Chapter 2: Project Initiation, Selection, and Planning

Chapter 2: Project Initiation, Selection, and Planning

As indicated in the first chapter, projects generally have four phases: initiation and selection, planning, scheduling and control, and implementation (including termination and evaluation). These phases frequently overlap and, in fact, more accurately exist along the continuum indicated in Figure 1.1. This chapter focuses on the first two phases, project initiation and selection, and project planning, in more detail. These two phases are critical parts of project management since they directly address the issues of “doing the right things, and doing them right.”

With respect to the project initiation and selection, we discuss

• How to initiate new projects
• Methods for evaluating project proposals
• Project selection as a portfolio problem
• Why project managers should have an “options” mind-set

Once an organization has started to seriously consider a new project, the proposal moves into the planning phase, during which managers further define the project specifications, user requirements, and organizational constraints. A primary goal of the project planning effort is to define the individual work packages or tasks that constitute the project. This is usually accomplished by developing a work breakdown structure (WBS) that defines specific work packages (tasks) as well as estimates of their costs and durations. This chapter will also cover the impact of learning, uncertainty, and risk, as well as numerous factors on the duration and cost estimation process.

As an organization continues the planning process, managers must design a detailed time and resource plan. Specifically, the project’s baseline schedule and budget serves as a benchmark for much of the remaining project, and is frequently used to judge the ultimate success or failure of the project. Finally, we must specify the processes that will be used to monitor and control the project when it gets started. The issues of scheduling and monitoring/control are discussed in more detail in Chapters 4 and 8, respectively.

This chapter will also discuss the issue of subcontracting; specifically: How do managers decide which part(s) of a project should be subcontracted? How many subcontractors should be used? What is the role of a subcontractor in the planning phase? And what trade-offs do managers have to make when considering the possible use of subcontractors?

This chapter concludes with a case study, Christopher Columbus, Inc. This case deals with the relationship between goal definition and resource requirements, and illustrates how a project plan should be used to develop a proposal and bid in response to an RFP (request for proposal).

Project Initiation and Selection

Project definition and selection are arguably the most important decisions faced by an organization. As noted by Cooper et al. (2000), an organization can succeed only by “doing projects right, and doing the right projects.” An organization must have a project portfolio that is consistent with the overall goals and strategy of the organization while providing desired diversification, maintaining adequate cash flows, and not exceeding resource constraints. Managers should focus not only on the overall set of projects and the dynamic evolution of this portfolio over time (i.e., which projects are added, which are terminated, etc.) but also on the relationships between these projects—not on individual projects.

Projects are initiated to realize process, program, or organizational improvements that will improve existing conditions and exploit new opportunities. Many organizations use a project initiation form or other internal process to encourage workers to propose new projects that can benefit the organization. Some projects result from critical factors or competitive necessity (for example, the development of a Web site for customers and/or investors or other projects resulting from technological changes). Other projects may be initiated to maintain or expand market share. In many cases, customers or suppliers dictate new products or processes.

In general, projects can be initiated in a top-down (e.g., the boss wants it) or bottom-up (e.g., workers see the need) fashion. For any proposed project, however, the following information may be requested from those who have suggested the project. While this list is not intended to be comprehensive, it does represent a compilation the author has observed at numerous successful companies. Some project initiation forms use a check-sheet (e.g., a list of yes or no questions), while others simply request information on the following topics:

• Project name
• Proposed project manager, division or department
• Brief problem description that the project will address
• Benefits of the project
• Estimated time and cost of project
• Whether subcontractors will be used or work will be done by in-house personnel
• Impact on workforce safety
• Impact on energy requirements
• Impact on customers

The accompanying cartoon provides an example of project selection from the top down.

[insert Dilbert cartoon]

If managers decide to consider a project further, numerous numerical metrics are frequently used, including the payback period and net present value (NPV)/discounted cash flow (DCF). Alternatively, some organizations use a scoring or ranking approach whereby each proposal is rated over some range based on a series of questions. Typically, these ranking approaches include questions addressing qualitative factors as well as quantifiable factors (e.g., what is the proposed project’s relationship with the organization’s overall mission and strategic goals?).

These measures are useful for evaluating the potential value and profitability of a project and are therefore usually used in the earlier stages of the project selection and planning process. The numerical measures described in the following section represent some of the most commonly used metrics. All of these measures are dependent on accurate forecasts of future cash flows; as the quality of these forecasts is reduced, so is the usefulness of these measures.

Numerical Measures

Numerical measures are frequently used to assist with project selection. While these measures are often criticized (for example, they are based on forecasted values that are subject to great uncertainty), they can provide a better understanding of the explicit costs and benefits of any proposed project. Most organizations use these measures in conjunction with other judgments to validate their decisions to undertake or not undertake a proposed project.

