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Saturday, May 7, 2011

Chapter 19: Understanding Project Selections

In the Previous chapter, we saw how projects originate. But, we havent seen who decides whether to proceed with the project or what are the criterion used to decide whether to proceed with a project or drop it. This is exactly what we are going to learn in this chapter.

So, lets get started

Selecting Projects for Execution:

As explained in the previous chapter, the business strategy of the organization is the biggest motivator to select chapters. That being said, a project can be selected by using one or more project selection methods that fall into three categories:

1. Benefit measurement methods
2. Constrained optimization methods and
3. Expert Judgment.

Let us take a look at them one by one.

Benefit Measurement Methods

These methods use comparative approaches to compare the benefits obtained from the candidate projects so that the project with the maximum benefit will be selected. These methods fall into three categories:

1. Scoring models
2. Benefit contributions and
3. Economic models.

Scoring Models

A scoring model evaluates projects by using a set of criteria with a weight or score assigned to each criterion. You can assign different weights to different criteria to represent the varied degree of importance given to various criteria. All projects are evaluated against this set of criteria, and the project with the maximum score is selected.

The set of criteria can include both objective and subjective criteria, such as financial data, organizational expertise, market value, innovation, and fit with the corporate culture. The advantage of a scoring model is that you have the freedom to assign different weights to different criteria in order to select projects consistent with the goals, mission, and vision of your organization. This freedom is also a disadvantage because your selection is only as good as the criteria with larger weights.

Another important point to note is that, a good scoring model is a mandatory requirement for success of such models and developing a good scoring model is a very difficult task and requires unbiased inputs from people in different levels of your organization.

Benefit Contributions

These methods are based on comparing the benefit contributions from different projects. These contributions can be estimated by performing a cost-benefit analysis, which typically calculates the projected cost, revenue, and savings of a project. This method favors the projects that create profit in the shortest time and ignores the long-term benefits of projects that might not be tangible at the current time, such as innovation and strategic values.

Economic Models

An economic model is used to estimate the economic efficiency of a project, and it involves a set of calculations to provide overall financial data about the project. As always money is king and any project that can provide monetary benefits to the company would invariably be selected. The common terms involved in economic models are explained in the following list.
Benefit Cost Ratio (BCR) - This is the value obtained by dividing the benefit by the cost. The greater the value, the more attractive the project is. For example, if the projected cost of producing a product is Rs.10,000, and you expect to sell it for Rs.40,000, then the BCR is equal to Rs.40,000/Rs.10,000, which is equal to 4. For the benefit to exceed cost, the BCR must be greater than 1.
Cash flow - Whereas cash refers to money, cash flow refers to both the money coming in and the money going out of an organization. Positive cash flow means more money is coming in than going out.
Internal Return Rate (IRR) - This is just another way of interpreting the benefit from the project. It looks at the cost of the project as the capital investment and translates the profit into the interest rate over the life of that investment. Calculations for IRR are not part of this certification. It is enough if you understand that the greater the value for IRR, the more beneficial the project is.
Present Value (PV) and Net Present Value (NPV) - To understand these two concepts, understand that one rupee today can buy you more than what one rupee can buy next year. (Inflation) The issue arises because it takes time to complete a project, and even when a project is completed, its benefits are reaped over a period of time and not immediately. For Ex: It is like planting a coconut tree. It costs you money to buy it, but after a few years, it will give you a continuous supply of coconuts which you can sell and make a profit.
So, to make an accurate calculation for the profit, the cost and benefits must be converted to the same point in time. The NPV of a project is the present value of the future cash inflows minus the present value of the current and future cash outflows. For a project to be worth-while economically, the NPV must be positive.

As an example, assume you invest Rs.300,000 today to build a house, which will be completed and sold after three years for Rs.500,000. Also assume that real estate that is worth Rs.400,000 today will be worth Rs.500,000 after three years. So the present value of the cash inflow on your house is Rs.400,000, and hence the NPV is the present value of the cash inflow minus the present value of the cash outflow, which equals Rs.400,000?-300,000, which equals Rs.100,000.
Opportunity cost - This refers to selecting a project over another due to the scarcity of resources. In other words, by spending this rupee on this project, you are passing on the opportunity to spend this rupee on another project. How big an opportunity are you missing? The smaller the opportunity cost, the better it is.
Discounted Cash Flow (DCF) - The discounted cash flow refers to the amount that someone is willing to pay today in anticipation of receiving the cash flow in the future. DCF is calculated by taking the amount that you anticipate to receive in the future and discounting it back to today on the time scale. This conversion factors in the interest rate and opportunity cost between now (when you are actually spending cash) and the time when you will receive the cash back.
Return on Investment (ROI) - The ROI is the percentage profit from the project. For example, if you spend Rs.400,000 on the project, and the benefit for the first year is Rs.500,000, then ROI equals (Rs.500,000-Rs.400,000)/Rs.400,000, which equals 25%.
As the name suggests, all the benefit measurement methods are based on calculating some kind of benefit from the given project. However, the benefit will never be realized if the project fails.

Constrained Optimization Methods

Constrained optimization methods are concerned with predicting the success of the project. These methods are based on complex mathematical models that use formulae and algorithms to predict the success of a project. These models use the following kinds of algorithms:

• Linear
• Nonlinear
• Dynamic
• Integer
• Multiple objective programming

These are used only for the most complex projects and therefore are not typically used for most projects.

Expert Judgment

Expert judgment is one of the techniques used in project management to accomplish various tasks, including project selection. It refers to making a decision by relying on expert advice from one or more of the following sources:

• Senior management
• An appropriate unit within the organization
• The project stakeholders, including customers and sponsors
• Consultants
• Professional and technical associations
• Industry groups
• Subject matter experts from within or outside of the performing organization
• Project management office (PMO)

The use of expert judgment is not limited to the project selection. It can be and is used in many processes, such as developing a project charter. Expert judgment can be obtained by using a suitable method, such as individual consultation, interview, survey, and panel group discussion.

Expert Judgment can be very subjective at times and may include political influence. An experienced/talented person can influence the outcome of any event to his benefit and such people might influence the selection or rejection of a project even though they know it may not be in the best interest of the company.

An organization might use multiple selection methods to make a decision.

Previous: Origin of Projects

Next: Developing a Project Charter

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