PROJECT VALUATION MODELS

The process for selecting project targets within the organization remains quite diverse across various industries. Traditionally, these decisions were driven within localized business entities; however, more recent trends have moved toward a more centralized view of project selection and management (Chapters 33 and 34 will discuss these trends in more detail).

While it is obvious that projects dominate the landscape of most organizations, the rationale for creating them is not so obvious. It would seem reasonable to conclude that a project is created to pursue some credible organizational goal, but what goal? In review- ing the typical stated benefits for a project, it is common to hear such attributes as follows:

• Achieve competitive market advantage • Cut operational costs

• Satisfy compliance requirements

• Achieve a strategic objective (that may not be financially quantified) • Improve employee morale

In the traditional view, a project was often chartered to improve an existing pro- cess. For example, automating a payroll system might be justified by cutting labor cost, improving preparation cycle time, or cutting processing errors. In many such early cases, an attempt would be made to justify the project by showing how it produced some tangible benefit over its projected life cycle. Technology-based projects often had the characteristics shown for the payroll example—cost, cycle time, and lower processing

errors. Justification for such projects was often based on a schematic cost–benefit view as exemplified in Figure 9.1.

Using this valuation model, the initial costs would be represented by a down arrow as illustrated in Figure 9.1, while upward arrows would represent the future benefits. Monetary values would then be estimated for all cost and benefit flows over the pro- jected life of the product. From this view, various financial metrics could then be pro- duced to show a value parameter. Typical evaluation metrics used were payback, net present value, internal rate of return, or benefit–cost ratio (see Appendix A for more details). In the case of projects designed to replace human labor, this method was rea- sonable, but as the breadth and complexity of project goals increased, it became obvious that a valuation model was much more complex than described above.

A second evolution of the project valuation model added consideration of intangible benefits to the structure, although these considerations were kept separate since mon- etary values were difficult to derive for this category. The basic problem with intangibles is that various stakeholders might value them differently. Financial types were more sensitive to forecast tangible benefits, while operational types might be more sensitive to items such as morale, ease of operations, and so on. In any case, recognition of intan- gibles opened the door to a more complete view of project value. Projects that would have been rejected in the first case using tangible criteria might now be accepted for less financial reasons. Use of classical financial metrics continued and some organiza- tions refined this model to begin recognizing risk and variations in the forecast values. Initially, the level of risk would have been considered intangible in a project assessment. However, failure to consider the downside of risk wiped out many projects that other- wise showed a great tangible financial benefit. Intangibles could also be seen in cus- tomer or employee reactions to an initiative. Installing an automated customer response system could show clear financial returns in regard to cost to respond to a customer. However, if it chases the customer away, is this still considered a successful project? Cost effective for sure, but does not help the organization. Intangibles are often subtle, but clearly have to be considered in the valuation process.

A third component of project valuation perspective recognized yet another role of projects in the organization. This view hits at the core of the organizational goal struc- ture. That is, projects should be created to support organizational goals and these goals can be very diverse in nature. Whereas the traditional view of a project was more local in scope, the third evolutionary wave moved that view toward a more top-level perspective. It now became necessary to deal more with linking organizational goals to projects than just evaluating the project itself. The fact is that, some projects might be undertaken

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Role of Projects in the Organization • 87

with no tangible estimation of future value. Management might decide that some ini- tiative should be undertaken to evaluate the potential of a technology or market. From this view, they would Charter something akin to an R&D pursuit. Some government regulatory-oriented projects have a similar lack of tangible benefit. Historically, high- tech organizations have derived values from projects in quite unexpected ways. The per- ceived reason to pursue the initiative was not at all where the future benefits came from. The new view of projects seeks to encompass tactical versus strategic initiatives, along with environmental, stockholder, and other perspectives. Clearly, the new generation of evaluation metrics has to include both soft and hard financial justification with organi- zational goal perspectives linked to the project objectives.

The concept of linking project roles to organizational goals remains a fundamental aspect of project value measurement; however, the enterprise view of value measurement continues to mature in its perspective as we will present shortly. Expanding the view of project value to include multiple attributes leaves behind the idea that some quantifiable metric can be used to compare one project with another. In reality, the valuation activ- ity has long been political in nature and that situation has grown as the cost of projects increased and the level of review expanded to top management. Today, project overview remains extremely political, risky, and technically complex. It certainly should not be thought of as simply defining the cost versus benefits with the decision made obvious from that calculation. Defining multidimensional project valuation criteria compounds the complexity model in regard to comparing dissimilar proposals. Many different tech- niques are described for this in the literature. Merkhofer describes multiple types of metrics useful for allocating resources. This includes the following (Merkhofer, 2003):

• Opportunity cost analysis

• Sensitivity analysis (variable estimates) • Multiperiod planning

This level of model sophistication remains beyond the capability of the typical orga- nization, but it does reveal some of the analysis issues that are relevant in the discussion. Concepts are related to missed opportunities, variation in estimates (risk), resource availability constraints, multiperiod views, project grouping, and so on. In this environ- ment, the process of project selection has risen to a new plane of sophistication, but not the one often pursued by organizations. One thought for this is that the perceived level of complexity encompassed by this view chased away many candidates.

The fourth evolutionary wave brings the project valuation story to the current time period. During the latter 1990s, proliferation of project activity in organizations made it clear that some type of centralized control was needed for project selection and resource allocation. Multiple studies of project selection indicated that organizations were not get- ting full value from their allocation of resources. Merkhofer reported that only about 60% of the value was realized (Merkhofer, 2003). The remaining 40% of available value was lost due to errors in the project selection process and weaknesses in business processes. Recognition of this phenomenon spurred industry interest in two directions: better proj- ect selection techniques and better project management to deliver the defined results.

The fourth wave is described as a portfolio view of projects. No longer were projects reviewed on a stand-alone basis with local benefits. Now, projects were viewed at the enterprise level and focused on organizational goals. The analogy used was that of a capital allocation model. That is, the potential for initiating projects was well beyond

the availability of resources to support that activity, so the primary selection goal is to

select and complete a slate of projects that optimize organization goal achievement. The

vocabulary term for this is goal alignment. Unfortunately, we are still left with the basic question regarding how to do this mechanically in terms of a single valuation metric. Chapters 33 and 34 will explore the operational project portfolio mechanics in greater detail. For the remainder of this discussion, we will focus on basic organizational strate- gies that are used to develop project candidates.