This recent series of posts has to do with the Integration Management Knowledge Area. The purpose of this post is to discuss in more detail the process of presenting the business case for a project and how project selection criteria are used. I am doing this because a) these criteria are not in the PMBOK® Guide, but may be referred to in questions on the PMP certification exam, and b) the importance of these criteria on the project during the lifetime of the project cannot be understated.
A. The Business Case for a Project
I have dealt with the Project Statement of Work (SOW) in a previous post. It is an input to the process 4.1 Develop Project Charter, and it contains the following three elements.
a) Business need for the project—is the project being launched in response to a perceived market demand, as a response to new government regulations, or to take advantage of the availability of new materials and/or technologies? Why is the project being launched?
b) Product scope description—characteristics of the product or service being created. What will the project create?
c) Strategic plan—documentation of the organization’s strategic goals. How will the organization profit from doing the project?
The business case is another input into the process 4.1 Develop Product Charter. It is an analysis that that ties together the three elements of the Project Statement of Work together. It takes the product scope description and shows how the product fits a business need and, with a cost-benefit analysis, shows how the product fits into the organization’s strategic plan.
The business need is simply an identification of which of the business needs mentioned above explains why the project is being launched in the first place. To do the cost-benefit analysis, product selection criteria are sometimes used. From the PMP exam prep books I have read, you will not have to calculate any of these numbers dealt with in the criteria, but you have to understand their significance, both in terms of the initial selection of the project and their subsequent significance for the rest of the project.
B. Product Selection Criteria—Benefit measurement methods (comparative approach)
In general there are two categories of project selection: 1) Benefit measurement methods (comparative approach) and 2) Constrained optimization methods (mathematical approach).
Here is a table explaining the various product selection criteria under the category Benefit measurement methods
and how they are used to select a project.
|
Criteria |
Explanation |
How used |
|
| 1. | Cost benefit analysis | a) Potential benefit of project divided by B) Expected Expected cost of project NOTE: Although it is called “cost benefit analysis”, it is usually measured in terms of a benefit cost ratio, meaning the benefits (= revenues) divided by the costs. So a benefit cost ratio of 1.5 means the revenue is 1.5 times the costs. |
The higher the benefit cost ratio, the better. Example: Project A has benefit cost ratio of 1.5, Project B has benefit cost ratio of 1.7, Project C has benefit cost ratio of 1.9. Which do you select? Answer: C, because it is the highest.
|
| 2. | Internal rate of return (IRR) | The “interest rate” at which the project revenues and project costs are equal. | The higher the internal rate of return or IRR, the better. Example: Project A’s IRR is 15%, Project B’s IRR is 25%, and Project C’s IRR is 20%. Which do you select? Answer: B, because it is the highest.
|
| 3. | Payback period | The length of time is takes for the organization to start profiting from its investment. | The shorter the payback period the better. Example: Project A’s payback period is four months, Project B’s is six months, and Project C’s is 12 months. Which do you select? Answer: A, because it is the shortest.
|
| 4. | Present Value (PV) and Net Present Value (NPV) | Present Value is the value today of the future cash flows from a project and is calculated by PV = FV/(1 + r)n, where FV is the future value of the investment, r is the interest rate, and n is the number of time periods (for example, years in the case of an annual interest rate). Net Present Value takes the present value of all the revenues and subtracts the present value of all the costs. |
The higher the NPV, the better. NOTE: It doesn’t matter how long the investment is for, present “present value” takes the amount of time involved in the investment into account. Example: Project A has an NPV of $40,000 and takes 6 years, Project B has an NPV of $30,000 and takes 4 years, and Project C has an NPV of $20,000 and takes 2 years. Which do you select? Answer: A, because the NPV is highest (the number of years is irrelevant). |
C. Product Selection Criteria—Other terms to know
Here are some additional terms dealing with product selection criteria:
|
Term |
Meaning |
NOTES |
|
| 1. | Depreciation | Large assets lose value over time and the amount of this lost value is depreciation.
|
There are two types of depreciation: a. Straight line depreciation: 100, 90, 80, … b. Accelerated depreciation: 100, 80, 50, … |
| 2. | Economic Value Added | Will the project return more value to the company than the costs to do the project?
|
|
| 3. | Law of Diminishing Returns | After a certain point, adding more inputs or resources will not produce a proportional increase in outputs or productivity.
|
If 3 people do the work in 9 days, doubling the number of people may not complete the work in 4.5 days, but will actually take more time than that. |
| 4. | Opportunity Cost | The cost of the project NOT selected. | If Project A costs $100,000, and Project B costs $200,000, the opportunity cost of selecting Project B is $100,000 (the cost of Project A, the one NOT selected).
|
| 5. | Sunk Costs | Costs already expended on a project. | The important point is that if a project has already spent a certain amount on a project, even if that amount already exceeds the budget, you don’t consider this amount in your decision to continue with the project or not because it is a sunk cost.
|
| 6. |
Working capital |
How much money the company has to invest, including in projects. |
D. Product Selection Criteria—Constrained optimization methods (mathematical approach)
Now there is another category of project selection criteria of constrained optimization methods, such as linear, integer, dynamic, and multi-objective programming. Note the word they have in common, which is “programming”, which means they are usually done on a computer. For this reason, they are too complicated to ask questions about so you will probably not get questions on the exam involving them. Just recognize they are from a different category of methods (the mathematical approach) than the questions you might get asked about on the exam, those from the comparative approach. Even these do not require calculation on the exam, but they will ask you questions that give you one of the four methods, state the value of two or three projects, and ask you to compare these and indicate which one you would select as a project. Examples of all of these are included in the table in section B.
E. Why do we have to know this stuff?
The project selection criteria, as part of the business case, are important for the Initiating Process in getting the project green-lighted by management. But they are also important during the rest of the project because they give you a vital clue as to which constraints have priority. For example, if the payback period method was used to select the project, and the supplier tells you that there will be a delay in supplying you a critical component such that it delays the project, then you need to have this selection criterion in the back of your head. If the entire basis for the project being profitable was that it would be done in 6 months, and you now tell the sponsor it will take 12 months, it could mean that the profit is no longer profitable, or no longer as profitable as another project that was initially rejected in favor of yours.
If the project selection criterion used was a cost benefit analysis, then the costs may be the more important constraint to pay attention to. If the benefit cost ratio is 1.5, and you now must increase the cost of the project to the point that the ratio is now only 1.2, then the project will no longer be as profitable in the eyes of the organization. It could be that your project was selected over a project that had a benefit cost ratio of 1.3, and now it is more profitable than yours. So this is why it is important to understand the business case and the project selection criteria behind the selection of your project in the initiating process, because it will affect the project for its entire duration.
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