Chapter 12: Project management I â€“ The business case
Chapter learning objectives
Upon completion of this chapter you will be able to:
- explain the typical distinguishing features of a project and the constraints of time, money and quality, and discuss their implications
- describe, for the strategic plan, how elements of the strategy can be broken down into a series of projects
- describe the process of identifying, assessing and dealing with risks
- advise on the structures and information that have to be in place to successfully initiate a project in organisations in general
- explain, using examples, how process redesign, e-business, systems development and quality initiatives can be treated as projects
- describe the contents of a business case document
- analyse, describe, assess and classify the benefits and costs of a project investment
- explain the role of a benefits realisation plan
- describe and assess a benefits dependency network
- evaluate a project using standard project appraisal techniques.
1 Project features
A project can be defined simply as an activity, which has a start, middle andend, and consumes resources. It will:
- have a specific objective
- have a defined start and end date (timescale)
- consume resources (people, equipment and finance)
- be unique (a one-time-only configuration of these elements)
- have cost constraints that must be clearly defined and understood to ensure the project remains viable
- require organisation.
2 Process redesign, e-business and systems development as projects
A project differs from 'ordinary work' that is ongoing and has amixture of many recurring tasks and more general goals and objectives.Although some projects may be initiated on an ad-hoc basis, it is morecommon for them to be an implementation tool for the strategic plan ofthe organisation.
Projects are fundamental to other aspects of the syllabus such as business process change and IT development.
Links to other syllabus areas
Process redesign project
Business process redesign often involves specific projects linked to specific processes.
Systems development project
Developing e-business opportunities often involves specific projects. Typical steps might include:
- System Analysis.
- Site Construction.
- System Integration.
- System Test.
- Final Evaluation.
3 Stages in the project life cycle
Every project is different, but each will include at least the following five stages:
This chapter explores the first stage of the process in more detail. The next chapter will cover the remaining elements.
Project initiation â€“ building the business case
This chapter focuses on project initiation. It examines thecontents of a business case document, it assesses what benefits might bederived from a project and how these benefits should be managed, itassesses potential project costs, and it finishes by matching up theproject costs and benefits in project appraisal techniques.
Reasons for building a business case:
- to obtain funding for the project
- to compete with other projects for resources
- to improve planning
- to improve project management
The need for a business case
Not every project that managers propose can be undertaken. Theremay be constraints on resources which mean that, for example, there isnot enough finance to fund every project, or it may simply be that insome projects the benefits do not outweigh the costs.
Therefore, a business case should be put together for any proposedproject. The aim of this is to achieve approval for the project and toobtain adequate resources to achieve its goals.
4 Contents of a business case
Organisations who have performed many projects will often havedeveloped their own method of presenting a business case. But there areusually some common contents:
(3)Description of current situation
(5)Analysis of costs and benefits
Explanation of the elements
This sets the scene and explains the rationale behind why the project has been considered.
(2) Executive summary
This is the most important part of thedocument as it is likely that this will be the part that is read in mostdetail by the senior management team. It will include the keyconsiderations that have been made, the options considered, therationale behind the recommendation and a summary of the key numbers(e.g. the output from a financial project appraisal).
(3) Description of current situation
This will be a strategic and operationalassessment of the business. It will include a SWOT analysis and aim toidentify the problems that the business is facing and the opportunitiesavailable to solve those problems.
(4) Options considered
This will have an assessment of each optionthat has been considered and provide reasons for the rejection ofoptions that have not been recommended.
(5)Analysis of costs and benefits
This will have the key elements for theproject assessment. The detail will be provided in the appendices. Thissection will provide quantifiable benefits and costs but will also makesome attempt to quantify intangible benefits and costs such as theimpact on customer satisfaction and staff morale. The output from anyproject appraisal techniques will also be provided.
This will examine the impact on elements ofthe cultural web (studied in a later chapter) such as the organisationculture, the management style, staff roles and routines etc.
(7) Risk assessment
This section will aim to identify the risksto successful project performance and suggest how each risk should bemanaged. It may also contain some contingency planning to give guidanceon different possible directions for the project in the face of theserisks arising (though this is often left until the detailed planningstage).
This will contain the justification for thesuggested path that the project has pursued. It will pull a lot of theother sections of the business case together.
This will lay out the detailed costs and benefits and schedules for areas such as project appraisal.
Many of these elements will now be explored throughout the rest of this chapter.
Further discussion on project constraints
Every project must be defined in terms of time, budget or costs andthe performance specifications of the project. These are called the'triple constraints'.
