NPV = -493000 + 1079000 = 585000
d. Given the large positive NPV, the project is worth conducting. Some of the simplifications done, such as working in calendar days rather than business days and rounding some intermediate numbers will not impact this result that the project should be done. The NPV is large enough that even errors due to these simplifications, the true NPV will also be
positive.
5. A Monte Carlo simulation can be done to show the range of possible benefits.
4.6 Discussion
Discounted cash flow/NPV analysis suffers from a major flaw. Each project is evaluated without regard to managerial flexibility. It is assumed that the entire project will be conducted exactly as planned and exactly when planned. There is no consideration of modifying the course of the project as more information is revealed or as events unfold. Simple examples of this include the ability to expand or contract the project, delay the project or even cancel based on how events unfold. NPV techniques tend to undervalue projects. The flexibility to limit losses or take advantage of opportunities increases the value of projects.
NPV/discounted cash flow techniques look at project value in terms of an absolute number. IRR reduces value to an interest rate. Payback period reduces value to a time period. All three can be combined to get an understanding of project value. They are three views into the same set of numbers.
Decision trees incorporate managerial choices, but are deficient in several aspects. First, as the number of decision points grows, they quickly become unmanageable with more
and more branches to keep track of. A second deficiency is that it necessary to estimate probabilities of possible outcomes. The trees require information such as a 0.25 chance of one cash flow and a 0.75 chance of another. At best, these probabilities are estimates. At worst, they are guesses. A third, more subtle, flaw in decision tree analysis is that typically the same discount rate is used for all branches. Whether nature is friendly and the best possible outcomes occur, for instance, the maximum cash flows are achieved or nature is against us, the same discount rate is used. This is equivalent to assuming that project risk is unchanged even though as more information is uncovered, project risk changes.
Real options are a technique where the mathematics of financial options is applied to the valuation of projects and capital asset investments. This analysis helps management decide whether there is value in delay, expansion, contraction or abandonment of the project. Real option techniques capture the value of flexibility, the value of changing the course of the project based on additional information as it progresses. One fault in real option approaches is that they only examine the project by itself. The effects of the outside world and particularly of competitors are not included.
Game theory provides means to reason about competitors and about competition in the market. It is relevant for large strategic types of projects such as entering new markets, new businesses or introducing entirely new products.
Process measures were seen as a means to quantify financial value in internal projects which ultimately allows application of the financial techniques described in this chapter to be used on both projects producing a product for sale and for internal projects.
Strengths and limitations of these approaches are listed in Table 23. The strengths and limitations listed are based on [67] [68] [69] [70].
Table 23 Strengths and Limitations of Financial Valuation Techniques
Financial Valuation
Technique
Strengths Limitations
Net Present Value Easy Calculation
Quantifies benefit of project as a single absolute number (profit).
Considers time value of money.
Considers risk (via discount rate).
Length of time not considered.
Rate of return not considered.
No accounting for managerial flexibility. No consideration of market or competitors.
Under values risky projects (by not considering flexibility)
Internal Rate of Return Easy Calculation
Considers time value of money.
Easy to understood (simple percentage)
Length of time not considered.
Risk not explicitly considered.
No accounting for managerial flexibility. Under values risky projects (by not considering flexibility).
No consideration of market or competitors.
No consideration of absolute amount.
Payback Period Consideration of time. Easy to understand.
Implicit consideration of risk (Favoring quick payback lowers risk).
Ignores revenues after payback period.
Considers only time, not absolute amount or percentages. No accounting for managerial flexibility. No consideration of market or competitors.
Real Options Considers managerial
flexibility.
Realistic valuations of risky or uncertain projects.
Complex calculations. Difficult to understand. No consideration of market or competitors.
Captures value of delaying until uncertainty is resolved. Game Theory Approaches Considers competition and
market factors.
Captures value of early entry into competitive markets.
Very difficult to fully understand markets and to predict the actions of competitors.
Only applies for strategic projects where competitors exist and matter.
The applicability of these techniques is to a large extent driven by the nature of the project. This is illustrated below in Figure 24.
Is this a large strategic project where an understanding of competitors and the market is
crucial?
Is there uncertainty about future cash flows or flexibility
to chance course based on events? Proposed Project No Use Basic Financial Measures (NPV, IRR, payback period) No
Use Game Theory Approaches
Use Real Option Analysis Yes
Yes
Chapter 5
Qualitative Approaches to the Measurement of Value
5.1 Overview
The techniques discussed in section 3.3 and Chapter 4 suffer from a common defect. They examine each project independently. Each project was evaluated as if there were unlimited access to capital and resources, as if there were no conflicts with other projects or with respect to corporate strategy and is if there was no overlap or synergy with other projects. The value of each project was evaluated independently.
There is uncertainty in quantitative measures. Costs and revenues are uncertain. How markets will develop is uncertain. Projects have multiple objectives, dependencies on other efforts and it is often unclear how to measure benefits [71]. Stakeholders value propositions and utility functions vary. Qualitative measures can compensate for a lack of confidence in financial measures such as ROI. [72]
The financial analysis techniques evaluated whether each project increased the wealth of the firm, that is, whether it had positive net present value. If it is assumed there is unlimited access to capital for projects, should all projects with positive NPV be conducted? No.