Payback Period

Payback period is the number of time periods (e.g., years) needed to recover the cost of the project. For example, assume that a bank can install a new ATM at a cost of $90,000; with this new ATM, the bank can reduce its number of bank tellers by one. Assuming that bank tellers are paid approximately $30,000 per year, the payback period is defined as $90,000/$30,000 = 3 years; that is, it will take three years before the bank can recover the initial cost of ATM. In general, the payback period is defined as:

We can extend this measure by considering the operating costs of the ATM, which were estimated at $4,000/year. The annual savings realized by the bank then becomes $30,000 – $4,000 = $26,000, resulting in a payback period approximately equal to 3.5 years.

The payback period measure suffers from numerous shortcomings. It ignores the time value of money including interest rates and inflation. To illustrate the limitations of this measure, consider the following two projects A and B:

Project A: Cost = $75,000Return: $25,000 for 4 years

Project B: Cost = $75,000Return: $15,000 for 8 years

The payback period for Project A is ($75,000/$25,000) = 3 years; the payback period for Project B is ($75,000/$15,000) = 5 years. Based on payback period, an organization might rank Project A higher than Project B, even though Project B will ultimately return $120,000; Project A will return only $100,000. Despite these limitations, payback period remains a popular measure; it is relatively easy to calculate and explain, and it may be useful for an organization that is concerned with short-run cash flows and profitability.

Net Present Value (NPV) or Discounted Cash Flow (DCF)

The discounted cash flows (DCF) over the estimated life of the project (also known as the deterministic discounted cash flow) based on the fundamental assumption that a dollar today is worth more than a dollar tomorrow. Net present value (NPV) is probably the most widely used measure that includes the time value of money.

Given an interest or discount rate (also referred to as the hurdle rate or cutoff rate), we can calculate the discounted stream of future costs and benefits. Let r denote the discount rate and Ft denote the forecasted cash flow in period t (that is, Ft represents the estimated benefits minus the costs in time period t), then the NPV or DCF of a project is defined as:

where T denotes the estimated life of the project. For example, consider a project that has an expected life of 6 years. If we assume that the annual discount rate, r, is equal to 20 percent and we will incur an estimated cost of $750 in the first year, then the discounted cash flow in the first year (t = 1) is:

Given the forecasted costs and benefits for all six years, the calculations to find the NPV are indicated in Figure 2.1. Year 0 represents the present time; note that net benefits of this proposed project are not positive until year 2, when the project starts to generate revenues and the costs associated with the project have decreased to $550.

[insert Figure 2.1 about here. NPV Calculations Illustrated]

Summing the discounted values in the last column, we find that the NPV is equal to $2,912. Since the NPV is positive, we would consider this project although there are many reasons why an organization might consider a project with a negative NPV (e.g., to open up a new market or to block a competitor) or reject a project with a positive NPV. When managers are considering multiple projects, they can use NPV to rank alternative proposals.

While NPV has fewer limitations than the payback period measure, it has also been widely criticized (Faulkner, 1996; Cooper et al., 2000; Hodder and Riggs, 1985). First, it ignores the risk of a project (or uncertainty that is treated as risk) since our calculations assume that the forecasted cash flows are known with certainty. A related problem is caused by the human bias that is part of the estimation process (or, as one manager stated, “What numbers do you want to see?”). A second problem is the failure to explicitly consider the effects of inflation when estimating the discount rate r, especially in long-term projects. Third, NPV ignores interactions with other projects and programs in the organization since it treats each project proposal individually. This is an important point; NPV may not be an effective measure when an organization is considering a portfolio of projects that compete for the same resources. For example, a project with the small positive NPV that uses slack resources might be more attractive than a project with a larger NPV that requires new facilities or workers. For this reason, organizations must be concerned about their portfolio of projects as opposed to a single project. A fourth criticism is a result of the assumption that a single discount rate is used for the entire project. As a project evolves over time, the risk of the project is likely to be reduced and, accordingly, the discount rate as well. The following sections include a discussion of some of these criticisms further and show ways that they can be mitigated.

Internal Rate of Return (IRR)

Internal rate of return (IRR) is the discount rate that results in an NPV equal to zero. Given the uncertainties associated with estimating the discount rate and future cash flows, the IRR simply finds the value of r that results in an NPV equal to zero. Generally, those projects with a larger IRR are ranked higher than those with a lower IRR. In addition, the IRR is usually compared to the cost of capital for an organization; that is, under most conditions, a project should promise a higher return than the organization has to pay for the capital needed to fund the project.

The IRR measure suffers from many of the same limitations of the NPV: It assumes forecasted cash flows are reasonably accurate and certain, it is subject to the same estimation bias that plagues the forecasts needed to compute the NPV measure, etc. An additional problem with this approach is that often there is not a single value of r that satisfies the equation NPV = 0.

