Strategic Management and Project Selection

1. MGMT 483 – Week 2 Strategic Management and Project Selection

2. Topics for today’s class • Focus on criteria and analytical tools for project selection • Project selection models and evaluation factors • Non-numeric models • Numeric models • Profitability models • Scoring models (using weightings) • Risk and uncertainty analysis • Project proposals – the procurement process Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

3. Types of companies that consider projects • Companies considering projects fall into two broad categories: • Companies looking at projects to do for others (ie. for external clients) • Companies looking at projects to do for themselves (internal projects) • Both types of company must have some kind of criteria to help them decide where to focus their efforts Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

4. Companies who do projects for external clients • Must select which projects they will bid on • Generally based on… • Their own expertise and track record • Resources they have available • Their chance of winning the bid • Preparing a bid is expensive • They do not want to waste that effort on bids where they are unlikely to be successful Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

5. Companies considering internal projects • Must decide which potential projects they will pursue (sometimes among many competing projects) • Available capital is the major constraint • Profitability is often the major criteria • Must evaluate approaches when there is more than one project that can accomplish a particular business goal Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

6. Criteria for project selection • Each project has different risks, benefits and costs – often much uncertainty • Companies need to be able to evaluate and select those projects that most closely fit the firm’s strategic objectives – always done in the context of competing for limited resources • Project selection models are used • Models abstract the relevant issues about a problem from the mass of detail in which the problem is embedded • Models help to make rational decisions Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

7. Two basic types of project selection model • Numeric • Use financial metrics such as cash flow, profit etc • Non-numeric • Do not use numbers as inputs into the model, but other data or considerations • The tendency to rely solely on numeric profitability models can be a serious mistake • If the estimated level of goal achievement is sufficiently large, the project is selected Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

8. Project evaluation factors • Table 2-1 on page 44 • Production factors • Marketing factors • Financial factors • Personnel factors • Administrative and Miscellaneous factors Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

9. Non-numeric models • The Sacred Cow (the boss wants to do it) • The operating necessity (the basement is flooded) • The competitive necessity (we will lose sales if we don’t change) • The product line extension (will it fit?) • Comparative benefit model (how does it look in the context of other projects) Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

10. Numeric Models • Models that return a numeric value for a project that can be easily compared with other projects • Two major categories of numeric models: • Profit/profitability • Scoring Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

11. Profit/Profitability Models • Models that look at costs and revenues – there are several models, we will look at two in a bit more detail • Payback period (PB) • Discounted cash flow (NPV) Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

12. Payback Period Example Problem 1, page 85 The Payback Period = the length of time until the original investment has been recouped by the project The lower the payback period the better – exposure / risk to the firm is minimized Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

13. Payback Period Drawbacks • Does not consider time value of money • More difficult to use when cash flows change over time • Less meaningful over longer periods of time (due to time value of money) • It ignores any cash flows beyond the payback period • However, it is relatively simple to calculate and understand Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

14. Discounted Cash Flow (NPV) • The current worth of a stream of future cash inflows and outflows in today’s dollars, given a specified rate of return (the discount rate) • Widely used to evaluate projects • Includes the time value of money (the value of money figuring in a given amount of interest for a given period of time) • Includes all inflows and outflows, not just the ones through to the payback point Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

15. Discounted Cash Flow (NPV)Continued • Requires a percentage to use to reduce future cash flows – the discount rate • The discount rate may also be know as a hurdle rate or cutoff rate • There will usually be one overall discount rate that is used as the standard for a company (set internally and used to evaluate all projects) • Cash flows are likely to vary over the life of a project Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

16. Calculating project NPV A0 Initial cash investment Ft The cash flow in time period t (negative for outflows) k The discount rate t The number of years of life • A higher NPV is better • The higher the discount rate, the lower the NPV Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

17. NPV Example • Initial investment of $100,000 with a net cash inflow of $25,000 per year for 8 years, a required rate of return of 15%, and an inflation rate of 3% per year, we have: The present value of the inflows is greater than the present value of the outflow – the NPV is positive. Therefore the project is acceptable. Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

