Hello and welcome back to our PMP Series. In the previous posts, we discussed
- Project Scope Management
- Project Time Management
- Project Cost Management
- Project Quality Management
- Project Human Resource Management
- Project Communication Management
- Project Risk Management
In this article, we will explore a key area of project management: project selection criteria.
Organizations regularly face the challenge of choosing among a variety of projects. This is because various projects would compete for the same organizational resources such as time, machines, human resources, etc. it is therefore important for an organization to select the project that would give the best value to the organization.
The big challenge then is how an organization can identify the project to select from the various options. In the rest of this article, we will look at the four selection criteria that can be used for project selection.
Net present value
Internal rate of return
This is one of the most basic project selection criteria. Just as the name suggest, it takes into consideration the payback period of an investment. This is the time frame required for the return on an investment to repay the original cost invested. The payback period calculation is really simple:
Payback Period = Cost of Project / Average Annual Cash Inflows.
For example, an investment of $500 with an average annual return of $100 would have a payback period of $500 / $100 = 5 years.
When using the payback period as a project selection criterion, the project with the shortest payback period is the most preferable since it allows the organization regain the original investment faster. For example, if Sally’s Estate Agents is considering developing an apartment building for $48,000,000 with an average annual return of $3,000,000 or a shopping mall for $84,000,000 with an average annual return of $5,600,000. Calculating the payback period as described above the, investing on the apartment building would have a payback period of 16 years (48,000,000 / 3,000,000), while the shopping mall project would have a payback period of 15 years (84,000,000 / 5,600,000). It is therefore advisable for Sally’s Estate Agents to embark on the shopping mall project as it has the shorter payback period.
As you can imagine, the payback period method is too easy to be true. Well, there are a few limitations of this method of project selection. A major limitation of the payback period is that it does not consider the time value of money. It is generally believed that the future value of money is worth less than the present value as a result of deflation that occurs over the years (more details on this below).
Another limitation of the payback period is that benefits that occur after the payback period are not considered, thus focusing more on liquidity while profitability is being neglected. For example, a project with a longer payback period might be more profitable as it continues to generate income after the payback period for a longer period of time than that with a shorter payback period.
Finally, while the payback period tends to account for risk by taking the project with the earliest payback period, the risk involved in individual project is neglected. There is a probability that a project with a shorter payback period to come with higher risk, which should also be an important consideration before project selection.
Net Present Value (NPV)
According to Wikipedia, this is defined as the “difference amount” between the sum of discounted cash inflows and cash outflows. NPV compares the present value of money today to the present value of money in the future taking into consideration inflation and returns. In simple terms, how much is my same $1 today worth in the future after factoring in inflation and returns?
Although a formula has been derived for calculating NPV, we will focus on understanding the principle of the NPV and how it is applied.
When using NPV as a project selection criterion, projects with a positive NPV should be selected while those with negative NPV should be discarded.
A key advantage of using NPV over the payback period is that it takes into consideration the future value of money. This is done by using a discount rate to calculate the present value (PV) of the anticipated future income .The summation of all PV is known as the NPV. For example, Jacosa is looking at expanding its grocery store by buying a local store in Alberta for $645,000. The management of Jacosa should calculate the expected future cash flows the new store would generate, factor in inflation by discounting the future value, and sum the discounted values up to generate a lump sum present value amount. If this value is greater than $645,000, then Jacosa should invest in the project as it would give a positive NPV, but if it is less than $645,000 then Jacosa should refrain from investing.
Some of the common limitations of the NPV are discussed below. First, there is no generally accepted method of deriving the discount value used for the present value calculation. While most organization resort to using the weighted average cost of capital (WACC) after tax in calculating, others believe that this is not efficient and does not take into consideration other factors such as risk and opportunity cost; thus, using a discount rate derived from the opportunity cost (alternative project) might be a better way to derive the discount value. Some practitioners also believe that variable discount rates across the years are more effective than a fixed rate. The inability to agree on the best form of deriving the discount rate poses a great challenge because it is important to the calculation of the NPV.
Secondly, the NPV does not in any way provide a detailed picture of the profit or loss an organization can make by embarking on a project. It is therefore mostly used with the internal rate of return (IRR) (discussed below) when making project decisions.
Internal Rate of Return (IRR)
This is a capital budgeting tool used to measure the profitability of an investment. It is defined as “annualized effective compounded return rate” or “discount rate that makes the net present value of all cash flows (both positive and negative) from a particular investment equal to zero.” In other words, it is the rate (interest) at which the NPV of the negative cash flow (cost) equals that of the positive cash flow (interest).
When investigating the desirability of a project, assuming all other factors are equal among projects, an organization should select the project that has the highest IRR. While in theory organizations should undertake any project that has a positive NPV, limited organizational resources compete for the unlimited project, thus the IRR is used to select the project with the best profitability. When using the IRR, an investment is considered acceptable only when it is greater than the acceptable minimum rate of return (e.g., buying United State bonds) or the cost of capital of the investment.
In contrast with the NPV, which shows the value of an investment, the IRR is used to show the efficiency or yield of an investment. However, when using IRR for project selection, it should not be used exclusively to decide among various projects to undertake, but it should be used to determine whether a single project is worth investing in. This is because a project with a lower IRR might have a higher NPV and, assuming there is no capital constraint, the project with the higher NPV should be selected, as this increases the shareholders wealth.
Organizational Goals (Non-Financial Factors)
The payback period, NPV, and IRR discussed above are all used for analyzing the financial gains of an organization when deciding to embark on a project. However, there are other non-financial factors that an organization might consider during project selection. These factors are mostly related to the overall organizational goals.
The organizational strategy of a company is a major factor that might affect its choice of project selection. For example, a product that aims to increase its market share might embark on a sales promotion project to increase its brand awareness among consumers. While this in itself might not result in financial increase, it could increase brand awareness and the product might serve as a loss leader to other products manufactured by the same organization.
Customer service relationship (CSR) is another organizational goal that influences the choice of project being selected by an organization. The ability to build an effective relationship with the customers and the environment at large is a necessary skill in today’s business world. Organizations focusing on developing CSR might therefore select a project that best improves its relationship with the environment rather than a project that cost the least or brings the best profit
Other non financial-factors that might affect project selection include political reasons, change of management, shareholders’ requests, speculative purposes, etc.
In conclusion, this article analyzed various project selection criteria with a focus on their uses, advantages, and limitations. The payback period, NPV, and IRR are selection criteria with a focus on the financial return of an investment. However, the article recognized that there are other, non-financial factors that might influence the selection of a project and this was also discussed.
For effective project selection, no single method is the most effective, but it is important for an organization to select the criteria it would use based on the organizational goal. A combination of methods has also been known to provide a more effective result during project selection.
Although project managers are not required to be financial experts, it is important for you to know how the CFO and CEO decide which projects to invest in. Also, if you grow to become a program manager, you will have to make this project selection decisions yourself and it is important to get familiar with these concepts in project selection.
Thank you for reading. Don’t forget to drop your thoughts and questions in the comments section. In the next article, we will explore the project procurement management knowledge area. Until then, have fun studying and managing projects!
A Guide to the Project Management Body of Knowledge: PMBOK Guide. Project Management Institute.