Every project has limited resources. Costs and resources â€“include people, equipment and money. They may be internal or externaland include:
- statutory bodies
- banks, loans, grants
- expert opinion (lawyers, accountants and consultants), etc.
Microsoft has linked quality with scope, time and cost, suggestingthat quality is at the centre of the project triangle. Changes you maketo any of the three sides of the triangle are likely to affect quality.Quality is not a side of the triangle; it is a result of what you dowith time, money, and scope.
Illustration 1 â€“ Project features and constraints
As potential project managers, we need to determine which of ourconstraints (time, costs or scope/performance) is the most important andwhich is the least in order to focus our resources in the mosteffective way. Additionally, when there are problems, we use the leastimportant constraint (weak constraint) to aid in the solution. The mostimportant of the constraints, the driver, is the last to be compromised.
If scope is driving your project, it will not be successful unlessthe project completely meets the performance criteria or specifications.You will spend more time or increase the budget rather than sacrificequality or features. If performance is the weak constraint, you mightconsider scaling back on features or quality to meet either time or costconstraints.
The driver may change during a project. That is part of thedynamics of project management. However, you have to know the initialorder of the constraints before you begin the project planning step.
Test your understanding 1
To help when you have problems determining the driver and weakconstraint, devise some comparative questions to explore your projectand develop a hierarchy of the constraints, e.g.
If I had to choose between spending more time on the project or cutting quality, which would I choose?
Risk is defined as 'the chance of exposure to the adverse consequencesof future events'. A risk is anything that will have a negative impacton any one or all of the primary project constraints â€“ Time, Scope andCost.
All projects include some risk.
- Cost over-run.
- Missed deadlines.
- Poor quality.
- Disappointed customers.
- Business disruption.
Risks can result in four types of consequences:
- benefits are delayed or reduced
- timeframes are extended
- outlays are advanced or increased
- output quality (fitness for purpose) is reduced.
Risks can be analysed and evaluated according to the likelihoodthey will occur and whether their level of seriousness/impact will below, medium or high if they happen.
Examples of project risks
The potential risks involved in undertaking a project can be presented in a tabular format as set out below:
Risks can be handled in a number of different ways.
- Ignore the risks and do nothing â€“ appropriate where the effect of the risk is small and the chances of it occurring remote.
- Purchase insurance against the risk.
- Transfer the risk â€“ e.g. arranging for third parties to complete the riskier parts of the project.
- Protect against the risk â€“ arrange for additional staff to be available at critical parts of the project to minimise the possibility of the project over-running.
Test your understanding 2
A leisure company has just approved a large-scale investmentproject for the development of a new sports centre and grounds in amajor city. The forecast NPV is approximately Â£6m, assuming five years'steady growth in business and constant returns in perpetuitythereafter. A number of specific risks have been identified:
(1)A potential lawsuit may be broughtfor death or injury of a member of the public using the equipment. Nosuch event has ever occurred in the company's other centres
(2)The loss of several weeks' revenuefrom pool closure for repairs following the appearance of cracks in theinfrastructure. This has occurred in several of the other centres in thepast few years.
(3)Income fraud as a result of high levels of cash receipts.
(4)Loss of playing field revenue from schools and colleges because of poor weather.
Suggest how these risks could best be managed.
SWOT analysis was discussed in earlier chapters as a tool forstrategic position analysis. A SWOT analysis can also be used inbuilding the business case for a project â€“ most likely in parts 2, 4and 6 of the document.
It can also be used as part of a periodic report to the project sponsor to summarise progress and raise issues.
Further explanation on the use of SWOT analysis
The internal appraisal should identify:
- strengths â€“ the organisation's strengths that the project may be able to exploit
- weaknesses â€“ organisational weaknesses that may impact on the project.
The external appraisal should identify:
- opportunities â€“ events or changes outside the project that can be exploited to the advantage of the project
- threats â€“ events or changes outside the project that should be defended against.
The four parts of the SWOT analysis are shown in the diagram below.
5 Objectives and drivers for projects
The preceding elements of this chapter have covered many elementsof the business case document. But so far the benefits and costs of theproject have not been discussed. The remainder of the chapter focuses onthese elements.
The key drivers of any project will be the business strategy andthe organisational objectives. Before work commences on a project, it isimportant that these drivers are understood and discussed. This isknown as driver analysis.
A list of drivers for the project should be created. It shouldinclude drivers at all levels of the business â€“ corporate, operationaland strategic. Senior management should be involved in this process toensure that the discussion has a strategic perspective.
