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Project Management

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LESSON 12
PROJECT SELECTION (CONTD.)
Broad Contents
Q-Sort Model
Pay-back Period
Average Rate of Return
Discounted Cash Flow
Internal Rate of Return (IRR)
12.1
Types of Project Selection Models (Continued):
Non-Numeric Models:
Q-Sort Model:
Of the several techniques for ordering projects, the Q-Sort (Helin and Souder,
1974) is one of the most straightforward. First, the projects are divided into
three groups--good, fair, and poor--according to their relative merits. If any
group has more than eight members, it is subdivided into two categories, such
as fair-plus and fair-minus. When all categories have eight or fewer members,
the projects within each category are ordered from best to worst. Again, the
order is determined on the basis of relative merit. The rater may use specific
criteria to rank each project, or may simply use general overall judgment. (See
Figure 12.1 below for an example of a Q-Sort.)
Figure 12.1: Example of a Q-Sort
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The process described may be carried out by one person who is responsible for
evaluation and selection, or it may be performed by a committee charged with
the responsibility. If a committee handles the task, the individual rankings can
be developed anonymously, and the set of anonymous rankings can be
examined by the committee itself for consensus. It is common for such rankings
to differ somewhat from rater to rater, but they do not often vary strikingly
because the individuals chosen for such committees rarely differ widely on
what they feel to be appropriate for the parent organization.
Projects can then be selected in the order of preference, though they are usually
evaluated financially before final selection.
There are other, similar nonnumeric models for accepting or rejecting projects.
Although it is easy to dismiss such models as unscientific, they should not be
discounted casually. These models are clearly goal-oriented and directly reflect
the primary concerns of the organization.
The sacred cow model, in particular, has an added feature; sacred cow projects
are visibly supported by "the powers that be." Full support by top management
is certainly an important contributor to project success (Meredith, 1981).
Without such support, the probability of project success is sharply lowered.
Numeric Models: Profit/Profitability
As noted earlier, a large majority of all firms using project evaluation and selection
models use profitability as the sole measure of acceptability. We will consider these
models first, and then discuss models that surpass the profit test for acceptance.
1.
Payback Period:
The payback period for a project is the initial fixed investment in the project
divided by the estimated annual net cash inflows from the project. The ratio of
these quantities is the number of years required for the project to repay its
initial fixed investment. For example, assume a project costs $100,000 to
implement and has annual net cash inflows of $25,000. Then
This method assumes that the cash inflows will persist at least long enough to
pay back the investment, and it ignores any cash inflows beyond the payback
period. The method also serves as an (inadequate) proxy for risk. The faster the
investment is recovered, the less the risk to which the firm is exposed.
2.
Average Rate of Return:
Often mistaken as the reciprocal of the payback period, the average rate of
return is the ratio of the average annual profit (either before or after taxes) to
the initial or average investment in the project. Because average annual profits
are usually not equivalent to net cash inflows, the average rate of return does
not usually equal the reciprocal of the payback period. Assume, in the example
just given, that the average annual profits are $15,000:
Neither of these evaluation methods is recommended for project selection,
though payback period is widely used and does have a legitimate value for cash
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budgeting decisions. The major advantage of these models is their simplicity,
but neither takes into account the time-value of money. Unless interest rates are
extremely low and the rate of inflation is nil, the failure to reduce future cash
flows or profits to their present value will result in serious evaluation errors.
3.
Discounted Cash Flow:
Also referred to as the Net Present Value (NPV) method, the discounted cash
flow method determines the net present value of all cash flows by discounting
them by the required rate of return (also known as the hurdle rate, cutoff rate,
and similar terms) as follows:
To include the impact of inflation (or deflation) where pt is the predicted rate of
inflation during period t, we have
Early in the life of a project, net cash flow is likely to be negative, the major
outflow being the initial investment in the project, A0. If the project is
successful, however, cash flows will become positive. The project is acceptable
if the sum of the net present values of all estimated cash flows over the life of
the project is positive. A simple example will suffice. Using our $100,000
investment with a net cash inflow of $25,000 per year for a period of eight
years, a required rate of return of 15 percent, and an inflation rate of 3 percent
per year, we have
Because the present value of the inflows is greater than the present value of the
outflow-- that is, the net present value is positive--the project is deemed
acceptable.
