Unit 04 - Project Selection
April 2007 | Project Management | Wilhelm F. Neuhäuser
© IBM Corporation 2007
Project Management
Agenda
Unit 4: Project Selection
Objectives
Nonnumeric selection models
Project selection overview
Life-cost cycle
Profitability measures
Using financial measures to select projects and
alternative strategies
Key messages - Unit 4
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Project Management
Objectives
At the end of this module, you will be able to Understand project selection and its role in the
overall project
Understand processes that drive the project
selection processes
Describe financial analysis approaches used for
project selection
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Unit 04 | Project Selection |
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Project Management
Non-numeric Selection Models
Sacred cow
Operating necessity
Competitive necessity
Product line extensions
Comparative benefit model
Just do it!
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Project Management
Numeric Project Selection Models
Portfolio Analysis
Opportunities
Future
Perceived
Why not
Profitability measures
Return on sales
Return on investments and return on assets (ROA)
Net present value (NPV)
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Project Management
Portfolio Analysis in Project Selection
Analytical tool to determine investments in
products, systems, businesses, and services
Results in Investment priorities
Alternative strategies
Performance improvement initiatives
Financial measurements
Typically used by corporate planning, business
segments, and portfolio management/market
planning teams
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Project Management
Portfolio Management - Logical View
Portfolio Management
Define Market
Segments
Define customer
market segments
Select current and
future markets
Map current
offerings into
market segments
Identify new market
opportunities
Link vision, mission,
and goals to
segments
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Collect Market
Segment Data
Collect and rank
customer
requirements
Determine
competitive
environment
Understand market
environment and
trends
Determine financial
performance of
segments
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Priorities Investments
Segment Data
Assess markets
Assess market
attractiveness
Assess competitive
position
Assess financial
performance
Perform strategic
position analysis
Perform financial
performance
analysis
Evaluate alternative
strategies
Assess Capabilities
by Segment
Optimize coverage
by segment and
business
Optimize financials
Evaluate linkage to
vision, mission, and
goals
Finalize customer
offerings portfolio
Commit to business
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Project Management
Life-Cycle Cost
Technique assesses "total cost" of project from
Concept to End-of-Life
Normalizes all risks to measure their effect on
baseline life-cycle cost (LCC)
Usually uses computer model
Generally used for complex projects that are
relatively expensive and multiyear in duration
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Project Management
Profitability Measures
Assess the relative levels of return to an
organization from various alternatives
May be applied to factors having nothing to do with
monetary profit or loss - are a means to evaluate
the relative desirability of a given option
Are selected for use based on the relative length of
an option, the level of investment, and the timing of
inflow and outflow
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Project Management
Profitability Measures (continued)
In order of increasing complexity, the most
common profitability measures are Present value
Return on sales (ROS) or simple profit
Return on assets (ROA) or return on investment
(ROI)
Economic value added (EVA)
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Project Management
Using Financial Measures to select Projects and
Alternative Strategies
Present value = PV
Payment today is worth more than payment
tomorrow
Present value is the value of a future payment
For a given future payment t years from now PV =
Mt
(1 + r)t
Mt = amount of payment t years from now
r = interest rate (sometimes called "discount rate")
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Project Management
Sample Calculation of Net Present Value (NPV)
Year
Year
Revenue t
Year Cost
0
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Net Cash
Flow Vt
Discount
factor dt
Discounted
Cash Flow Vtdt
Net Present
Value Vtdt
50,000
-50,000
1.0000
-50,000
-50,000
1
3,000
35,000
-32,000
0.9091
-29,091
-79,091
2
13,500
15,000
-1,500
0.8264
-1,240
-80,331
3
30,000
5,000
25,000
0.7513
18,782
-61,549
4
40,000
5,000
35,000
0.6830
23,905
-37,644
5
50,000
5,000
45,000
0.6209
27,941
-9,703
6
50,000
10,000
40,000
0.5645
22,580
12,867
7
50,000
15,000
35,000
0.5132
17,962
30,839
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Project Management
Return on Sales (ROS)
ROS is a simple, non-time-dependent measure of
net profit or return as a percentage of a project's
total sales or revenue generated
ROS =
Net Profit
Sales
Negative return on sales indicates a loss
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ROS Example
Components of a compute system are purchased for
$500,000. Additional systems integration and
programming work is performed for $200,000.
Indirect (overhead) expenses of 50% of labor costs
are allocated to the project. Once assembled, the
computer system is sold for $1 million. Income taxes
are 40%.
Calculate net profit and return on sales.