The drivers can come from the analysis carried out earlier in thesyllabus â€“ both externally and internally. They should be linked tocritical success factors as well as organisational objectives. In orderto fulfil all of the drivers, more than one project may be necessary.
Objectives should also be personalised to the investment. Thesewill be more detailed and operational than the overall project drivers.However, each should be directly linked to one or more of the projectdrivers.
The list should be short (with between three and six targets) andprecise. Ideally, each objective should follow a SMART criteria.
SMART is a pneumonic used to ensure that objectives are meaningful targets.
For example, a company in debt might have the following objective:
Only when an objective meets all 5 criteria is it deemed to be useful.
Linking the investment objectives to business drivers
Each project undertaken should address at least one businessdriver. On the other hand, any project that aims to meet all businessdrivers is likely to be large and complex to manage successfully tocompletion.
Each investment objective should be linked to at least one businessdriver. It will also be important to ensure that the investmentobjectives to not change or evolve over time and lose these links (forexample, by focusing more on functional or operational objectives thathave become more easily achievable).
Once investment objectives are agreed and linked to businessdrivers, it is then possible to consider the business benefits that canbe realised and manage the process of achieving these.
6 Project benefits
There can be a wide variety of benefits from new projects such as:
- strategic benefits
- productivity gains
- management benefits
- operational benefits
- functional and support benefits
- intangible benefits
- emergent benefits.
More details on project benefits
A new project might be a way to gain a competitive advantage asalready seen with areas such as business process redesign and supplychain management.
A project may make operations more efficient or remove non valueadding activities from the value chain in order to increase overallproductivity of the business. This may be tied-in to a strategic benefitsuch as cost leadership.
A project may make the organisation more flexible and reactive toits environment. It might give more up-to-date information to managersso that they can make more agile decisions. These benefits often arisefrom projects which involve organisational redesign or investments innew IS/IT systems.
These involve benefits seen in areas such as resources and assets.The project may lead to better management and utilisation of these areasâ€“ for example, it may simplify job roles or reduce staff turnover.
Functional and support benefits
Other areas of the value chain may also see benefits such as HRM, marketing, service etc.
These can only be measured subjectively. A benefit of a projectmight be to improve staff morale or customer satisfaction. Thesebenefits should be included in the business case, and many organisationstry to put some value on them regardless of how subjective that valuemight be.
Often referred to as secondary or unexpected benefits thesebenefits might not be expected at the outset of a project but they'emerge' over time. For example, we've seen how a change to a divisionalstructure for a business might lead to greater focus and responsibilityaccounting, but it might also provide opportunities for furtherdiversification that was not envisaged as part of the original changeproject. The benefits might only emerge as the organisation becomes morecomfortable with its new structure. Benefits management (discussedlater) aims to manage for these benefits as well as for plannedbenefits.
In order to make a business case on the basis of these benefits,the scale of the benefits should be assessed. The benefits can often beclassified along the following scale:
In order to convince management of the business case for theproject, the aim should be to have each benefit as high up the scale aspossible (where level 4 is higher than level 1).
The scale of benefits
Intangible benefits (such as improvementsin staff morale) often fall into this category. Individuals or groups inthe organisation with a level of expertise in this area will often useagreed criteria to determine whether or not this benefit has beenrealised.
Despite the fact that the benefits aren't measureable, theyshould still be included in the business case as they will have animportance to many stakeholders. It will also be important that theyform part of the benefits management process (covered later).
A measure may exist for this type ofbenefit, but it may not be possible to estimate by much performance willimprove when the changes are completed. This means that the businesscan often tell where it is at the moment but cannot specify where itwill be post project.
Many strategic benefits fall into this category â€“ forexample, a project to improve product quality is likely to lead to anincrease in market share, but it may not be possible to quantify by howmuch the increase in market share will be. But a timescale should be setfor when the measure will be tested to show the benefits of thisparticular project (rather than being the result of other factors suchas competitor actions).
If it is deemed too difficult or expensive to measure theincrease in performance, then the benefit should be relegated to anobservable benefit.
These benefits should be forecastable interms of the benefit that should result from the changes. This meansthat their impact can be estimated before the project commences (unlike measureable benefits where the impact can only be assessed afterthe project has been completed). Often, productivity gains andoperational benefits will fall into this category. For example, it maybe possible to estimate that new machines will be able to produce 20%more units per hour.
