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Two Important Considerations
Project selection is usually based on several decision-making points, such as the project's potential for profitability and its life-cycle cost. As the inflow of funds is usually limited, project selection is critical. Another key decision making point that is usually left out is the level of risk. During the project selection process, risk management needs to be conducted. Let's look at an example to understand the importance of risk management during the process of project selection.
Suppose you are implementing a project that increases a manufacturing plant’s capacity. The project involves installing new equipment and building workforce capacity. After months of careful project execution and risk management, you close the project successfully. This is when theoretically the project should provide value to the project sponsor. However, what if, during project selection, the stakeholders did not consider the risk of low demand for the manufactured product? The extra plant capacity provided by the new project would be an absolute waste. The money spent on the new project could have been used on another project that would have given greater returns. Therefore, it is imperative to conduct Risk Management and Project Selection simultaneously.
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Measuring Benefits Vs. Mathematical Models
Two commonly used project selection techniques are benefit measurement models and mathematical models. In the workplace, benefit measurement models are often conducted, including cost-benefit analysis, weighted scoring models, cash flow analysis, and time value of money.
Cost-benefit analysis: Provides you with a net gain. To compute the net gain during project selection, subtract the benefit value from the cost. When using this method, make sure you calculate the total cost, include Life Cycle Costs and Cost of Quality. Typically, the net gain is proportional to the risk level, i.e. the higher the risk, the higher the gain. Therefore, risk management and project selection should factor in the ultimate decision.
Weighted scoring model: Each project is evaluated based on set criteria. For example, suppose the project decision factors are profit potential, marketability, life-cycle cost, cost of quality, and risk of incompletion. Each project is then evaluated based on those criteria. The profit potential can be deduced from the cost-benefit analysis. Risk of incompletion is a factor that needs to be considered when comparing projects. Use this weighted scoring model for risk management and project selection to help you select a project.
Cash flow analysis: Takes into account the payback period. For example, if you’ve invested $400,000 and you have cash flows as follows:
- Year 0: ($400,000)
- Year 1: $40,000
- Year 2: $ 3,600,000
- Year 3: $350,000
Therefore, the payback period is two years ($400,000 - $40,000 - $360,000 = $0). If the payback for another project, which requires a $400,000 investment, is one year and all factors are considered the same, then the latter project is a better selection. However, that is too simplistic of a scenario. Usually, there are several other factors that need to be considered. For example, if Project 1 has a lower risk of incompletion than Project 2, then your decision might sway in favor of Project 1. Risk management and project selection need to be considered.
Time value of money: Uses Net Present Value (NPV) and Internal Rate of Return (IRR). Generally, the higher the NPV, the better the project is. Using this as the sole criterion for choosing a project is not advisable as this method does not account for risk.
PMP Exam Tip: Mathematical models are used for extremely complex projects. This technique is not often used nor is it often asked in the PMP exam. Benefit measurement models often show up in the PMP exam.
Generally, people perceive risk with a negative connotation. There are positive risks in every project and you should know how to respond to them. Risk Management and Project Selection should also account for positive risks. Another risk-related criterion you can use for risk management and project selection is expected monetary value by using Decision trees. The article about computing EMV with decision trees contains an effective example.