For example, assume that a project is expected to take 2 years (that is, T = 2). Finding the IRR requires solving the quadratic equation:

Assume that the proposed project will require an initial outlay of $100 but will return $40 (benefits minus costs) at the end of the first year and $75 in net benefits at the end of the second year. Finding the IRR requires solving the following equation for r:

which becomes:

Solving this quadratic equation, we find that r can equal either 0.089 or –1.689 (both values set NPV equal to zero). While we can ignore the negative value of r in this case and assume that the IRR is equal to 8.9 percent, it becomes more difficult when there are many time periods that may result in multiple positive values of r. When this occurs, it is unclear how these multiple values should be interpreted or which value of r should be adopted.

Expected Commercial Value (ECV)

Expected commercial value (ECV) is the expected NPV of the project, adjusted by the probabilities of various alternatives. ECV-type measures extend the concept of net present value (NPV) to explicitly consider the fact that most projects consist of multiple stages (e.g., design, marketing, testing, and implementation). For example, consider a proposed new product development project with two alternative design options. ECV explicitly considers the probabilities that various outcomes will occur as a result of the design option that is selected, and it uses these probabilities to compute an expected NPV. ECV also allows managers to use different hurdle or discount rates at different stages of the project—thereby responding to one of the criticisms directed at the use of NPV/DCF. For these reasons, ECV-type measures are gaining increasing visibility and use.

ECV is based on the concept of a decision tree that is a logical framework for evaluating sequential decisions and outcomes. Such a decision tree is illustrated in Figure 2.2. The “root” of this decision tree begins with a decision maker selecting one of two alternatives (A1 or A2). If the decision maker selects alternative A1, then three outcomes or states of nature are possible (S1, S2, or S3) with probabilities (p1, p2, or p3), respectively. If the decision maker selects alternative A2, then three other outcomes or states of nature are possible (S4, S5, or S6) with probabilities (p4, p5, or p6), respectively. As indicated in Figure 2.2, the square represents a decision point, and the ovals represent alternatives available to the decision maker. This example can easily be extended to multiple stages; at any outcome (Si), another decision node can be added that represents additional alternatives, outcomes, etc.

[insert Figure 2.2: Decision Tree Example about here]

To evaluate the decision tree in Figure 2.2, first consider selecting alternative A1. If A1 is selected, the expected outcome is (S1)(p1) + (S2)(p2) + (S3)(p3); if alternative A2 is selected, then the expected outcome is (S4)(p4) + (S5)(p5) + (S6)(p6). Working backward, the expected payoff can then be found for each alternative by subtracting the cost of each alternative from its respective expected outcome. If ci denotes the cost of alternative i (i = 1, 2), then the expected value of each alternative is:

Expected value of alternative 1: (S1)(p1) + (S2)(p2) + (S3)(p3) – c1

Expected value of alternative 2: (S4)(p4) + (S5)(p5) + (S6)(p6) – c2

Typically, the values of the outcomes, Si, are the discounted cash flows or NPV resulting from the given alternative and resultant outcome or state of nature. The estimated commercial value (ECV) of the project is the value of the alternative with the largest expected value.

To illustrate these concepts further, consider the case of an opera company trying to decide which opera to select for the opening performance of its season. For each opera, the company managers have estimated the possible demands (high, medium, low) and their respective revenues and probabilities. Assuming two possible choices (Rigoletto or Falstaff), the decision tree faced by the opera company is given in Figure 2.3.

[insert Figure 2.3: Opera Decision Tree Example about here]

If the opera company selects Rigoletto, its expected revenues would be $148,000 (.5 × $200K + .3 × $120K + .2 × $60K). If the company selects Falstaff, its expected revenues would be $128,000 (.4 × $220K + .2 × $150K + .4 × $25K). Assuming that Rigoletto would cost an estimated $75,000 to perform (cast, set, director, etc.), the opera company would realize an estimated gross profit of $148,000 – $75,000 = $73,000. If it selects Falstaff (assuming it would cost approximately $50,000 to produce), the company’s estimated gross profit would be $128,000 – $50,000 = $78,000. Thus, based on expected revenues only, the opera company could expect make an additional $5,000 if it selects Falstaff to open the season (although there are still many good reasons why the company might select Rigoletto instead).

To illustrate an Expected Commercial Value (ECV) measure, consider the decision tree for a hypothetical product development project that is represented in Figure 2.4. In this case, there are two decision points: (1) to develop (or not develop) the product, and (2) to launch (or not launch) the product. If the product is developed, it could be a technical success (with probability pt) or technical failure (with probability 1 – pt); if it is launched, it could be a commercial success (with probability pc) or commercial failure (with probability 1 – pc). In Figure 2.4, assume that the organization does not launch the product if it is a technical failure (so that future cash flows are zero in this case). If the product is a commercial success, then all future cash flows are discounted back to the present time; these discounted cash flows are denoted by NPV.