These benefits can be given a financialvalue â€“ either in terms of a cost reduction or a revenue increase. Theaim should be to have as many benefits as possible in this category sothat a financial appraisal of the project is possible.
7 Benefits management
'The purpose of the benefits management process is to improve theidentification of achievable benefits and to ensure that decisions andactions taken over the life of the investment lead to realising all thefeasible benefits.'
(Benefits Management, Ward and Daniel, 2006)
Origins of benefits management
Benefits management originally grew out of the failure of manyinformation systems (IS) and information technology (IT) projects.Organisations started performing in-depth Post Implementation Reviews(explored in more detail in the next chapter) to determine what could belearnt from past failures.
One of the key discoveries from project failures was that perceivedbenefits from projects often failed to materialise or be fully realised.Organisations determined that they needed a process in order to avoidthese failures in future projects.
Therefore benefits management was developed as a process forensuring that benefits were both identified and realised. Nowadays, thisprocess has been expanded beyond IS/IT investments into all kinds ofbusiness projects.
The suggestion here is that project benefits are not automatic â€“they need to be identified, planned for and actively worked on to berealised.
The benefits management process
Ward and Daniel suggest the following stages to ensure that thebenefits management process realises the maximum set of benefits fromthe project:
(1)Identify and structure benefits
(2)Plan benefits realisation
(3)Execute benefits plan
(4)Review and evaluate results
(5)Establish potential for further benefits
Identify and structure benefits
Potential benefits from projects have already been discussed inthis chapter. The key element at this stage is to quantify the benefits,establish ownership of them, determine the impact on stakeholders andconsider their impact on the business case.
It will be important that the links to the business strategy andobjectives can be identified (and, ideally, quantified). The businessshould understand completely what it is getting from the project andwhere within the organisation that benefits will arise.
It is important that the benefit is linked to a particularstakeholder(s) so that an individual or group within the organisationcan take ownership of delivering the benefit to the stakeholder. Thelikely benefit to that stakeholder should be measured (though this mightnot necessarily be in financial terms) and responsibility for realisingthat value be allocated to whoever has taken ownership of the benefit.
If sufficient benefits are not identified then the project should be abandoned at this stage.
Planning benefits realisation
This stage is a vital element of the project business case. This iswhat management will consider when making a decision for projectapproval.
It is important that all benefits are identified, responsibility isclear and the likely value of the benefit is quantified. The currentlevel of performance should be used as a starting position (baseline),and then performance measures should be identified which can identifyprogress towards achieving the perceived improvement in performance/value of the benefit.
At this stage a benefit dependency network would be created (covered later in the syllabus).
The key here is that there will be an allocated responsibility forthe benefit(s). This should provide better focus on achieving thebenefit and the performance measures attached to each benefit shouldallow management to gauge performance against set parameters.
It should also identify organisational factors that will enable orfrustrate the achievement of benefits. Alongside this a stakeholderanalysis will enable buy-in from the stakeholders, identify whichstakeholders may be resistant to change and how to overcome thisresistance, and ensure that the key stakeholders for a project play arole in the project process.
Executing the benefits plan
The plan then needs to be put into action. Interim targets shouldbe monitored and assessed and remedial action may have to be taken whenthese targets are not being met.
Further benefits may also be identified and a decision has to be taken on whether or not to pursue these.
Another problem at this stage will be that changes in the businessenvironment (whether internal â€“ for example, from changes of personnelâ€“ or external â€“ for example, from changes in legislation) makeintended benefits no longer feasible or relevant. In that case thebenefits plan (stage 2) needs to be reassessed, and it may even be thatthe whole business case for the project falls apart.
Change management programmes will also be important here and these are explored in more detail later in the syllabus text.
Reviewing and evaluating the results
One important element of this will involve a Post ImplementationReview which is discussed in more detail in the next chapter. Thisallows the organisation to learn from the project so that future projectdecisions and actions can be improved.
The evaluation should involve all those who have responsibility fordelivering benefits. It should focus on what has been achieved, identifyreasons for the lack of any benefit deliveries, and identify furtheraction needed to deliver what has not been achieved.
Establishing the potential for further benefits
Some benefits only become apparent when the project has beenimplemented and the associated business changes have been made. So thepotential for these further benefits needs to be assessed and analysed(similar to stage 1 in this overall process).
This stage might actually involve a new project and a new businesscase for developing the newly identified further benefits. Benefitsidentification should be a continuous process and a benefits drivenapproach should applied to all projects.
