03) The resulting decision based on above data: You should invest. Expected Net Present Value Analysis I provided an article in the learning module on this subject. Please read it carefully and we may have a problem using this method in the final exam of this course. References • • • • Guidelines and Discount Rates for Benefit-cost Analysis of Federal Programs (1992). Office of Management and Budget (OMB) circular A-94. Carlin A (2005). The New Challenge to Cost Benefit Analysis. Regulation, Fall 2005, 18-23. An Introduction to Cost Benefit Analysis. Retrieved on 16 February 2007 from: http://www.sjsu.edu/faculty/watkins/cba.htm Clemen, R. T. (1986). Making Hard Decisions. Boston, MA: PWS-Kent Publishing. © Master of Project Management, Western Carolina University 5 of 6 PM 652: Project Initiation and Selection PM652 Learning Module 7 Assignments You will get full points only if you answer them correctly As Individuals, solve the problems below: Problem 1 (100 Points): Two project proposals have been submitted. You have a choice of selecting only one project for implementation due to resource constraints. Each project has a life of 5 years. The expected rate of return for your organization is 15%. The table below provides estimated cash flow for these projects. Project A Project B Initial investment $700,000 $500,000 Cash inflow 1st year $250,000 $150,000 Cash inflow 2nd year $250,000 $150,000 Cash inflow 3rd year $250,000 $150,000 Cash inflow 4th year $250,000 $150,000 Cash inflow 5th year $200,000 $200,000 What is your decision? Use cost-benefit analysis to solve the problem. Problem 2 (100 Points): You wanted to make quick money and bought a ticket online. The ticket will permit you to participate in a game designed by one of the websites and you have a 45% probability of winning $100 (or a 55% probability of winning nothing). During your team meetings, one of your teammates informed you that she has a lottery ticket, which has a 35% chance of winning $250 (or 65% probability of winning nothing). Your friend has offered to exchange her ticket with your ticket and $18. What will you do? Should you keep your ticket or trade it with your friend? (This example is a modified version of a problem from Robert Clemen’s book Making Hard Decisions) Reference: Clemen, R. T. (1986). Making Hard Decisions. Boston, MA: PWS-Kent Publishing. © Master of Project Management, Western Carolina University 6 of 6