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Project Management
ROS Example (continued)
Sales
Material
Labor
Overhead
Profit
Taxes
Net Profit
=
=
=
=
=
=
=
ROS =
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$ 1,000,000
500,000
200,000
100,000
200,000
80,000
120,000
Net Profit
Sales
=
$120,000
$1,000,000
= 12%
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Project Management
Profit & Loss Calculation Example
Revenue - Cost (royalties, warranty, maintenance, base manufacturing cost, goods,...) =
Gross profit (GP); % GP (percentage from revenue)
- Unique expenses (development expense, direct marketing and services,...)
- SG&A (sales, general administration & allocations)
= NEBT (net earnings before tax) = Profit contribution
% NEBT (percentage from revenue)
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P&L ($M)
2003
2004
2005
2006
2007
Program
Revenue
0,0
2,6
8,8
6,2
4,0
21,6
Costs
0,0
0,5
0,8
0,6
0,4
2,3
Gross Profit (GP)
0,0
2,1
8,0
5,6
3,6
19,3
GP %
N/A
81%
91%
90%
90%
89%
Development
3,0
3,0
0,5
0,5
0,5
7,5
SG&A (40%)
0,0
0,9
3,1
2,2
1,4
7,6
Total Expense
3,0
3,9
3,6
2,7
1,9
15,1
E/R %
N/A
150%
41%
43%
48%
70%
NEBT $
-3,0
-1,8
4,4
2,9
1,7
4,2
NEBT %
N/A
70%
50%
47%
43%
20%
Cummulative NEBT
-3,0
-4,8
-0,4
2,5
4,2
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Project Management
Return on Asset
A relative measure of profitability comparing an
organization's return on an effort with its overall
investment in assets required to perform the effort
Sometimes referred to as return on investment
(ROI)
ROA =
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Net Profit
Total assets
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Project Management
ROA Example
In the previous example, assume the computer
assembly operation required an asset base of $2
million to support its operation.
Calculate ROA.
ROA =
18
Net Profit
Total assets
Unit 04 | Project Selection |
=
$120,000
$2,000,000
= 6%
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Project Management
Economic Value Added (EVA) and
Economic Value Loss (EVL)
Approach that evaluates the return-on-capital
percentage versus the cost-of-capital percentage
Can be calculated using various methods
Assesses the effectiveness of creating value for
shareholders
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Project Management
What is the Cost of Capital
Represents the cost of financing an organization's
operations
Reflects the minimum rate of return required by
investors
Debt holders require interest and principle repayment
Shareholders require dividends and stock price
appreciation
Focusing on the cost of capital enables an
organization to identify development projects that
create value for shareholders
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Project Management
EVA Approach and Example
EVA is used to measure financial value created for
shareholders
EVA = net operating profits after taxes minus the
weighted average cost of capital (NOPAT - WACC)
Using the same information from the ROS and ROA examples,
assume the weighted average cost of capital for your company
is determined to be 10%.
Calculate EVA.
EVA
= NOPAT
- WACC
= $120,000
- 10% x $2,000,000
= $120,000
- $200,000
= -$80,000
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Raising EVA
There's nothing fancy or complicated about how to make economic value
added (EVA) go up. It's a fundamental measure of return on capital, and there
are just three ways to increase it:
Earn more profit without using more capital
You probably spend much of your time thinking of ways to do this; cost cutting is
today's favorite method. Nothing wrong with that, but focusing on it often blinds
companies to other ways of raising EVA.
Use less capital
In practice, this is often the method that companies adopting EVA find most
effective.
Coke uses plastic containers for concentrate instead of costlier metal ones. CSX
figures out how to operate with 100 locomotives instead of 150. Quaker
reschedules production to require fewer warehouses.
What to do with the capital saved? Companies can return it to shareholders
through higher dividends or stock buybacks, or can ...
Invest capital in high-return projects
This is what growth is all about. Just make sure you expect these projects to earn
more than the total cost of the capital they require.
From "The Real Key to Creating Wealth", Fortune, September 20, 1993
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Project Management
Summary of Profitability Measurement Tools and
Techniques
Tool
ROS
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Advantages
Simplicity of use
Simplicity of understanding
Flexibility
Disadvantages
Does not evaluate relative levels
of investment
Does not consider length of
project or effort
Does not reflect time value of
return
ROA
Reflects actual level of
investment in effort
Reflects time value of
investment
Easy method is relatively
accurate
More complex than ROS
measurement
EVA
Measures value created
Easy to understand
Focuses decision making
No set formulas
Difficult to compute EVA at
project level
Unit 04 | Project Selection |
© IBM Corporation 2003
Project Management
Key Messages
Project success is often driven by the clarity of
project definitions
Plan globally, think locally
The individual project manager may or may not be
involved in the project selection process for a
specific project
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