8 A benefits dependency framework
A benefits dependency framework is aimed at ensuring that thebusiness drivers and investment objectives are achieved by ensuringthere are appropriate business changes in areas such as work methods,structure, culture etc.
The network should be established in the following order:
(1)Identify business drivers
(2)Establish investment objectives
(3)Identify business benefits
(4)Identify required business changes
(5)Associate further enabling changes
Business and enabling changes explained
Business drivers, investment objectives and business benefits havebeen discussed earlier in this chapter. The changes required within thebusiness to facilitate a successful project have been further dividedinto two categories:
These are permanent changes to working methods that are required inthe business in order to achieve and sustain the proposed benefits.This might include new roles and responsibilities, new performancemeasures, new information systems, new reward schemes etc.
Although such changes should be seen as permanent changes, they maynot necessarily be long term. As further projects are introduced futurebusiness changes may be needed.
These are one-off changes that are necessary to allow the businesschanges to be brought about. Examples include staff training, migrationof data, data collection etc.
These may be further extended into enabling IS/IT changes that arerequired. This could include the purchase of a new IT system, forexample.
It may be that each enabling change relates to more than onebusiness change and that each business change relates to more than onebusiness benefit (and so on). It may even be that changes within eachlevel might relate to each other.
Illustration of a benefits dependency framework
The following is an extract from a benefits dependency frameworkfor a business that currently finds itself in a poor competitiveposition on the strategy clock.
Discussion on the dependency diagram
The diagram in the preceding illustration is only an extract fromthe full dependency framework. The full framework would have moreinvestment objectives (e.g. they may also want to maintain quality),business benefits (e.g. such as economies of scale and increased marketshare) etc. But an examination of the diagram should highlight theprocesses involved and how each element can link together.
Creating the network can be a complicated process. It may besimplified by pulling benefits and changes together into benefitsstreams whereby linked business and enabling changes are associated totheir related benefits.
There should be measures in place at each stage of the network todetermine when and if success has been achieved. An organisation needsto know when enabling changes have been made, when business changes havebeen achieved etc.
Benefits dependency frameworks are often created from right toleft (i.e. start with the business drivers and work back towards theenabling changes) â€“ as has been seen in this chapter. But the workhappens from left to right.
The next step in finalising the benefits dependency network is tocreate measures for each element so that success or failure of eachelement can be determined, and to then allocate responsibility orownership for each each change and benefit in the network.
A benefit owner should be assigned to each benefit. Ideallyit should be someone who gains an advantage from the benefit and istherefore motivated to ensure that the benefit is realised.
It may occasionally be necessary to have more than one benefitowner for each benefit, but this group should be kept as small aspossible.
A change owner will be appointed for each enabling andbusiness change. It will be their job to ensure that the change issuccessfully achieved. For example, if an enabling change is to trainstaff in new production techniques, then perhaps an HR manager will begiven ownership of this change and responsibility for its success orfailure.
Benefit and change owners should have the power to effect theachievement of either benefits of change. Benefit owners might need tohave the power to add extra resources to the project, whilst changeowners may have to use their influence to overcome problems. Therefore,the owners will often hold senior positions in the organisation.
However, this does not always have to be the case. For simpleprojects where there is significant past experience, middle managersmight play some ownership roles â€“ particularly as change owners.
Let's examine how the ownership might look for the changes and benefits expected in the earlier illustration.
It can be seen that it is often the case that those who wereresponsible for making the changes also derived benefits from thosechanges. It can also be seen that there are a wide range of owners inthe network from middle line managers to senior directors.
The role of the project team
The project team will work alongside these benefit and changeowners. The team might take some responsibility for enabling changes(and therefore become respective change owners), but they are unlikelyto become benefit owners.
Balancing benefit and change owners
There may be a conflict in the network if the change owner differsin goals and outlook from the benefits owner. The change owner may lackmotivation if he/she enables changes but derives no benefit from thosechanges.
It is therefore important that change owners can understand theimpact of their changes and the benefits that will be derived by theorganisation as a whole. It may be important that they understand andare motivated by the business drivers. For example, in the aboveillustration, it will be important for HR managers to understand thatwithout a change in competitive position the business might fail overalland put everyone's job at risk. This might make them more motivated toenable the change in workforce that is required through redundancies andnew recruitment.
Therefore a balance must be sought between benefit owners andchange owners. In some extremes, where there is a resistance from changeowners to make the change, it may be that some project benefits have tobe sacrificed for the good of the project overall.