For example:
PsychoCeramic Sciences, Inc. (PSI), a large producer of cracked pots and other
cracked items, is considering the installation of a new marketing software
package that will, it is hoped, allow more accurate sales information concerning
the inventory, sales, and deliveries of its pots as well as its vases designed to
hold artificial flowers.
The information systems (IS) department has submitted a project proposal that
estimates the investment requirements as follows: an initial investment of
$125,000 to be paid up-front to the Pottery Software.
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Corporation; an additional investment of $100,000 to modify and install the
software; and another $90,000 to integrate the new software into the overall
information system. Delivery and installation is estimated to take one year;
integrating the entire system should require an additional year.
Thereafter, the IS department predicts that scheduled software updates will
require further expenditures of about $15,000 every second year, beginning in
the fourth year. They will not, however, update the software in the last year of
its expected useful life.
The project schedule calls for benefits to begin in the third year, and to be up-
to-speed by the end of that year. Projected additional profits resulting from
better and more timely sales information are estimated to be $50,000 in the first
year of operation and are expected to peak at $120,000 in the second year of
operation, and then to follow the gradually declining pattern shown in the table
12.1 below.
Project life is expected to be 10 years from project inception, at which time the
proposed system will be obsolete for this division and will have to be replaced.
It is estimated, however, that the software can be sold to a smaller division of
PsychoCeramic Sciences, Inc. (PSI) and will thus, have a salvage value of
$35,000. The Company has a 12 percent hurdle rate for capital investments and
expects the rate of inflation to be about 3 percent over the life of the project.
Assuming that the initial expenditure occurs at the beginning of the year and
that all other receipts and expenditures occur as lump sums at the end of the
year, we can prepare the Net Present Value analysis for the project as shown in
the table 12.1 below.
The Net Present Value of the project is positive and, thus, the project can be
accepted. (The project would have been rejected if the hurdle rate were 14
percent.) Just for the intellectual exercise, note that the total inflow for the
project is $759,000, or $75,900 per year on average for the 10 year project. The
required investment is $315,000 (ignoring the biennial overhaul charges).
Assuming 10 year, straight line depreciation, or $31,500 per year, the payback
period would be:
A project with this payback period would probably be considered quite
desirable.
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Table 12.1: Net Present Value (NPV) Analysis
4.
Internal Rate of Return (IRR):
If we have a set of expected cash inflows and cash outflows, the internal rate of
return is the discount rate that equates the present values of the two sets of
flows. If At is an expected cash outflow in the period t and Rt is the expected
inflow for the period t , the internal rate of return is the value of k that satisfies
the following equation (note that the A 0 will be positive in this formulation of
the problem):
The value of k is found by trial and error.
5.
Profitability Index:
Also known as the benefit­cost ratio, the profitability index is the net present
value of all future expected cash flows divided by the initial cash investment.
(Some firms do not discount the cash flows in making this calculation.) If this
ratio is greater than 1.0, the project may be accepted.
6.
Other Profitability Models:
There are a great many variations of the models just described. These variations
fall into three general categories. These are:
a)
Those that subdivide net cash flow into the elements that comprises the
net flow.
b)
Those that include specific terms to introduce risk (or uncertainty,
which is treated as risk) into the evaluation.
c)
Those that extend the analysis to consider effects that the project might
have on other projects or activities in the organization.
12.1.1 Advantages of Profit-Profitability Numeric Models:
Several comments are in order about all the profit-profitability numeric models. First,
let us consider their advantages:
The undiscounted models are simple to use and understand.
All use readily available accounting data to determine the cash flows.
Model output is in terms familiar to business decision makers.
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With a few exceptions, model output is on an "absolute" profit/profitability scale
and allows "absolute" go/no-go decisions.
Some profit models account for project risk.
12.1.2 Disadvantages of Profit-Profitability Numeric Models:
The disadvantages of these models are the following:
These models ignore all non-monetary factors except risk.
Models that do not include discounting ignore the timing of the cash flows and the
time­value of money.
Models that reduce cash flows to their present value are strongly biased toward the
short run.
Payback-type models ignore cash flows beyond the payback period.
The internal rate of return model can result in multiple solutions.
All are sensitive to errors in the input data for the early years of the project.
All discounting models are nonlinear, and the effects of changes (or errors) in the
variables or parameters are generally not obvious to most decision makers.
All these models depend for input on a determination of cash flows, but it is not
clear exactly how the concept of cash flow is properly defined for the purpose of
evaluating projects.
