John C. Goodpasture
Publication date: 10/01/2001
John C. Goodpasture
John C. Goodpasture is a certified Project Management Professional with broad practical experience in executive management, project management, system engineering, and operations analysis in both industry and government. As founder and chief consultant at Square Peg Consulting, he specializes in customized application and delivery of project management, business process analysis and characterization, and training of project practitioners.
A graduate of Georgia Tech, John has proven hands-on executive, functional, and project management experience from assignments as vice president of a document archive and imaging operations group at a Fortune 500 company, director of a strategic project office, and director of a system engineering program office with responsibility for a multi-million dollar software systems product line at a major corporation. He began his career in the Department of Defense, where he had system engineering and program management responsibility for highly technical defense and intelligence systems.
He has developed unique techniques in his field, many of which are described in numerous papers he has authored on the subject of project management. Adept at personal communication and simplification of complex ideas, he has developed and delivered project training to numerous project and functional teams working in many different countries in the fields of information management, manufacturing, production operations, and software development.
Whether stated or implied, every organization has some purpose or mission that drives achievement. Likewise, each possesses some vision for the future that inspires, motivates, and attracts stakeholders. From vision and mission, opportunity can be revealed. To exploit opportunities, goals are developed.
Five key concepts guide the management of projects for value.
Goals represent that portion of the opportunity value that can be transferred into the business. Goals are the state or condition to which organizations aspire; thus, value is attached to their achievement. Insofar as proposed projects are deemed necessary to achieve goals, projects are valuable to the organization (see Figure 1-1).
Said another way, projects are not valuable in and of themselves; they only acquire value from the role they play in exploiting opportunity. This idea forms the first of five concepts in managing projects for value: A project’s value is derived from the value obtained by reaching goals (Figure 1-2).
By definition, projects begin and projects end, 1 but business goes on. For projects to exist, a deliberate assignment of resources must occur. In return for these resources, there is an expectation of a deliverable with benefits attached. Thus, projects can be seen as investments: principal applied, time expended, and return expected. For purposes of this book, the project sponsor is the project investor with authority to commit resources and charter the project. The charter becomes the investment agreement, specifying the value expected, the risk allowed, the resources committed, and the project manager’s authority to apply organizational resources.
The concept of investment is that a commitment is made in the present time with an expectation of a future reward. The displacement of the future from the present introduces the possibility that unfavorable outcomes could occur (see Figure 1-3). Risk is the word used to capture the concept of potentially unfavorable outcomes. Project sponsors, acting as investors, embrace and understand risk as an unavoidable aspect of pursuing reward. Although project investors/sponsors “tolerate” risk, they do not manage it. Instead, the project manager manages the risk of achieving successful deliverables. Once the project itself is complete, a “benefits manager” manages the risk of achieving the operational value of the project.
As individuals, project investors/sponsors have different attitudes regarding risk. For instance, “objective” investors/sponsors are indifferent to the specific nature of risk, judging only the risk-adjusted value. In effect, different risks of the same value or impact are judged equally.
Risk-averse project investors/sponsors seek a balance of risk and reward. Risk-averse investors/sponsors are not necessarily risk avoiders, but they do avoid risks that cannot be afforded if the risk comes true, or cost more if the risk comes true, than the value of the “try.”
The following example illustrates this concept. In a coin toss, the bet is that heads gets $200 and tails gets $0. The expected value is $100 since half the time $200 will come up and half the time $0 will come up. The “value of the try” is negligible; nothing but a little time is lost if tails comes up. Suppose the bet is changed so that heads gets $400 and tails pays $200 for the same average outcome of $100. The risk-averse investor may not play the second bet even though it has the same positive expected value as the first because of the investor’s aversion to even a 50 percent chance of losing $200 and a judgment that the entertainment “value of the try” is not worth $200. 2
Figure 1-4 illustrates the concept of risk aversion applied to projects. Even though Project 2 has a higher expected return, its risk is beyond a threshold of affordable risk compared with Project 1. The risk-averse manager will approve Project 1 and disapprove Project 2.
The traditional investment equation of “total return equals principal plus gain” is transformed into the project equation of “project value is delivered from resources committed and risks taken.” This equation is the project manager’s “math.” Many persons use the terms “benefits,” “return,” and “value” somewhat interchangeably even though they have different meanings.
