Explanation Organizations identify many potential projects as part of their strategic planning processes, but the list of most beneficial potential projects needs to be created. Selecting projects is not an exact science, but it is a critical part of project management. You can choose from several methods for selecting possible projects. Four common methods are:
· Focusing on broad organizational needs
· Categorizing IT projects
· Performing analyses of the NPV or other financial aspects
· Using a weighted scoring model
In practice, organizations use a combination of these approaches to select projects. Each approach offers several advantages and disadvantages, and management can decide the best approach for selecting projects.
Focusing on broad organizational needs
Senior managers must focus on meeting their organization’s needs when deciding the projects to undertake and their time span. Projects meeting the overall organizational needs are likely to be successful. However, it is often difficult to correlate many IT projects with organizational needs. For example, it is often impossible to estimate the financial value of such projects, although managers might be able to indicate such projects do have a high value.
A method for selecting projects based on broad organizational needs is to determine whether the projects meet three important criteria: need, funding, and will. For example, many visionary CEOs can highlight the need for their organization to improve communication. Although it might not be clear how this improvement will be brought about, funds might be allocated to projects that address
this need. Another example is that of a project for developing strong IT infrastructure, providing all employees, customers, and suppliers with the hardware and software they need to access information.
As projects progress, the organization must reevaluate the need, funding, and will for each project to decide if it should be continued, redefined, or terminated.
Categorizing IT projects
Another method of selecting projects is based on various categorizations. One type of categorization assesses whether projects provide a response to a problem, an opportunity, or a directive:
· Problems are undesirable situations that prevent an organization from achieving its goals.
Problems might be current or anticipated. For example, users of an information system might face problems logging on to the system or accessing information because the system has reached its capacity. To solve this problem, the company can initiate a project to enhance the current system by adding more access lines or upgrading the processor, memory, and storage space that are part of the hardware.
· Opportunities are circumstances that help an organization to improve. For example, a
company might believe that it can enhance sales by selling products directly to customers over the Internet. The company can initiate a project to enable direct product sales from its Web site.
· Directives are new requirements imposed by management, government, or an external body.
For example, an organization might want all its vendors to use a form of electronic data interchange (EDI) for all business transactions. The organization initiates a project to implement this form of EDI.
Organizations select projects for many reasons. Projects that address problems or directives are approved and funded readily because organizations must carry out these categories of projects to prevent any negative impact on their business. Most problems and directives must be resolved quickly, but managers must also take a holistic view and seek opportunities for improving the organization by carrying out IT projects.
Another categorization for IT projects is according to the time required to complete them or the end date of the project. For example, some projects must strictly be completed within a specific time line, after which they lose their viability. Some projects can be completed quickly—within a few weeks, days, or even minutes. Many organizations have a help desk function that handles small projects with a short life span. While many IT projects can be completed quickly, it is important to prioritize them.
A third categorization for project selection is according to its overall priority. Many organizations assign the high, medium, or low priority to IT projects. The high-priority projects must always be completed first, even if a low or medium priority project can be finished in less time. Usually, more potential IT projects are available than an organization can undertake at any point in time, so it is important to work on the most crucial ones first.
Net present value analysis, return on investment, and payback analysis
Financial considerations are an important concern in the project selection process. The three primary methods for determining the projected financial value of projects are net present value (NPV) analysis, return on investment (ROI), and payback analysis.
NPV analysis is a method of calculating the expected net monetary gain or loss from a project by discounting all expected future cash inflow (income) and outflow (payments, negative values). Only projects with a positive NPV should be considered if financial value is a key criterion for project selection. This is because a positive NPV means the return from a project exceeds the cost of capital
—the return available by investing the capital elsewhere. Projects with high NPVs are preferred to projects with low NPVs, if all other parameters are constant. Exhibit 3-2 illustrates this concept for two different projects.
Exhibit 3-2: Examples of NPV
Note that the sum of the cash flow, $5,000, is the same for both projects. The NPV differs because it accounts for the time value of money. Money earned today is worth more if the same amount is
earned in the future. Project 1 had a negative cash flow of $5,000 in the first year, but Project 2 had a negative cash flow of only $1,000 in the first year. Although both projects had the same total cash flow without discounting, the financial value of the cash flow cannot be compared. NPV analysis, therefore, is a method that involves comparing cash flows for projects running into several years.
To determine NPV:
1 Determine the cash inflow and outflow for the project. Exhibit 3-2 shows an example. Notice that the sources of cash inflow are listed as projected benefits and the sources of cash outflow are listed as projected costs for the project. The cash flow each year is calculated by
subtracting the cost from the benefits for each year.
2 Determine the discount rate. A discount rate is the minimum acceptable rate of return on an investment. It is also called the required rate of return, hurdle rate, or opportunity cost of capital. Most companies use a discount rate based on the return that the organization expects to receive for an investment from other sources of comparable risk. In Exhibit 3-2, the discount rate used is 10 percent per year.
