IE 426: Project Management

Chapter 02
Strategic Management and
Project Selection
Ramzi Alahmadi, Ph.D.
Industrial Engineering Department
 Projects Performance
• Organizations spend billions per year on creating
competitive strategies
- 90% fail due to poor project execution

How to Improve?
• Organizational Project Management (OPM) and Governance
• Project Selection Models

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 OPM and Project Governance
• Organizational Project Management (OPM) is a
framework that connects projects, programs, and portfolios
directly to an organization’s strategy. It ensures that all project-
related work contributes to achieving strategic goals. The Project
Management Institute (PMI) created OPM3® (Organizational
Project Management Maturity Model) for implementing strategy
through projects.

• Project Governance includes the role of oversight committees,

project managers, and the project management office (PMO).
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 The Project Portfolio Management
(PPM)

*Adapted from: Project Management for Engineering, Business and Technology by John Nicholas and Herman Steyn

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 Organizational Project Management
Maturity Model OPM3

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 Project Governance Structure

Justifies why the

project should Feedback Loops ensures
exist: linking it to alignment with organizational
strategy and strategy and stakeholder needs.
expected benefits.

Planning: Define objectives, Ensures project’s results

schedule, budget, scope, risks. are now integrated into
Execution: Deliver the project day-to-day operations.
outputs (product, system, or
service). Ensure that the outcomes
delivered by the project are
used and produce the
intended strategic benefits.

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 Project Selection
How to select a project to be implemented?

• Evaluating
• Choosing

Examples:
• A construction firm can select the subset of a large group of potential
projects on which to bid
• A company can select a product to launch among many other products

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 The Project Portfolio Management (PPM)

*Adapted from: Project Management for Engineering, Business and Technology by John Nicholas and
Herman Steyn

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 Purpose of Project Portfolio Process
• Identify non-projects
• Prioritize list of projects
• Identify the real options for each project
• Identify projects with good fit
• Identify co-dependent projects
• Eliminate risky projects
• Keep from overloading the organization
• Balance the resources with needs
• Balance short, medium, and long-term returns
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The Project Portfolio Symptoms of a Misaligned
Management (PPM) Portfolio
• More projects than management
• Links projects directly expected
to the goals and strategy • Projects that don’t contribute to
of the organization. the strategy
• Competing projects
• Decides which • Costs exceed benefits
projects and programs • Lack of tracking against the plan
should be invested in. • No risk analysis of projects
• No client for project
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 Types of Project Selection Models
➢Nonnumeric models
➢Numeric models

• Models turn inputs into outputs

• The inputs never fully describe the situation
• The outputs never fully describe the expected results
• Models are tools
• Managers are the decision makers

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 Nonnumeric Models

• Models that do not return a numeric value for a

project to be compared with other projects
• These are not “models” but rather justifications for
projects
• Just because they are not true models does not
make them all “bad”

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 Types of Nonnumeric Models 1/2
➢Sacred Cow
A project, often suggested by the top management. The project is
“sacred” in the sense that it will be maintained until successfully
concluded, or until the boss, recognizes the idea as a failure and
terminates it.
➢Operating Necessity
A project that is required in order to protect lives or property or to
keep the company in operation
➢Competitive Necessity
A project that is required in order to maintain the company’s
position in the marketplace
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 Types of Nonnumeric Models 2/2
➢Product Line Extension
A project to develop new products would be evaluated on how
well the new product impacts the total system performance, and
with less focus on the new product profitability.
Examples: Diet Coke, light version of snacks
➢Comparative Benefit
Projects are subjectively rank ordered based on their
perceived benefit to the company
➢Sustainability
Focusing on long-term profitability rather than short-run payoff
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 Numeric Models
Models that return a numeric value for a project that can
be easily compared with other projects.

Major types
• Profitability-based models
• Scoring-based models

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 Numeric Models: Profit/Profitability
Models that look at costs and revenues
• Payback period
• Discounted cash flow (NPV)
• Internal rate of return (IRR)
• Profitability index/Benefit/Cost Ratio

NPV and IRR are more common methods

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 Payback Period
• The length of time until the original investment has been re-payed by
the project
• A shorter payback period is ……?……?
• The method serves as a proxy for risk. The faster the investment is
recovered, the ……?…… the risk to which the firm is exposed.

Project Cost/Investment
Payback Period =
Annual Cash Flow
Payback Period Example:
$100,000
Payback Period = = 4 year
$25,000 / year
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 Payback Period
A project requires an initial investment of $200,000 and will generate
cash savings each year as listed in the table for the next five years. What
is the payback period?

Year Cash Flow Cumulative

0 - $200,000 - $200,000 Payback Period =
1 $50,000 - $150,000 15,000
3− = 2.8 𝑦𝑒𝑎𝑟𝑠
2 $90,000 - $60,000 75,000
3 $75,000 $15,000 Divide the cumulative amount by the
cash flow amount in the third year

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 Payback Period Drawbacks

• Does not consider time value of money

• Less meaningful for longer periods of time
(due to time value of money)
• It ignores any cash inflows beyond the payback
period