This book employs the following definitions:
Benefits are the mechanism for recovering project investment. For example, a project might be chartered to reduce production costs. Reduced production costs are the benefits that pay for the project investment.
Return is the rate of change of a financial metric; for example, percentage incremental profit per period generated after the project is completed.
Value is the need being satisfied by the project and the source of improved wealth in the business. In this project example, the business need may be to retain the production capability for customer satisfaction.
“Balance” is another term for equation. It is the state achieved when one side equals the other. In this context, quality demands are balanced or “provided” by resources and risk. Quality is used here in the sense of satisfying all dimensions of customer and stakeholder needs and expectations. Achievement of quality is accompanied by risk. How much risk? The answer is: only as much as is required to balance quality with resources (see Figure 1-5).
How is value dimensioned, and how is it measured? For most organizations, money is the objective measure of value. Consider this definition from James Anderson, Dipak Jain, and Pradeep Chintagunta: “Value … is the worth in monetary terms of the economic, technical, service, and social benefits a customer … receives in exchange for the price it pays for a market offering.” 3 Money (or money equivalents) is consideration given for the value provided.
Quality, and therefore value, is multidimensional. Quality often is considered in terms of compliance with standards, applicability to function and use, effectiveness of cost, timely and convenient availability, and responsiveness to context and environment. Some quality measures also include satisfaction of unspoken need. Regardless of the dimension used, in the final analysis, quality represents the value worth paying for.
“In competitive terms, value is the amount buyers are willing to pay for what a firm provides them.” 4
Projects are often chartered to design and deliver improved processes and organizational functionality. Michael Hammer, 5 noted business process authority, consultant, and author, defines process this way: “Process: an organized group of tasks that together create customer value.” By convention, processes are categorized as value adding (VA) or non–value adding (NVA).
A value-adding process begins with materials or information in a form not useful to users, applies a process to them, and produces a product or service that is useful. Consider this industrial VA process: Iron ore is mined and made into steel; the steel is then made into automobiles. Michael Porter uses the term primary activities to describe VA processes: “Primary activities … are the activities involved in the physical creation of the product and its sale and transfer to the buyer as well as after-sale assistance.” 6 The beneficiaries of value-added processes are consumers—customers or users who can be internal or external to the organization. If these benefits are not dollar-denominated, as many may not be, then the “with-without principle” (discussed in detail in Chapter 3) is used to quantify process values in dollars.
Value can be measured monetarily in several ways; these methods are developed in depth in many books and journals. Figure 1-6 illustrates three of these measures that are important to project managers. Their value lies in the fact that an otherwise straightforward calculation of cost and benefit often fails to represent project value correctly. Financial investment analysis techniques are required because:
Projects take time to execute, and money is less valuable in the future. Therefore, the time value of money needs to be taken into account to estimate properly the value of outlays and benefits.
Project investors have other choices for their investment dollars. It is often necessary to demonstrate to investors that a particular project is a good choice for investment.
The future is subject to many outcomes, and each outcome potentially risks the value of the project.
Net present value, economic value add, and expected monetary value take these factors into account.
Net present value (NPV) is a calculation of cash value over a period of time. The NPV calculation is first applied to projects during the approval or selection process; later it is applied when there are scope changes that affect resources or the benefits stream. NPV captures two important concepts for the project manager:
1. The value of money decays over time. This decay is due to the effects of inflation, the uncertainty that future flows will continue or begin, and the uncertainty that a better investment is available elsewhere. In all cases, the “present value” is more than the “future value.”
2. The value of the project is the net of the present value of all the cash outlays for investment and inflows from operations and salvage.
Cash flow is money—cash—coming from a “source” and going to a “use.” Referring to the Figure 1-6 graphical notations for cash flows, outlays (investments) are uses of cash; cash outlays are shown along the timeline as down-pointing arrows placed at the point in time when the flow occurs. Inflows (benefits) are sources of cash; cash benefits are shown as up-pointing arrows placed appropriately on the timeline.
Consider the first NPV concept stating that money has a time value. Project managers have a great deal to say about time. There are two time segments to consider:
1. The project implementation schedule. For the most part, the project schedule is in the hands of the project manager to develop and then to manage.
