Module 8 Terms Flashcards
Project Selection Model Criteria
Realistic -
Capable -
Flexible -
Easy to use -
Low cost -
Comparable -
Non-numeric selection methods
In fact, non-numeric models incorporate the flexibility necessary to develop criteria that closely capture the intent of company strategic goals or to meet immediate operational needs regardless of a project’s financial viability.
Some popular examples of non-numeric models are:
Competitive necessity
Operating necessity
Sacred cow
Competitive necessity
Projects evaluated under the competitive necessity model still require a project proposal, which includes justification, cost, and time estimates, as well as documented outcomes. However, the decision of whether to approve or disapprove the project is based on whether implementing the project will ensure the viability of the company in the competitive market. If your market is being dominated by gas stations that include convenience stores, and your company’s chain of gas-only facilities is losing market share, then a project may be needed to upgrade facilities to include convenience stores to remain competitive in the market.
Operating necessity
When equipment fails or disasters threaten company operations, projects may need to be undertaken regardless of their financial viability. Operating necessity evaluates a project based on whether it will ensure ongoing operations with the understanding that not executing the project will result in operations being interrupted.
Sacred cow
Sacred cow projects are suggested by senior leadership or a powerful constituent of the company. These projects are often created to satisfy the expectations of the leader with little regard for the project’s viability or contribution to strategic or operational needs. The “sacred” nature of the project is that its existence will not be questioned but will be pushed toward completion until the sponsor realizes the futility of the effort.
Checklist model
Checklist models are a frequently used non-numeric method for project selection. This method uses a series of questions to evaluate each potential project. Each project would be analyzed using the same set of questions, and then the answers to the questions would be compared to determine whether a project is accepted or rejected.
This approach to project selection affords the company great flexibility. Questions may be generated that cut across organizational boundaries and cover a wide range of operational and strategic issues. The following table provides examples of sample checklist questions.
Numeric Selection Criteria
Numeric project selection models use financial and other quantitative measures to drive decision-making. Although many companies focus on profitability measures, numeric models are not limited to a sole measure.
Numeric models can be grouped into two general categories:profit/profitability based and scoring models. Profit/profitability based models use some aspect of measuring the financial returns of the project relative to the cost of the project or the time required to break-even. These models include payback period, net present value, and internal rate of return.
Scoring models allow the company to integrate multiple criteria in analyzing project proposals. These types span from basic scored criteria to including weights on each criteria so that some criteria are emphasized over others.
Scoring criteria
The use of a scoring model extends the benefits of the checklist approach and overcomes some of its weaknesses. Similar to the checklist model, the scoring model incorporates flexibility by including several selection criteria. Criteria can be quantitative or qualitative in form but must be answered using a scale. The format of the scale can vary, but for simplicity, you can use a scale of 1 to 10 with 1 being weakest and 10 being strongest.
In practice, a set of criteria would be developed based on the strategic objectives of the company. This will usually result in 8 to 15 specifically defined criteria. The criteria are identified by the senior leadership of the company and then passed to a project priority team or other group of raters that will evaluate each project proposal. Using a team of raters enhances the reliability of the scores and reduces the biasing of results by a single rater. Individual rater scores of project proposals can then be averaged or discussed until consensus is reached.
Weighted Factor Scoring Model
A popular enhancement to the scoring model approach is the weighted factor scoring model. In the traditional scoring model approach, each criterion is treated equally. When it comes to project selection, some criteria may be more important than others.
To address this concern, weighted factor scoring models require that senior management assigns a weight to each criterion, which places some emphasis on selected criteria when calculating the total project score.
Time Value of Money
The concept of time value of money suggests that money is worth more to an organization now than in the future. It makes sense if you consider that if someone gave you $1,000 today and you could invest the money such that the investment would return additional value to you in the future.
In project management, you look at it in the reverse, saying that if completing a project will bring in revenue next year of $1,000, then the future $1,000 is worth less than $1,000 to you today.
Opportunity cost
if the organization spends money on a project, then other possible uses of the money would need to wait. In finance, this concept is defined as an opportunity cost. The opportunity cost of executing a specific project is the benefit that the next best alternative use of the money would have provided. In this case, benefit could refer to revenue generated, another project funded, or any other value the organization could have gained.
Payback period
Payback period calculates the amount of time required to earn back the cost of doing the project. In order to calculate the payback period, you need to know the cost of the project and the amount of revenue the project will generate in future periods.
Payback Period (months)=Estimated Project Cost/Monthly Return
If purchasing a new piece of equipment will cost the company $250,000 but will save the company $25,000 per month in labor expenses due to increased efficiencies, the payback period can be easily calculated in months. In this example, the initial project investment of $250,000 will be repaid in 10 months.
Payback Period (months)=$250,000/$25,000=10 months
Assuming the company has several projects from which to choose, calculating the payback period for each project would allow for a comparison. Remembering that there is a time value of money, earning the invested cost of the project back sooner is better than later, and the lower payback period project would be preferred. Using a payback period model would encourage the decision maker to select a project with a payback period of two years over a project with a payback period of three years.
Although this method is very simple to calculate and the information can be easily gathered, it does not take into consideration the additional returns that a project might generate after it reaches its payback. If a company compared two projects and both had the same payback period of two years, how would they choose? Payback period alone will not help because the payback model ignores how much benefit the company gets from the project beyond the payback of the initial investment.
In addition, the traditional payback period model does not take into consideration the time value of money. This means that the cash inflows received in future months are not discounted so the payback period is actually underestimated.
Internal Rate of Return
The internal rate of return (IRR) evaluates potential projects as if they were financial investments. Think of each project like investing in a stock or bond fund. Investors would probably want to place their investment in the fund that provides the highest rate of return.
IRR calculates the rate of return for a project. Keep in mind that when choosing a stock or bond fund, the investor also considers the riskiness of the investment to ensure that taking on a higher level of risk is associated with a higher rate of return. This approach recognizes the time value of money by capturing both the duration of the investment return and the return rate.
IRR is difficult to calculate manually. The rate that is identified by IRR is the rate of return, which makes the cost of the project equal to the future cash flows of the project.
Net Present Value
Net present value (NPV) is a financial measure of the total future benefits of a project minus the costs of the project. If the future benefits (revenue, income, savings) are greater than the costs of the project, NPV is positive. If the costs of the project outweigh the future benefits, NPV will be negative. So overall, negative NPV is bad, positive NPV is good, and projects with higher NPV have greater benefits to companies.
Future Net Cash Flows
NPV uses the concept of future net cash flows, which means that in order to evaluate a project, you need to know the costs (cash outflows) and benefits (cash inflows) for the entire working life of the project outcome. So if a company is evaluating a project to replace a current packaging machine, it will need to estimate the cost of installing the machine (the project cost), the cost of maintaining the machine, and the benefits (operational savings derived) for its operating life.
