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Product Details
| ISBN-13: | 9781567264555 |
|---|---|
| Publisher: | Berrett-Koehler Publishers |
| Publication date: | 10/01/2001 |
| Series: | Project Management Essential Library |
| Sold by: | Barnes & Noble |
| Format: | eBook |
| Pages: | 120 |
| File size: | 5 MB |
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Read an Excerpt
Managing Projects for Value
By John C. Goodpasture
Management Concepts Press
Copyright © 2002 Management Concepts, Inc.All rights reserved.
ISBN: 978-1-56726-455-5
CHAPTER 1
Understanding Project Value
Whether stated or implied, every organization has some purpose or mission that drives achievement. Likewise, each possesses some vision for the future that inspires, motivates, and attracts stakeholders. From vision and mission, opportunity can be revealed. To exploit opportunities, goals are developed.
CONCEPTS IN MANAGING PROJECTS FOR VALUE
Five key concepts guide the management of projects for value.
Concept 1: Projects Derive Their Value from Goal Achievement
Goals represent that portion of the opportunity value that can be transferred into the business. Goals are the state or condition to which organizations aspire; thus, value is attached to their achievement. Insofar as proposed projects are deemed necessary to achieve goals, projects are valuable to the organization (see Figure 1-1).
Said another way, projects are not valuable in and of themselves; they only acquire value from the role they play in exploiting opportunity. This idea forms the first of five concepts in managing projects for value: A project's value is derived from the value obtained by reaching goals (Figure 1-2).
Concept 2: Projects Are Investments Made by Management
By definition, projects begin and projects end, but business goes on. For projects to exist, a deliberate assignment of resources must occur. In return for these resources, there is an expectation of a deliverable with benefits attached. Thus, projects can be seen as investments: principal applied, time expended, and return expected. For purposes of this book, the project sponsor is the project investor with authority to commit resources and charter the project. The charter becomes the investment agreement, specifying the value expected, the risk allowed, the resources committed, and the project manager's authority to apply organizational resources.
Concept 3: Project Investors/Sponsors Tolerate Risk
The concept of investment is that a commitment is made in the present time with an expectation of a future reward. The displacement of the future from the present introduces the possibility that unfavorable outcomes could occur (see Figure 1-3). Risk is the word used to capture the concept of potentially unfavorable outcomes. Project sponsors, acting as investors, embrace and understand risk as an unavoidable aspect of pursuing reward. Although project investors/sponsors "tolerate" risk, they do not manage it. Instead, the project manager manages the risk of achieving successful deliverables. Once the project itself is complete, a "benefits manager" manages the risk of achieving the operational value of the project.
As individuals, project investors/sponsors have different attitudes regarding risk. For instance, "objective" investors/sponsors are indifferent to the specific nature of risk, judging only the risk-adjusted value. In effect, different risks of the same value or impact are judged equally.
Risk-averse project investors/sponsors seek a balance of risk and reward. Risk-averse investors/sponsors are not necessarily risk avoiders, but they do avoid risks that cannot be afforded if the risk comes true, or cost more if the risk comes true, than the value of the "try."
The following example illustrates this concept. In a coin toss, the bet is that heads gets $200 and tails gets $0. The expected value is $100 since half the time $200 will come up and half the time $0 will come up. The "value of the try" is negligible; nothing but a little time is lost if tails comes up. Suppose the bet is changed so that heads gets $400 and tails pays $200 for the same average outcome of $100. The risk-averse investor may not play the second bet even though it has the same positive expected value as the first because of the investor's aversion to even a 50 percent chance of losing $200 and a judgment that the entertainment "value of the try" is not worth $200.
Figure 1-4 illustrates the concept of risk aversion applied to projects. Even though Project 2 has a higher expected return, its risk is beyond a threshold of affordable risk compared with Project 1. The risk-averse manager will approve Project 1 and disapprove Project 2.
Concept 4: The Investment Equation Becomes the Project Equation
The traditional investment equation of "total return equals principal plus gain" is transformed into the project equation of "project value is delivered from resources committed and risks taken." This equation is the project manager's "math." Many persons use the terms "benefits," "return," and "value" somewhat interchangeably even though they have different meanings.
This book employs the following definitions:
• Benefits are the mechanism for recovering project investment. For example, a project might be chartered to reduce production costs. Reduced production costs are the benefits that pay for the project investment.
• Return is the rate of change of a financial metric; for example, percentage incremental profit per period generated after the project is completed.
• Value is the need being satisfied by the project and the source of improved wealth in the business. In this project example, the business need may be to retain the production capability for customer satisfaction.