12.1.3 Profit-Profitability Numeric Models ­ An Overview:
A complete discussion of profit/profitability models can be found in any standard work
on financial management--see Ross, Westerfield, and Jordan (1995), for example.
In general, the net present value models are preferred to the internal rate of return
models. Despite wide use, financial models rarely include non-financial outcomes in
their benefits and costs. In a discussion of the financial value of adopting project
management (that is, selecting as a project the use of project management) in a firm,
Githens (1998) notes that traditional financial models "simply cannot capture the
complexity and value-added of today's process-oriented firm."
The commonly seen phrase "Return on Investment," or ROI, does not denote any
specific method of calculation. It usually involves Net Present Value (NPV) or Internal
Rate of Return (IRR) calculations, but we have seen it used in reference to
undiscounted average rate of return models and (incorrectly) payback period models.
In our experience, the payback period model, occasionally using discounted cash flows,
is one of the most commonly used models for evaluating projects and other investment
opportunities. Managers generally feel that insistence on short payout periods tends to
minimize the risks associated with outstanding monies over the passage of time. While
this is certainly logical, we prefer evaluation methods that discount cash flows and deal
with uncertainty more directly by considering specific risks. Using the payout period as
a cash-budgeting tool aside, its primary virtue is its simplicity.
Real Options: Recently, a project selection model was developed based on a notion
well known in financial markets. When one invests, one foregoes the value of
alternative future investments. Economists refer to the value of an opportunity foregone
as the "opportunity cost" of the investment made.
The argument is that a project may have greater net present value if delayed to the
future. If the investment can be delayed, its cost is discounted compared to a present
investment of the same amount. Further, if the investment in a project is delayed, its
value may increase (or decrease) with the passage of time because some of the
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uncertainties will be reduced. If the value of the project drops, it may fail the selection
process. If the value increases, the investor gets a higher payoff. The real options
approach acts to reduce both technological and commercial risk. For a full explanation
of the method and its use as a strategic selection tool, see Luehrman (1998a and 1998b).
An interesting application of real options as a project selection tool for pharmaceutical
Research and Development (R and D) projects is described by Jacob and Kwak (2003).
Real options combined with Monte Carlo simulation is compared with alternative
selection/assessment methods by Doctor, Newton, and Pearson (2001).
PROJECT PROPOSAL
12.2
Introduction:
Project Proposal is the initial document that converts an idea or policy into details of a potential
project, including the outcomes, outputs, major risks, costs, stakeholders and an estimate of the
resource and time required.
To begin planning a proposal, remember the basic definition: a proposal is an offer or bid to do
a certain project for someone. Proposals may contain other elements ­ technical background,
recommendations, results of surveys, information about feasibility, and so on. But what makes a
proposal a proposal is, that it asks the audience to approve, fund, or grant permission to do the
proposed project.
If you plan to be a consultant or run your own business, written proposals may be one of your
most important tools for bringing in business. And, if you work for a government agency, non-
profit organization, or a large corporation, the proposal can be a valuable tool for initiating
projects that benefit the organization or you the employee proposed (and usually both).
A proposal should contain information that would enable the audience of that proposal to decide
whether to approve the project, to approve or hire you to do the work, or both. To write a
successful proposal, put yourself in the place of your audience ­ the recipient of the proposal,
and think about what sorts of information that person would need to feel confident having you
do the project.
It is easy to get confused about proposals. Imagine that you have a terrific idea for installing
some new technology where you work and you write up a document explaining how it works
and why it is so great, showing the benefits, and then end by urging management to go for it. Is
that a proposal? The answer is "No", at least not in this context. It is more like a feasibility
report, which studies the merits of a project and then recommends for or against it. Now, all it
would take to make this document a proposal would be to add elements that ask management
for approval for you to go ahead with the project. Certainly, some proposals must sell the
projects they offer to do, but in all cases proposals must sell the writer (or the writer's
organization) as the one to do the project.
12.3
Types of Project Proposals:
Consider the situations in which proposals occur. A company may send out a public
announcement requesting proposals for a specific project. This public announcement, called a
Request for Proposal (RFP), could be issued through newspapers, trade journals, Chamber of
Commerce channels, or individual letters. Firms or individuals interested in the project would
then write proposals in which they summarize their qualifications, project schedules and costs,
and discuss their approach to the project. The recipient of all these proposals would then
evaluate them, select the best candidate, and then work up a contract.
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But proposals come about much less formally. Imagine that you are interested in doing a project
at work (for example, investigating the merits of bringing in some new technology to increase
productivity). Imagine that you visited with your supervisor and tried to convince her of this.