18. PsychoCeramic Sciences Inc example on page 48 • Read through this and note the examples • Then do Problem 3 on page 85 Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

19. Advantages of Profitability Models in general • The undiscounted models (such as Paybabck Period) are easy to use and understand • Based on readily available accounting data and forecasts • Familiar and well understood by business decision makers • Can give a go/no-go indication, because they are based on “absolute” inputs • Some models can an be modified to include risk Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

20. Disadvantages of Profitability Models in general • They ignore non-monetary factors except risk • Some ignore time value of money • Discounting models are biased to the short-term because they reduce cash flows to present value • Payback models ignore cash flow after payback • They rely on accurate estimations of cash flow (which can be difficult) • They cannot deal with a lot of the complexity of the modern firm – reliance on financial data only Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

21. Numerical models: Scoring Models • Scoring models attempt to overcome some of the disadvantages of probability models by incorporating additional decision criteria • Two broad categories of scoring models • Unweighted factor model • Weighted factor model Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

22. Unweighted (0-1) Factor Model • Uses a set of relevant factors as determined by management • Each factor is weighted the same • Less important factors are weighted the same as important ones • Easy to compute - just total or average the scores • The major disadvantage is that the model assumes that all factors are equally important Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

23. Unweighted(0-1) Factor Model Example Figure 2-2 Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

24. Weighted Factor Scoring Model • When numeric weights reflecting the relative importance of each individual factor are added ,we have a weighted factor scoring model • Weighting allows important factors to stand out • A good way to include non-numeric data in the analysis • Factors need to sum to one • All weights must be set up so higher values mean more desirable • Small differences in totals are not meaningful Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

25. Gettin’ Wheels – example on page 55 • Read through this and note the examples • Then do Problem 9 on page 85 Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

26. Weighted Factor Scoring Model Example Figure B Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

27. Advantages of the scoring model • They allow multiple criteria to be used for evaluation • Weighted models recognize that some criteria are more important than others • Structurally simple and relatively easy to understand • They are a direct reflection of management policy • Easily altered to accommodate change in management policy or priorities • They allow for sensitivity analysis, because trade-off between factors is easily observable Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

28. Disadvantages of the scoring model • Ease of use can lead to the inclusion of too many criteria • The output of a scoring model is strictly a relative measure rather than an absolute go/no go indication • Unweighted scoring models assume all criteria are of equal importance – this is seldom the case Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

29. Analysis Under Uncertainty—The Management of Risk • Everything to do with projects is risky • Some projects, like R&D, are more risky than others, like construction • Risks include… • The timing of the project and its associated cash flow • Risk regarding the outcome of the project • Risk about the side effects • Risk can be assessed by a number of methods, including simulation Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

30. Distinguishing between risk and uncertainty • Risk applies to events that have a known (or estimated) probability of occurrence. • Uncertainty applies to events where there is insufficient data to estimate the probability of occurrence. • For effective project management, decisions should be treated as risks rather than uncertainties. Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

31. Project proposals - procurement • The project proposal is the document that contains the information needed to evaluate and score a project proposal • From the point of view of the bidder preparing proposals is substantial work • Which proposals should we bid on? • What resources should be spent on writing the proposal? • What should be bid price be? What is the bid strategy? Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

32. Types of project calls • Large organizations put out bids for projects • RFP (request for proposal) • RFI (request for information) • RFQ (request for quotation) • Electronic tendering / procurement • In Canada, public sector work is put out to bid via Merx and / or via online sites such as BC Bid • Firms respond to the competitive process with project proposals Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

33. Typical format and sections of a project proposal document • The technical approach A general description of the problem to be solved or the project to be undertaken • The general proposed approach / solution • The implementation plan • Estimates of the time required, materials and other resources to be used, aggregate costings • Gantt charts, network diagrams etc to show project timeline and milestones Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

34. Typical format of a project proposal (cont’d) • The plan for logistic support and administration • A description of the ability of the proposer to supply the routine facilities, equipment and skills needed • How subcontractors will be dealt with • Nature and timing of project reports and deliverables • Past experience of the proposer • A list of key project personnel and their experience and credentials (usually full CVs) Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.