Concept 5: Value Is a Balance of Quality, Resources, and Risk
"Balance" is another term for equation. It is the state achieved when one side equals the other. In this context, quality demands are balanced or "provided" by resources and risk. Quality is used here in the sense of satisfying all dimensions of customer and stakeholder needs and expectations. Achievement of quality is accompanied by risk. How much risk? The answer is: only as much as is required to balance quality with resources (see Figure 1-5).
DIMENSIONS AND MEASURES OF VALUE
How is value dimensioned, and how is it measured? For most organizations, money is the objective measure of value. Consider this definition from James Anderson, Dipak Jain, and Pradeep Chintagunta: "Value ... is the worth in monetary terms of the economic, technical, service, and social benefits a customer ... receives in exchange for the price it pays for a market offering." Money (or money equivalents) is consideration given for the value provided.
Quality Dimensions of Value
Quality, and therefore value, is multidimensional. Quality often is considered in terms of compliance with standards, applicability to function and use, effectiveness of cost, timely and convenient availability, and responsiveness to context and environment. Some quality measures also include satisfaction of unspoken need. Regardless of the dimension used, in the final analysis, quality represents the value worth paying for.
Consumers Value the Outcomes of Processes
Projects are often chartered to design and deliver improved processes and organizational functionality. Michael Hammer, noted business process authority, consultant, and author, defines process this way: "Process: an organized group of tasks that together create customer value." By convention, processes are categorized as value adding (VA) or non–value adding (NVA).
A value-adding process begins with materials or information in a form not useful to users, applies a process to them, and produces a product or service that is useful. Consider this industrial VA process: Iron ore is mined and made into steel; the steel is then made into automobiles. Michael Porter uses the term primary activities to describe VA processes: "Primary activities ... are the activities involved in the physical creation of the product and its sale and transfer to the buyer as well as after-sale assistance." The beneficiaries of value-added processes are consumers — customers or users who can be internal or external to the organization. If these benefits are not dollar-denominated, as many may not be, then the "with-without principle" (discussed in detail in Chapter 3) is used to quantify process values in dollars.
MONETARY MEASURES OF VALUE
Value can be measured monetarily in several ways; these methods are developed in depth in many books and journals. Figure 1-6 illustrates three of these measures that are important to project managers. Their value lies in the fact that an otherwise straightforward calculation of cost and benefit often fails to represent project value correctly. Financial investment analysis techniques are required because:
• Projects take time to execute, and money is less valuable in the future. Therefore, the time value of money needs to be taken into account to estimate properly the value of outlays and benefits.
• Project investors have other choices for their investment dollars. It is often necessary to demonstrate to investors that a particular project is a good choice for investment.
• The future is subject to many outcomes, and each outcome potentially risks the value of the project.
Net present value, economic value add, and expected monetary value take these factors into account.
Net Present Value
Net present value (NPV) is a calculation of cash value over a period of time. The NPV calculation is first applied to projects during the approval or selection process; later it is applied when there are scope changes that affect resources or the benefits stream. NPV captures two important concepts for the project manager:
1. The value of money decays over time. This decay is due to the effects of inflation, the uncertainty that future flows will continue or begin, and the uncertainty that a better investment is available elsewhere. In all cases, the "present value" is more than the "future value."
2. The value of the project is the net of the present value of all the cash outlays for investment and inflows from operations and salvage.
Cash flow is money — cash — coming from a "source" and going to a "use." Referring to the Figure 1-6 graphical notations for cash flows, outlays (investments) are uses of cash; cash outlays are shown along the timeline as down-pointing arrows placed at the point in time when the flow occurs. Inflows (benefits) are sources of cash; cash benefits are shown as up-pointing arrows placed appropriately on the timeline.
Consider the first NPV concept stating that money has a time value. Project managers have a great deal to say about time. There are two time segments to consider:
1. The project implementation schedule. For the most part, the project schedule is in the hands of the project manager to develop and then to manage.
2. The operational life of the deliverable, which begins once project implementation is complete. This lifecycle is defined and developed by the project management team in the course of the project.
To evaluate a project investment properly, and the subsequent cash flows associated with operations and salvage, all cash values must be adjusted to a common timeframe, typically taken to be the present, by "discounting" the value of future funds. Discounting is a risk management measure for uncertainties in the future. The degree of discount is not ordinarily within the purview of the project manager. Discounting is accomplished by applying a weighting factor to each future period, compounding the factor at each period to take into effect the accumulation of time. Table 1-1 presents the relevant equations and demonstrates their application.