Even with unlimited capital (money), other resources are limited. There are limits on the number of available skilled employees.
Attempting to increase the number of resources available beyond some limit is difficult and probably unwise. The labor pool limits the number of potential resources. And even if the labor pool was unlimited, there are limits to the number of new resources that can be successfully integrated in a given time frame.
Suppose there is sufficient capital and other resources, should all projects with positive NPV be conducted? No.
There are possible conflicts with the goals and requirements of other projects. The techniques explored in section 3.2 looked at ways to determine and satisfy stakeholder value propositions of stakeholders of a single project. The imperfect knowledge of the stakeholders of an individual project about other efforts the firm is conducting leads to the possibility of conflicts between projects and of lost opportunity for synergy due to overlap between projects.
Even if it is assumed that an extraordinarily job was done in requirements, that all potential stakeholders have been included, that all conflicts and overlap with other projects have been uncovered and accounted for, that all capital and resources are unlimited, should all projects with positive NPV be conducted? No.
At the core, the project may be at conflict with overall corporate strategies. Microsoft could conceivably conduct profitable projects to produce crackers, sardines and toy guns. These are probably unaligned with corporate goals and strategy.
Given that a firm can’t and shouldn’t conduct every profitably project, which should be conducted, how should the success of those projects be measured and how should those projects be monitored and controlled to achieve success. Balanced score card techniques are considered in section 5.2 as a way to analyze project alignment with corporate strategy. Project portfolio techniques are considered in section 5.3 as a means of evaluating project conflicts and synergies with other projects.
5.2 Balanced Score Cards
5.2.1 Introduction
Financial measures, while critical in measuring value at the project, program and overall corporate level, cannot alone guide an organization toward its strategic goals. Financial measures have limitations. First, they tend to be backward looking or lagging. That is,
they are a measure of what has occurred, not what can be achieved or how additional value can be created. A second criticism is that there is no explicit linkage between financial measures and the corporation’s strategic goals and that there is no linkage between the financial measures and strategic goals with operational changes and with programs and projects. The balances scorecard provides a framework to map the organizations strategic goals into concrete measures and to link those measures to individual projects.
The balanced scorecard is a technique that allows modeling, measurement and understanding of financial measures to be combined with measures of value in other dimensions. It provides a concise summary of value along several dimensions. By considering value along several dimensions, certain types of sub-optimizations are avoided. A simple example is that of achieving an objective of reducing time to market. Within the software industry this could conceivably be achieved by lowering quality standards. Thus, reduced time to market could be achieved at the expense of other goals such as customer satisfaction or having a loyal customer base for future products. This can be summarized by “Even the best objective can be achieved badly” [73].
5.2.2 Traditional Balanced Scorecards
The balanced scorecard technique as developed by Kaplan and Norton [73] measures performance along four dimensions or perspectives. Measures, sometimes referred to as key performance indicators, KPIs, are developed to understand performance in each perspective:
Financial Perspective Customer Perspective
Internal Business Perspective
Innovation and Learning Perspective
The customer perspective is an external view of the organization. What do customers think about the organization; what do they value? A key point here is that source of value and its measurement is defined by the customer. It is what they value and should be determined by them, not internally. The sources of value can be identified via surveys and via feedback from external parties. Measurement of value in this perspective should also be done externally, either by the customer directly, or via a third party evaluations by government agencies or external third parties, such as industry groups or companies such as JD Powers or Gartner who specialize in producing comparative measurements of performance. Having the customer define “value” is analogous to requirements engineering techniques that look to identify all stakeholders and have them define their requirements.
The internal business perspective looks at current processes and their measures. Broadly, this perspective can be divided between processes whose aim is achieving customer satisfaction and core competencies. Core competencies for an organization might include design and manufacturing. For software organizations manufacturing competency could be seen as the ability to produce high quality, low defect software.
The innovation and learning perspective looks at measures of how well the organization expands its capabilities and those of its employees. Long term, the only way that an organization can grow is to launch new products and expand into new markets. This
perspective measures the organization’s processes that support this expansion by improving staff.
It is interesting to note that the perspectives have different temporal focuses. The financial perspective measures how well the organization has done. The customer and internal business perspectives examine the present time; how well customer needs are currently being met and how well the organization is currently functioning. The innovation and learning perspective looks forward at how the company is organizing to achieve longer term strategic goals and to expand.
The financial perspective, as stated earlier, is really a backward look at how the company has performed with respect to the bottom line. But, it serves a critical purpose. It provides a reality check on the other three perspectives. The customer, internal business and innovation and learning perspectives in some sense are hypotheses. The ultimate goal of the business is financial success; the achievement of increased value for stakeholders. The success of any initiative in the other dimensions is ultimately measured in the financial perspective. Kaplan [73] notes “the hard truth is that if improved performance fails to be reflected in the bottom line, executives should reexamine the basic assumptions of their strategy and mission. Not all long term strategies are profitable strategies”.
