How do project managers select or prioritise projects? It is not always possible for each new project to have a full feasibility and financial analysis performed before the project is undertaken, therefore other non-numeric methods are used to determine which projects should go ahead.
The following non-numeric methods can be used for project selection
Operating Necessity - this refers to instances where a project is fundamentally important and that if it does not go ahead there will be dire consequences to the business. For instance, an old IT system must be upgraded (which could be at significant cost to the business) instead of an alternative system being installed because after review, it was found that the alternative systems does not provide the same services as the original system (Hickey, 2021).
Sacred Cow - this refers to instances in which senior managers (often large organisations) have made suggestions to use or adopt a new service or product which could enhance the productivity of the organisation. The suggestion materialises into a project which is now deemed as ‘sacred’ as the senior manager has put forward the suggestion. The project will proceed until it either concludes naturally with a successful implementation or it will be closed once its realised that the suggestion will not work (Hickey, 2021).
Competitive necessity - this refers to instances in which the business takes on specific projects with the sole objective to raise their profile or production output to remain competitive in their market field. For instance, this could be a company restructure or implementing new technologies/products (Hickey, 2021).
The following numeric methods can be used for project selection.
Cost Benefit
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Cost benefit analysis - a full financial review and associated costs of the project is undertaken. This is then reconciled against the total benefits of completing project (which can include financial, competitiveness, profile etc). If the benefit of the project outweighs the total cost, then the project is likely to proceed.
To use this method effectively, specific data criteria or framework needs to be established. This includes:
1. Establish a Framework for Your Analysis - identify goals or objective that you want to achieve and establish the metric they will be measured against.
2. Identify Your Costs and Benefits - indirect, intangible and opportunity costs e.g. overall expenses (materials etc) vs overall benefit (industry leader etc)
3. Assign an amount or Value to Each Cost and Benefit - these should be realistic and obtainable.
4. Tally the Total Value of Benefits and Costs and Compare - if the benefit outweighs the cost then the project should go ahead (Stobierski, 2019).
Financing Cost
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Financing costs - this is a review of the entire cost of the project. Financing costs can include monies that are already in the business, borrowed funds such as loans which will have interest charges, increase of capital from investors which may require the payment of dividends as well as other funds that don’t need to be paid back such as grants, subsidies or donations.
Payback Method
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Payback method - this is the total time (usually measured in years) that is required to pay back the initial investment and whether it will be a lump sum on incremental amounts. Payback does not consider the time value of money.
This is a simple and effective calculation.
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Average rate of return (ARR)
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Average rate of return (ARR) - this method is used to compare profitability or proceeds per annum against the overall expected life cycle of a project in the form of a rate (percentage) of return. This method can be used for every project opportunity whereby the project yielding the highest rate would be chosen. This is an effective method of calculating and comparing the cost of projects that have variable timeframes. This method also takes into account the time value of money and should be used in conjunction with the payback method (BBC, 2021).
The formula for the IRR is
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Discounted Cash Flow
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According to (Fernando, 2021), “Discounted cash flow (DCF) helps determine the value of an investment based on its future cash flows. The present value of expected future cash flows is arrived at by using a discount rate to calculate the DCF. If the DCF is above the current cost of the investment, the opportunity could result in positive returns. Companies typically use the weighted average cost of capital (WACC) for the discount rate because it takes into consideration the rate of return expected by shareholders. The DCF has limitations, primarily in that it relies on estimations of future cash flows, which could prove inaccurate”.
The formula for DCF is expressed as:
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Net Present Value (NPV)
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The net present value is the difference between the present value of cash inflows and outflows over a specific timeframe. According to (Fernando, 2021), “Net present value, or NPV, is used to calculate the current total value of a future stream of payments. If the NPV of a project or investment is positive, it means that the discounted present value of all future cash flows related to that project or investment will be positive, and therefore attractive. To calculate NPV, you need to estimate future cash flows for each period and determine the correct discount rate”.
The formula for NPV is expressed as:
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Both NPV and IRR are both DCF methods.
References
BBC, 2021. Average Rate of Return. URL:https://www.bbc.co.uk/bitesize/guides/z7kpt39/revision/3 Accessed 15.10.2021
Fernando, J. 2021. Discounted Cash Flow (DCF). URL: Discounted Cash Flow (DCF) Definition (investopedia.com) Accessed 17.10.2021
Fernando, J. 2021. Net Present Value (NPV). URL: Net Present Value (NPV) Definition (investopedia.com) Accessed 17.10.2021
Hickey, R. 2021. Project Selection. URL: https://www.learning101.ie/projectmanagement.html
Javed, R. 2020. Payback Method. URL: https://www.accountingformanagement.org/payback-method/. Accessed on 15.10.2021
Stobierski, T. 2019. How to do a cost-benefit analysis & why it’s important. URL: https://online.hbs.edu/blog/post/cost-benefit-analysi
Accessed on 15.10.2021
Hi Kerry, very nice blog post. You´ve done quite some research for this post. I like your use of formulas which makes the layout very organised. Thanks, Michaela
Hi Kerry, this is some good, well researched information here. The use of visuals makes the post quite attractive and I like the way you added in the formulas for each equation, which really helped with understanding the various scenarios that they are uniquely related to!
James