2. The operational life of the deliverable, which begins once project implementation is complete. This lifecycle is defined and developed by the project management team in the course of the project.
To evaluate a project investment properly, and the subsequent cash flows associated with operations and salvage, all cash values must be adjusted to a common timeframe, typically taken to be the present, by “discounting” the value of future funds. Discounting is a risk management measure for uncertainties in the future. The degree of discount is not ordinarily within the purview of the project manager. Discounting is accomplished by applying a weighting factor to each future period, compounding the factor at each period to take into effect the accumulation of time. Table 1-1 presents the relevant equations and demonstrates their application.
The significance of the net of the present value to project mangers is this: Successful projects are those projects that add value to the business. Value is only added if the net of all cash flows is positive; otherwise, there is more value going out of the business than there is coming in.
The net present value (NPV) of project outlays and inflows is equal to the sum of their future value, times a discount factor, compounded for time periods. The discount factor is a number less than 1 that weights the future value for the risk and uncertainties of future events
Present value (PV) = Future value/(1 + Discount factor)n
where n is the number of discounted periods between present and future. The present time is represented by n = 0. Where n = 0, PV = Future value/1
NPV = PV (Outlays) – PV (Inflows)
For example, a $500 investment made now that yields a $1,000 benefit two years from now, at a discount factor of 10 percent, has a net present value of $326.45.
$326.45 = –$500/(1 + 10%)0 + $1000/(1 + 10%)2
$326.45 = –$500 + $826.45
Valuable projects have a positive NPV over their lifecycle.
The discount factor that brings the NPV to exactly zero, thereby not adding dollar value but not detracting either, is called the internal rate of return (IRR). IRR is the upper bound of the discount for which the project adds financial value to the organization. Rewriting the equations in Table 1-1 leads to the following:
PV = Future value/(1 + IRR)n
Applying IRR as the discount rate,
NPV = PV (Outlays) – PV (Inflows) = 0
Consider the following project management example. Paul is a project manager responsible for a warehouse management project estimated to cost $500K and return cash benefits of $650K. These benefits are planned to come in the form of reduced costs of $130K per year for five years, beginning in the second year. To simplify matters, the following business rules apply:
The $500K will be expensed in one year, thereby avoiding capital budgeting and the complications of depreciation.
All benefits are after-tax cash.
Jim, Paul’s finance manager, has an additional business rule: The project must have positive cash flow. In other words, it must have a positive NPV over a five-year lifecycle. The firm’s discount rate is 12.8 percent for this type of project. From a table of present values, Paul finds that the benefits are worth less each year:
At the beginning of the first benefit year, which is one year from the beginning of the project, the $130K benefit is only worth $115.25K ($130K discounted 12.8 percent for one year, calculated as $130K/(1 + 0.128)).
As shown in Table 1-2, the sum of all the benefits in present value is only $459.48K. This amount is less than the $650K originally planned, and it is less than the $500K needed to have positive cash flow and meet Jim’s criterion for acceptance. Unless benefits can be increased, the project will not be accepted.
On the other hand, if the discount factor could be as low as 9.43 percent, as shown in Table 1-3, then the NPV would be $0K and the project might be accepted. Thus, 9.43 percent is the IRR for the project.
Jim considers the 9.43 percent issue but states that it is unlikely that the discount factor can be reduced from 12.8 percent to 9.43 percent. Therefore, as shown in Table 1-4, to have the project accepted, annual benefits must be raised to approximately $141.46K per year. At this benefit value, the NPV, figured at a discount rate of 12.8 percent, will be $0K after five years. Paul will have to reevaluate the project scope to see if such a benefit stream can be realized.
The second monetary value measure is economic value add (EVA). * EVA is closely related to NPV because both employ measures of discounted cash flow (DCF). EVA is a financial measure of how project performance, especially after the deliverables become operational, affects earnings. 9 Projects with positive EVAs earn back more than their cost-of-capital funding; that is, they return to the business sufficient earnings from reduced costs or increased revenues and margins to more than cover the cost of the capital required to fund these projects initially.
Cost of capital is an opportunity cost. It is not an expense on the project’s expense statement. It is the “cost,” used in the sense of return, that is “paid” to investors to keep them from taking their investments elsewhere to the next best opportunity. Capital is the “capital employed” or invested in the project that will be depreciated over time, as shown in Figure 1-8.