A key benefit of balanced scorecard approaches is that they provide a framework for explicit linking between operations and finance. The act of modeling, of creating balanced scorecards can add value as consideration is given as to how initiatives and projects in the other dimensions translate into performance in the financial perspective.
5.2.3 Linking Strategy to Measures
The relationship between measures and strategy can be seen as bidirectional. The balanced scorecard can be seen as a set of measures that indicate progress toward a strategy. Looking in the other direction, an interesting observation is that people are motivated and influenced by the measurements made. The measures themselves influence performance. Carefully selected measures can guide the organization toward completion of its strategic objectives. The taking of measurements establishes goals for individual employees and can guide performance.
The balanced scorecard displays a set of measurements. An implicit assumption is that there is a causal relationship between the measurements and successful implementation of the strategies they support. For instance, suppose a software company selling shrink wrapped software to retail customers has a strategic objective to increase profit. Assume that higher sales will increase profit. Sales can be measured in terms of number of units sold. Assume that reducing the defect rates will increase customer satisfaction and ultimately increase sales. The operational measure of defect rate is a measure supporting the strategic objective of increased sales. Defect rates can be measured in defects per thousand lines of code. Customer satisfaction can be measured (subjectively) using surveys and a numeric scale. The next question becomes how a lower defect rate can be obtained. Assume that developer education can achieve this. That is, developer education causes a lower defect rate. Developer education could be measured in hours of training per developer. The causal relationships, measurements and perspectives can be summarized as follows.
Table 24 Causal Relationships Supporting Strategic Objective of Increased Sales
Relationship Measurement Perspective
Better educated developers produce code with fewer defects
Hours of training per employee
Innovation and Learning Perspective
Fewer defects increase customer satisfaction
Customer surveys Customer perspective More satisfied customers
will purchase more software
Number of units sold Financial Perspective
Here we see three measures supporting one objective. Further analysis might indicate that a better defined software process will lead to fewer defects in code. Process can be measured via internal software quality assurance audits.
Table 25 Additional Measure Supporting Strategic Objective of Increased Sales
Relationship Measurement Perspective
Better process produces software with fewer defects
Percentage of processes followed as measured in SQA audits
Internal business perspective
The process of finding measures may lead to more strategic objectives. For instance, increased customer satisfaction might be another strategic objective. Following along the lines of the above analysis, a simple balanced scorecard can be drawn.
Financial Perspective
Strategic Objective: Increase Profit Measures: Total revenue
Total costs
Number of units sold
Business Process Perspective
Strategic Objective: Better Quality Code Measures: Defect rate (defects per KLOC)
SQA Audit results (percent compliance)
Customer Perspective
Strategic Objective: Higher customer
satisfaction
Measures: Customer surveys
Innovation and Learning Perspective
Strategic Objective: Better trained staff Measures: Training hours per employee
Figure 25 Organizational Balanced Scorecard Example
This process also shows the benefits of modeling. The process of finding causal relationships and trying to form hypothesis between operational changes (such as training) and achievement of strategic objects (which can also be called goals) lead to the discovery of more strategic objectives and iteratively leads to more measures.
Measurements, also known as indicators, can be leading or lagging. Leading indicators are indicators that show changes before the strategic objective is obtained. For instance, a lower defect rate would be seen in advance of increased customer satisfaction. Leading indicators are also called performance drivers. The act of measuring defect rate will encourage developers to test more carefully (perhaps). Leading indicators also give early feedback on the success or lack of success toward achieving strategic goals. Lagging indicators are measurements of the achievement of the strategic objective. Lagging indicators are also referred to as outcome measures. For instance, total revenue and total cost are direct measures of profit (neglecting the intricacies of accounting and tax codes). A successful balanced score card will have both leading and lagging measures.
Outcome measures without associated performance drivers do not show how the outcome will be achieved. For instance, for the outcome measure of defect rate, associated performance driving measures such as measures of staff education or measures of use of
testing tools must be established. Without them, the outcome measure may not be achieved. [74] [75].
Performance drivers not linked to outcome measures have no demonstration of value. For instance, measurements of staff education will drive line level managers to arrange training for staff. Without a causal link to an outcome measure such as higher productivity, lower defect rate or higher staff retention, the value of this training cannot be established [73] [75].
5.2.4 Balanced IT Scorecards
The example developed in the previous section described applying a traditional balanced scorecard approach to a company whose business was primarily producing software for purchase. A more common case is that of an organization that engages in a business other than software, but has internal groups dedicated to producing specialized software to support the organizations business. In this case, the business has overall strategies and goals that are not focused on software but are instead focused on goals for the overall business. The internal software groups with the larger organization serve to support and enable overall business strategies.
Similar to the way the software group can be thought of as enabling the larger organization to achieve its strategy, it’s possible to construct an IT specific balanced scorecard that can be shown to enable the strategies of a traditional balanced scorecard and thus the strategies of the larger organization [75] [76]. Grembergen describes a hierarchy of scorecards with the lower levels supporting or enabling higher levels. From [75]:
Business Balanced Scorecard IT Strategic Balanced Scorecard IT Development