She might respond by saying, "Write me a proposal and I will present it to upper management."
As you can see from these examples, proposals can be divided into several categories:
1.
Internal Proposal:
If you write a proposal to someone within your organization (a business, a government
agency, etc.), it is an internal proposal. With internal proposals, you may not have to
include certain sections (such as qualifications), or you may not have to include as
much information in them.
2.
External Proposal:
An external proposal is one written by a separate, independent consultant proposing to
do a project for another firm. It can be a proposal from organization or individual to
another such entity.
3.
Solicited Proposal:
If a proposal is solicited, the recipient of the proposal in some way requested the
proposal. Typically, a company will send out requests for proposals (RFPs) through the
mail or publish them in some news source. But proposals can be solicited on a very
local level. For example, you could be explaining to your boss what a great thing it
would be to install a new technology in the office; your boss might get interested and
ask you to write up a proposal that offered to do a formal study of the idea.
4.
Unsolicited Proposal:
Unsolicited proposals are those in which the recipient has not requested proposals.
With unsolicited proposals, you sometimes must convince the recipient that a problem
or need exists before you can begin the main part of the proposal.
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Table 12.2: Solicited Versus Unsolicited Proposals
12.3.1 Request for Proposal:
A Request for Proposal (referred to as RFP) is an invitation for suppliers, through a
bidding process, to submit a proposal on a specific product or service.
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A Request for Proposal (RFP) typically involves more than the price. Other requested
information may include basic corporate information and history, financial information
(can the company deliver without risk of bankruptcy), technical capability (used on
major procurements of services, where the item has not previously been made or where
the requirement could be met by varying technical means), product information such as
stock availability and estimated completion period, and customer references that can be
checked to determine a company's suitability.
In the military, Request for Proposal (RFP) is often raised to fulfill an Operational
Requirement (OR), after which the military procurement authority will normally issue a
detailed technical specification against which tenders will be made by potential
contractors. In the civilian use, Request for Proposal (RFP) is usually part of a complex
sales process, also known as enterprise sales.
Request for Proposals (RFPs) often include specifications of the item, project or service
for which a proposal is requested. The more detailed the specifications, the better the
chances that the proposal provided will be accurate. Generally Request for Proposals
(RFPs) are sent to an approved supplier or vendor list.
The bidders return a proposal by a set date and time. Late proposals may or may not be
considered, depending on the terms of the initial Request for Proposal. The proposals
are used to evaluate the suitability as a supplier, vendor, or institutional partner.
Discussions may be held on the proposals (often to clarify technical capabilities or to
note errors in a proposal). In some instances, all or only selected bidders may be invited
to participate in subsequent bids, or may be asked to submit their best technical and
financial proposal, commonly referred to as a Best and Final Offer (BAFO).
12.3.2 Request for Proposal (RFP) Variation:
The Request for Quotation (RFQ) is used where discussions are not required with
bidders (mainly when the specifications of a product or service are already known), and
price is the main or only factor in selecting the successful bidder. Request for Quotation
(RFQ) may also be used as a step prior to going to a full-blown Request for Proposal
(RFP) to determine general price ranges. In this scenario, products, services or suppliers
may be selected from the Request for Quotation (RFQ) results to bring in to further
research in order to write a more fully fleshed out Request for Proposal (RFP).
Request for Proposal (RFP) is sometimes used for a Request for Pricing.
12.3.3 Request for Information (RFI):
Request for Information (RFI) is a proposal requested from a potential seller or a
service provider to determine what products and services are potentially available in the
marketplace to meet a buyer's needs and to know the capability of a seller in terms of
offerings and strengths of the seller. Request for Information (RFIs) are commonly used
on major procurements, where a requirement could potentially be met through several
alternate means. A Request for Information (RFI), however, is not an invitation to bid,
is not binding on either the buyer or sellers, and may or may not lead to a Request for
Proposal (RFP) or Request for Quotation (RFQ).