Capital and its cost are two important concepts from capital budgeting. The terms “discount factor” and “cost of capital” are used interchangeably in capital budgeting. Of course, capital budgeting is not employed in all organizations. In many government organizations, for instance, payments are expensed in the same year they are appropriated.
The logic of EVA is that if the business activity resulting from projects is not more profitable than the cost of capital the project consumes, then it may be more profitable, or at least equally profitable, and perhaps less risky, to invest the capital elsewhere.
EVA measures the economic performance of cash earnings. Earnings are what are reported as profit on the project’s profit-and-loss (P&L) statement, but earnings are not all cash. P&L statements have many non-cash items on them; depreciation expense and expense accruals are two common entries. The examples that follow show how to take non-cash expenses into account.
“Profits are an opinion, but cash is a fact.” 10
Furthermore, a double entry for the capital outlay (on the cash flowsheet) and the capital depreciation (on the expense statement) must be avoided. Depreciation is simply the capital outlay distributed over time as an expense. Here are the rules for the project manager:
Benefits, as used here, are measured as after-tax cash benefits.
Depreciation, as a non-cash expense, through its impact on income tax cash payments, does have a cash benefit for taxable organizations by reducing the tax on gross benefits.
Earnings and cash are related. Here are the equations:
(Pre-tax operating cash benefits – Depreciation) × (1 – Tax rate) = After-tax earnings
Cash benefits = After-tax earnings + Depreciation
In the second equation, cash benefits are also known as after-tax operating benefits. If the tax rate is 0 percent, as it would be for nonprofit and government organizations, then the equation becomes:
Operating cash benefits = Cash benefits
If the project is not a capital project, then also:
Cash benefits = After-tax earnings
Depreciation is not of consequence since it is not cash.
Consider the impact of EVA on Paul’s warehouse improvement project if Jim imposes the requirement that the $500K investment be a capital investment depreciated over five years. Not only must the NPV be at least zero, but also the project must earn at least its cost of capital. Continuing with the warehouse project example, Table 1-5 is the depreciation schedule for Paul’s project.
Now, to have an EVA equal to zero or better, after-tax earnings must at least be equal to CCE, the cost of capital employed. Proceed as follows:
In equation form: EVA = After-tax earnings – CCE ≥ 0. In Paul’s project, this equation requires that the present value of after-tax earnings be ≥ $146.55K, which is the PV of the cost of capital employed. (See Table 1-5 for PV CCE.)
To simplify matters, assume that PV after-tax earnings will exactly equal $146.55K.
Then, calculate the future value (FV) of the earnings to get annual figures to which depreciation can be added back. In the nth year, FV = PV × (1 + Discount factor)n.
Cash benefits equal this sum: FV (After-tax earnings) + Depreciation.
NPV = PV (Outlays) – PV [FV (After-tax earnings) + Depreciation].
Table 1-6 summarizes the results. The first three rows calculate the EVA. Rows four through seven calculate the NPV. Notice that the PV of the EVA, as shown in the third row, is exactly 0. This result is a consequence of the assumption made that earnings will exactly equal the cost of the capital employed.
Table 1-6 illustrates an interesting result, which is shown below.
NPV (Cash flow) = Present value EVA (After-tax earnings)
This is not a coincidence of the figures used. It is a consequence of the relationships of cash flow and earnings after-tax. 11 Thus, it does not matter o the project manager whether the criterion and measurement are NPV or EVA. Either will suffice for project selection and financial performance evaluation.
Before leaving the subject of EVA, several points are worth making. To be precise with EVA calculations, financial managers make adjustments for “equity equivalents” to restate the income statement in cash equivalents. This is a complex calculation beyond the scope of this book. A very readable treatment is given in Chapter 5 of the book Value Based Management. 12
The third financial measure is expected monetary value (EMV). It is an NPV measure employed when more than one project outcome is possible, and each outcome has a different cost and schedule. Usually there can be only one figure for the project cost or schedule for which the project manager is responsible. In effect, a risk-averse estimate is needed for this “one figure.” Risk-averse means that the risk is in balance with the reward, not that no risk exists. The “best point” estimate in the face of uncertainty is a statistic called “expected value.” 13
For the project manager, expected value is one of the most valuable statistics to know and apply. It is the best statistical estimate in the face of uncertainty. It is best in the sense that expected value is the only “unbiased” estimator of the average outcome of all possible outcomes. The group of “all possible outcomes” is called the “population.” More often than not, the project manager cannot explicitly know all possible outcomes. However, an average outcome of all possible outcomes can be estimated. Unbiased estimator means that in the long haul, as more becomes known about the population, the estimate of the average will, in fact, turn out to be equal to the true average of the population.