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 Discounted Cash Flow
• The value of a stream of cash inflows and outflows in today’s
dollars
• Also know as the net present value (NPV) method
• Widely used to evaluate projects
• Includes the time value of money
• Includes all inflows and outflows, not just the ones through payback
point
• Requires a percentage to use to reduce future cash flows
• This is known as the discount rate
• The discount rate may also be known as a hurdle rate or cutoff rate
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 Net Present Value (NPV)
NPV measures the equivalent present wealth contributed by
the investment
𝒏
𝑭𝒕
𝑵𝑷𝑽 𝒑𝒓𝒐𝒋𝒆𝒄𝒕 = 𝑨𝒐 + ෍
(𝟏 + 𝒌 + 𝑷𝒕 )𝒕
𝒕=𝟏
⚫ A0 Initial cash investment
⚫ Ft Cash flow in time period t (negative for outflows)
⚫ k The discount rate: the minimum accepted rate of return on the investment
⚫ 𝑃𝑡 Predicted rate of inflation during period t
⚫ t The number of years of product/project life
– A higher NPV is ……?.…..
– Higher the discount rate ……?.….. the NPV
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 NPV Formula
𝑛
𝐹𝑡
𝑁𝑃𝑉 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 = 𝐴𝑜 + ෍
(1 + 𝑘 + 𝑃𝑡 )𝑡
𝑡=1
8
$25,000
NPV (project) = −$100,000 + 
t =1 (1 + 0.15 + 0.03)t

= $1,939

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 NPV
Should you invest $60,000 in a project that will return $15,000 per year for five
years? You have a minimum return of 8% and expect inflation to hold steady at 3%
over the next five years.
Year Net flow Discount NPV
0 -$60,000 1.0000 -$60,000 𝒏
1 $15,000 0.9009 $13,513.51 𝑭𝒕
𝑵𝑷𝑽 𝒑𝒓𝒐𝒋𝒆𝒄𝒕 = 𝑨𝒐 + ෍
(𝟏 + 𝒌 + 𝑷𝒕 )𝒕
2 $15,000 0.8116 $12,174.34 𝒕=𝟏

3 $15,000 0.7312 $10,967.87

4 $15,000 0.6587 $9,880.96 The NPV column
5 $15,000 0.5935 $8,901.77 total is negative,
-$4,561.54 so don’t invest!

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 NPV
Select from 4 independent projects at MARR/discount rate of 15% per
year; investment limit = $15,000.
Project Initial Investments Annual Net Cash Flow Life, Years
F $−8,000 $3870 6
G −15,000 2930 9
H −6,000 2080 5
J −10,000 5060 3
NPV of viable bundles (after G is
Project Life, n NPV at 15%, $ removed).
P W F = $6,646
F 6 6646
Only 5 require $15,000 or less: P W H = $973
G 9 −1019 (out)
P W J = $1,553
F, G, H, J, FH H 5 973
P W F H = 6,646 + 973 = $7,619
J 3 1553
Bundle with largest NPV is FH. Select
these two projects.

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 Internal Rate of Return [IRR]
• The discount rate (k) (interest rate) that causes the NPV to be
equal to zero
• The higher the IRR, the better
• Finding the IRR requires a financial calculator or computer
• In Excel “=IRR(Series,Guess)”

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 Internal Rate of Return [IRR]

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 Profitability Index

• Also known as Benefit/Cost ratio

• Total benefits divided by Total Costs
• Ratios greater than 1.0 are ……?.……

𝑁𝑃𝑉 + 𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐶𝑜𝑠𝑡𝑠

Profitability index/ (B/C ratio)=
𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐶𝑜𝑠𝑡𝑠

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 Advantages of Disadvantages of
Profitability Models Profitability Models
• Ignore nonmonetary factors
• Some ignore time-value of money
• Easy to use and understand
• Biased toward the short-term
• Based on accounting data and
forecasts • Payback ignores cash flow after
payback
• Gives a go/no-go indication
• IRR can have multiple solutions
• Dependent on determination of cash
flows

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 Scoring Models
• Unweighted 0–1 factor model
• Unweighted factor model
• Weighted factor model

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 Unweighted 0-1 Factor Model
• Factors selected
• Listed on a preprinted form
• Raters score the project on each factor
• Each project gets a total score
• Main advantage is that the model uses
multiple criteria
• Major disadvantages are that it assumes
all criteria are of equal importance

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 Unweighted Factor Scoring Model
• Replaces X’s with factor score
• Typically a 1-5 scale
• Column of scores is summed
• Projects with high scores are
selected

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 Weighted Factor Model Example

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 Weighted Factor Model Example

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Unweighted Factor Weighted Factor Scoring
Model Model
• Each factor is weighted relative to its
• Easy to compute importance
• Weighting allows important factors to
• Less important factors are stand out
weighted the same as
• A good way to include nonnumeric data in
important ones the analysis
• Factors’ weights need to sum to one (100%)
• All weights must be set up, so higher values
mean more desirable

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 More Methods for Comparing and
Selecting Projects
Project selction approaches tend to aim at the following
goals:

• Maximize the value or utility of the portfolio

• Achieve balance in the portfolio
• Fit the portfolio to the organization’s objectives and strategic
intitatives.
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 Methods for Comparing and Selecting Projects
Value or Utility_ multiple criteria method
Select projects with the highest “value” or usefulness as
determined from financial models or scoring models

*Adapted from: Project Management for Engineering, Business and Technology by John Nicholas and Herman Steyn

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 Methods for Comparing and Selecting Projects
Portfolio Balance

*Adapted from: Project Management for Engineering, Business and Technology by John Nicholas and Herman Steyn
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 Assignment …

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 Assignment …

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