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Table of Contents:
  1. INTRODUCTION TO PROJECT MANAGEMENT:Broad Contents, Functions of Management
  2. CONCEPTS, DEFINITIONS AND NATURE OF PROJECTS:Why Projects are initiated?, Project Participants
  3. CONCEPTS OF PROJECT MANAGEMENT:THE PROJECT MANAGEMENT SYSTEM, Managerial Skills
  4. PROJECT MANAGEMENT METHODOLOGIES AND ORGANIZATIONAL STRUCTURES:Systems, Programs, and Projects
  5. PROJECT LIFE CYCLES:Conceptual Phase, Implementation Phase, Engineering Project
  6. THE PROJECT MANAGER:Team Building Skills, Conflict Resolution Skills, Organizing
  7. THE PROJECT MANAGER (CONTD.):Project Champions, Project Authority Breakdown
  8. PROJECT CONCEPTION AND PROJECT FEASIBILITY:Feasibility Analysis
  9. PROJECT FEASIBILITY (CONTD.):Scope of Feasibility Analysis, Project Impacts
  10. PROJECT FEASIBILITY (CONTD.):Operations and Production, Sales and Marketing
  11. PROJECT SELECTION:Modeling, The Operating Necessity, The Competitive Necessity
  12. PROJECT SELECTION (CONTD.):Payback Period, Internal Rate of Return (IRR)
  13. PROJECT PROPOSAL:Preparation for Future Proposal, Proposal Effort
  14. PROJECT PROPOSAL (CONTD.):Background on the Opportunity, Costs, Resources Required
  15. PROJECT PLANNING:Planning of Execution, Operations, Installation and Use
  16. PROJECT PLANNING (CONTD.):Outside Clients, Quality Control Planning
  17. PROJECT PLANNING (CONTD.):Elements of a Project Plan, Potential Problems
  18. PROJECT PLANNING (CONTD.):Sorting Out Project, Project Mission, Categories of Planning
  19. PROJECT PLANNING (CONTD.):Identifying Strategic Project Variables, Competitive Resources
  20. PROJECT PLANNING (CONTD.):Responsibilities of Key Players, Line manager will define
  21. PROJECT PLANNING (CONTD.):The Statement of Work (Sow)
  22. WORK BREAKDOWN STRUCTURE:Characteristics of Work Package
  23. WORK BREAKDOWN STRUCTURE:Why Do Plans Fail?
  24. SCHEDULES AND CHARTS:Master Production Scheduling, Program Plan
  25. TOTAL PROJECT PLANNING:Management Control, Project Fast-Tracking
  26. PROJECT SCOPE MANAGEMENT:Why is Scope Important?, Scope Management Plan
  27. PROJECT SCOPE MANAGEMENT:Project Scope Definition, Scope Change Control
  28. NETWORK SCHEDULING TECHNIQUES:Historical Evolution of Networks, Dummy Activities
  29. NETWORK SCHEDULING TECHNIQUES:Slack Time Calculation, Network Re-planning
  30. NETWORK SCHEDULING TECHNIQUES:Total PERT/CPM Planning, PERT/CPM Problem Areas
  31. PRICING AND ESTIMATION:GLOBAL PRICING STRATEGIES, TYPES OF ESTIMATES
  32. PRICING AND ESTIMATION (CONTD.):LABOR DISTRIBUTIONS, OVERHEAD RATES
  33. PRICING AND ESTIMATION (CONTD.):MATERIALS/SUPPORT COSTS, PRICING OUT THE WORK
  34. QUALITY IN PROJECT MANAGEMENT:Value-Based Perspective, Customer-Driven Quality
  35. QUALITY IN PROJECT MANAGEMENT (CONTD.):Total Quality Management
  36. PRINCIPLES OF TOTAL QUALITY:EMPOWERMENT, COST OF QUALITY
  37. CUSTOMER FOCUSED PROJECT MANAGEMENT:Threshold Attributes
  38. QUALITY IMPROVEMENT TOOLS:Data Tables, Identify the problem, Random method
  39. PROJECT EFFECTIVENESS THROUGH ENHANCED PRODUCTIVITY:Messages of Productivity, Productivity Improvement
  40. COST MANAGEMENT AND CONTROL IN PROJECTS:Project benefits, Understanding Control
  41. COST MANAGEMENT AND CONTROL IN PROJECTS:Variance, Depreciation
  42. PROJECT MANAGEMENT THROUGH LEADERSHIP:The Tasks of Leadership, The Job of a Leader
  43. COMMUNICATION IN THE PROJECT MANAGEMENT:Cost of Correspondence, CHANNEL
  44. PROJECT RISK MANAGEMENT:Components of Risk, Categories of Risk, Risk Planning
  45. PROJECT PROCUREMENT, CONTRACT MANAGEMENT, AND ETHICS IN PROJECT MANAGEMENT:Procurement Cycles