If μ is the true average of the population, then as the sample size becomes “very large”
Expected value = μ
An unbiased estimator also is a “maximum likelihood” estimator. Maximum likelihood means that as more samples are taken of the population, the estimator continues to converge on a value. However, not all maximum likelihood estimators are unbiased.
Expected value is calculated this way: Each possible outcome of a task or work package is evaluated in monetary terms, with all monetary units discounted to their present value by the organization’s cost of capital. Then, each present value outcome is weighted according to its probability of occurrence, where each probability or weight is a number between 0 and 1. The sum of all probabilities or weights must equal 1 exactly; if they do not, then not all possibilities have been considered, or too much weight has been given to one or more possibilities. These weighted outcomes are then summed into an expected value. By definition, expected value is the value of an outcome weighted by the probability of occurrence. Because each outcome is denominated in dollars, this expected value is called the expected monetary value. In the face of uncertainty, the project manager makes decisions to obtain the most favorable EMV.
Consider how Paul might employ EMV in his project. Paul must redesign his project to yield higher benefits than originally planned. Some risk must be taken to accomplish this goal. One approach might be to increase the face value of annual benefits to $170K, which is enough, but Paul estimates that there is only a 40 percent chance of success in achieving this figure. In fact, he estimates that there is a 60 percent chance that this approach will only yield $140K, which is not enough. Using expected value analysis, Paul finds that the EMV of this approach is $152K:
40% × $170K + 60% × $140K = $152K EMV
The NPV of Paul’s project is $33.01K, which is enough.
All other considerations being equal, Paul could justify taking a risk and adopting this approach on the basis of the EMV of its earnings.
Projects are valuable because they are the means by which to extract value from opportunity by managed application of resources.
Value, no matter how dimensioned and measured, is the intended outcome of investment.
Risk objectivity means evaluating risk by the expected outcome, not necessarily the path to get there.
Risk aversion means taking only those risks that are “affordable.”
Projects are investments. The project equation is: Project value is delivered from resources committed and risks taken.
For most organizations, money is the objective measure of value. Three primary measures are employed for money values: net present value, economic value add, and expected monetary value.
2 David T. Hulett. The example of risk aversion was provided to the author in a technical note from Dr. Hulett, 2000.
3 James C. Anderson and James A. Narus, Business Market Management: Understanding, Creating, and Delivering Value (Upper Saddle River, NJ: Prentice Hall, 1999), p. 5.
4 Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York: Simon and Schuster, Inc., 1998), p. 38.
5 Michael Hammer. Seminar materials: Managing the Process-Centered Enterprise: Principles and Practices (Boston, MA: Hammer and Company, presented December 3-4, 1997), pp. 1-9.
6 Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York: Simon and Schuster, Inc., 1998), p. 38.
7 P. T. Finegan, “Financial Incentives Resolve the Shareholder-Value Puzzle,” Corporate Cashflow, October 1989, pp. 27-32.
8 Shawn Tully, “The Real Key to Creating Wealth,” Fortune, September 20, 1993, pp. 38-50.
9 Robert C. Higgins, Analysis for Financial Management (Boston: Irwin/McGraw-Hill, 1998), p. 299.
10 Tom Pike, Rethink, Retool, Results (Needham Heights, MA: Simon and Schuster Custom Publishing, 1999), p. 177.
11 Robert C. Higgins, Analysis for Financial Management (Boston: Irwin/McGraw-Hill, 1998), p. 300.
12 John D. Martin and J. William Petty, Value Based Management (Boston: Harvard Business School Press, 2000).
13 John R. Schuyler, Decision Analysis in Projects (Sylva, NC: Project Management Institute, 1996), p. 11.
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