3 Calculate NPV. There are several ways to do so. Most types of spreadsheet software use a built-in function to calculate NPV. For example, Exhibit 3-2 shows the formula that Microsoft Excel uses: =npv(discount rate, range of cash flows), where the discount rate is in cell B3 and the range of cash flows for Project 1 are in cells B8 through F8. The formula’s result yields an NPV of $2,316 for Project 1 and $3,201 for Project 2. Because both projects have positive NPVs, they are both good candidates for selection. However, since Project 2 has a higher NPV than Project 1, an organization would prefer Project 2 over Project 1.
The mathematical formula for calculating NPV is:
NPV = ?t=1…n A/(1+r)t
where t equals the year of the cash flows, A is the amount of cash flow each year, and r is the discount rate. A simpler way to use this formula is to first determine the annual discount rate and then apply it to the cost and benefits for each year. Calculate NPV by determining the total discounted benefits and adding the discounted cost, assuming the cost is entered as a negative number. Exhibit 3-3 and Exhibit 3-4 illustrate this method of calculating NPV. Recall that the discount rate in this example is 10 percent or 0.10. You can calculate a discount factor—a multiplier for each year based on the discount rate and year—for each year as follows:
Year 1: discount factor = 1/(1+0.10)1 = .91 Year 2: discount factor = 1/(1+0.10)2 = .83 Year 3: discount factor = 1/(1+0.10)3 = .75 Year 4: discount factor = 1/(1+0.10)4 = .68 Year 5: discount factor = 1/(1+.010)5 = .62
You can then calculate the discounted cost each year by multiplying the discount factor by the cost for each year. You calculate the discounted benefits in the same way. To calculate NPV, add the discounted benefits and the discounted cost, entering cost as a negative number. Notice that the NPV for Project 1 is 2,316 and that for Project 2 is 3,201 in Exhibit 3-3, and Exhibit 3-4, respectively.
Return on investment
Another important financial consideration is return on investment (ROI). ROI is calculated by dividing the income by investment. For example, if you invest $100 today and the next year, it is worth $110, your ROI is $110/100 or 0.10 or 10 %. It is best to consider discounted income and investment for multi-year projects when calculating ROI. You calculate the ROI for Project 1 as follows:
ROI = (total discounted benefits - total discounted costs)/total discounted costs
ROI = (9,747 – 7,427) / 7,427 = 31%
A high ROI value is best for an organization. Because the ROI for Project 2 is 42 percent, an organization will prefer this project over Project 1.
Many organizations have a required rate of return for projects. The required rate of return is the minimum acceptable rate of return on an investment, and it is based on the return that the organization expects to receive by investing in other sources of comparable risk.
Payback analysis
Payback analysis is another important financial tool that organizations use when selecting projects.
Payback period is the amount of time it will take to recoup, in the form of net cash inflows, the net dollars invested in a project. In other words, payback analysis determines how much time will lapse before accrued benefits exceed accrued and continuing costs. Payback occurs when the cumulative discounted benefits and costs are greater than zero. Exhibit 3-3 and Exhibit 3-4 show how to calculate the payback period, NPV, and ROI. For Project 1, payback occurs in year 5 (see Exhibit 3-3), and for Project 2, it occurs in year 3 (see Exhibit 3-4). Project 2, therefore, has a better payback period because the period is shorter.
Many organizations follow specific recommendations for the length of an investment’s payback period. They might require all IT projects to be planned for a payback period of less than three or even two years, regardless of the estimated NPV or ROI.
To aid in project selection, it is important for project managers to understand their organizations’
financial expectations from projects. It is also important for senior managers to understand the limitations of financial estimates, particularly for IT projects. For example, it is difficult to develop good estimates of projected costs and benefits for IT projects.
Exhibit 3-3: NPV, ROI, and payback analysis for Project 1
Exhibit 3-4: NPV, ROI, and payback analysis for Project 2
Weighted scoring model
A weighted scoring model is a tool that provides a systematic process for selecting projects based on several criteria. These criteria can include factors, such as the organizational needs; the problems, opportunities, or directives for the organization; the amount of time it will take to complete the project; and the project’s overall priority and the projected financial performance.
The first step in creating a weighted scoring model is to identify the criteria important for the project selection process. This is a critical activity that is performed by holding facilitated brainstorming sessions or using groupware to exchange ideas. Some possible criteria for IT projects include:
· Support for key business objectives
· A strong internal sponsor
· Strong customer support
· A realistic level of technology
· Ability to be implemented in one year or less
· A positive NPV
· Low risk in meeting scope, time, and cost goals
After you define the criteria, you need to assign a weight to each criterion. These weights indicate how important each criterion is. You can assign weights based on percentages. The total of these weights must be 100 percent. You then assign numerical scores to each criterion (for example, 0 to 100) for each project. The scores indicate to what extent each project meets each criterion. At this point, you can use a spreadsheet application to create a matrix of projects, criteria, weights, and scores.
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