The significance of the net of the present value to project mangers is this: Successful projects are those projects that add value to the business. Value is only added if the net of all cash flows is positive; otherwise, there is more value going out of the business than there is coming in.
The discount factor that brings the NPV to exactly zero, thereby not adding dollar value but not detracting either, is called the internal rate of return (IRR). IRR is the upper bound of the discount for which the project adds financial value to the organization. Rewriting the equations in Table 1-1 leads to the following:
PV = Future value/(1 + IRR)n
Applying IRR as the discount rate,
NPV = PV (Outlays) – PV (Inflows) = 0
The IRR for the example given in Table 1-1 thus is 41.4 percent. It is the upper amount of any discount rate for which the NPV is 0 or greater. Figure 1-7 illustrates these principles.
Consider the following project management example. Paul is a project manager responsible for a warehouse management project estimated to cost $500K and return cash benefits of $650K. These benefits are planned to come in the form of reduced costs of $130K per year for five years, beginning in the second year. To simplify matters, the following business rules apply:
• The $500K will be expensed in one year, thereby avoiding capital budgeting and the complications of depreciation.
• All benefits are after-tax cash.
Jim, Paul's finance manager, has an additional business rule: The project must have positive cash flow. In other words, it must have a positive NPV over a five-year lifecycle. The firm's discount rate is 12.8 percent for this type of project. From a table of present values, Paul finds that the benefits are worth less each year:
• At the beginning of the first benefit year, which is one year from the beginning of the project, the $130K benefit is only worth $115.25K ($130K discounted 12.8 percent for one year, calculated as $130K/(1 + 0.128)).
• As shown in Table 1-2, the sum of all the benefits in present value is only $459.48K. This amount is less than the $650K originally planned, and it is less than the $500K needed to have positive cash flow and meet Jim's criterion for acceptance. Unless benefits can be increased, the project will not be accepted.
On the other hand, if the discount factor could be as low as 9.43 percent, as shown in Table 1-3, then the NPV would be $0K and the project might be accepted. Thus, 9.43 percent is the IRR for the project.
Jim considers the 9.43 percent issue but states that it is unlikely that the discount factor can be reduced from 12.8 percent to 9.43 percent. Therefore, as shown in Table 1-4, to have the project accepted, annual benefits must be raised to approximately $141.46K per year. At this benefit value, the NPV, figured at a discount rate of 12.8 percent, will be $0K after five years. Paul will have to reevaluate the project scope to see if such a benefit stream can be realized.
Economic Value Add
The second monetary value measure is economic value add (EVA). EVA is closely related to NPV because both employ measures of discounted cash flow (DCF). EVA is a financial measure of how project performance, especially after the deliverables become operational, affects earnings. Projects with positive EVAs earn back more than their cost-of-capital funding; that is, they return to the business sufficient earnings from reduced costs or increased revenues and margins to more than cover the cost of the capital required to fund these projects initially.
Cost of capital is an opportunity cost. It is not an expense on the project's expense statement. It is the "cost," used in the sense of return, that is "paid" to investors to keep them from taking their investments elsewhere to the next best opportunity. Capital is the "capital employed" or invested in the project that will be depreciated over time, as shown in Figure 1-8.
Capital and its cost are two important concepts from capital budgeting. The terms "discount factor" and "cost of capital" are used interchangeably in capital budgeting. Of course, capital budgeting is not employed in all organizations. In many government organizations, for instance, payments are expensed in the same year they are appropriated.
The logic of EVA is that if the business activity resulting from projects is not more profitable than the cost of capital the project consumes, then it may be more profitable, or at least equally profitable, and perhaps less risky, to invest the capital elsewhere.
EVA measures the economic performance of cash earnings. Earnings are what are reported as profit on the project's profit-and-loss (P&L) statement, but earnings are not all cash. P&L statements have many non- cash items on them; depreciation expense and expense accruals are two common entries. The examples that follow show how to take non-cash expenses into account.
(Continues...)
Excerpted from Managing Projects for Value by John C. Goodpasture. Copyright © 2002 Management Concepts, Inc.. Excerpted by permission of Management Concepts Press.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Table of Contents
Contents
Preface,Acknowledgments,
CHAPTER 1 Understanding Project Value,
CHAPTER 2 The Sources of Value for Projects,
CHAPTER 3 Balancing investment, Returns, and Risk,
CHAPTER 4 Estimating the Future,
CHAPTER 5 Delivering Value,
CHAPTER 6 Schedule Risk and Value Attainment,
Bibliography,
Index,