Advantages of a benefits dependency network
- it clearly illustrates the why (business drivers), what (business benefits) and how (business and enabling changes) for the project
- linkages can be clearly identified
- enabling changes can be followed through to the business drivers
- if some business benefits require too many enabling and business changes then they may be dropped from the project
- it can feed into the project plan and improve the efficiency of that stage of project management
- it may form the basis of a project SWOT analysis
- the impact of a failure to make an enabling change, for example, can be followed through to discover the overall impact on the project
Disadvantages of a benefits dependency framework
- it can be complicated to illustrate
- not all links from enabling changes to business changes and so forth may be identified
- it may not be complete
9 Project costs
In order to properly assess a project the potential benefits needto be measured against the potential costs. Typical project costs mightbe:
- capital investment costs
- development costs
- centrally allocated costs / infrastructure costs
- external consultancy costs
- resource costs
- quality costs
- flexibility costs
- disruption costs
Further details on project costs
- capital investment costs* â€“ this would include the costs of IT hardware and software, project specific assets etc.
- development costs* â€“ historic development costs may be easier to ascertain than future development costs which arise as the project is better understood and modifications are required. But an estimate of such costs should still be made.
- centrally allocated costs/infrastructure costs* â€“ these would be costs for the use of premises and central services (such as accounting or personnel services) and may also include an allocation of charges such as depreciation. But, again, only those costs that are incurred exclusively for the project should be included as a project cost.
- external consultancy costs â€“ these might be incurred in project design, quality management, procuring software etc.
- resource costs â€“ these can include the ongoing staff and material costs. In the project appraisal it is normal to include only incremental costs here, so if staff, for example, are transferred from elsewhere in the business no cost might actually be attributed to the project.
- quality costs â€“ this can include the cost of training staff, monitoring performance, reworks etc.
- flexibility costs â€“ project management teams need to be as flexible as possible and there may be costs associated with achieving this. These could be costs involved in facilitating flexible working (such as providing IT equipment in staff homes) or in flexible production or servicing (such as lower batch sizes or depackaged services).
- disruption costs â€“ an attempt should be made to quantify these (often) intangible costs from elements such as a loss of productivity during project changeover or from resource reallocations.
- these costs may be deemed to be capital costs and thereforecharged to the statement of financial position (balance sheet) ratherthan the income statement. From an accounting perspective, the costwould then be spread (through either depreciation or amortisation) over anumber of accounting periods. This can give different results forproject appraisal depending on the method of appraisal used (forexample, the ARR method will use the accounting treatment whereas theNPV method will follow the timing of the cash flows and ignore theaccounting treatment).
Costs are often more tangible than benefits so the importantelement will be to identify all costs and attempt to quantify them anddetermine when they will occur.
10 Project appraisal
Due to the large amount of time and resources that can be tied upin a project, it is important that they are screened properly. Part ofthat screening will involve an assessment of the financial rewards thatmay be derived from the project. You should be familiar from yourprevious studies with financial appraisal methods such as:
- accounting rate of return (ARR)
- payback period
- net present value (NPV)
- internal rate of return (IRR)
Problems in focusing on financial returns
The project appraisal methods which follow focus purely on thefinancial rewards of a project. However this should not be the onlydecision criteria that an organisation employs. Examining only financialcosts and benefits can lead to the following problems:
- non-financial costs or benefits might outweigh the financial ones. Earlier in the chapter we discussed other types of benefits such as observable and measureable benefits which are ignored in financial calculations.
- managers may be encouraged to use 'creative' calculations of benefits in order to have them classified as financial benefits.
- costs may be removed from the forecasts in order to 'overstate' the case for the project.
- managers may include slack in their forecasts in order to show enough benefit to achieve the project approval but without having onerous targets.
- projects with no financial benefits would automatically be rejected.
Accounting rate of return (ARR)
The ARR method is an accounting method that gives a percentage return that is expected from the investment.
The most common formula is:
- The ARR for a project may be compared with the company's target return and if higher the project should be accepted.
- Faced with a choice of mutually-exclusive investments, the project with the highest ARR should be chosen.
Further details on ARR
Average annual profit = Net cash flow less depreciation
- The 'average annual profit' is after depreciation.
- Net cash flow is equivalent to 'profit before depreciation'.
- The average value of the investment represents the average capital employed over the life of the project.
- That is the initial investment plus the residual value, then all divided by two.
The target return might be determined from a number of sources:
- the return from existing, similar projects
- the return on investment (ROI) of the business unit
- the return on capital employed (ROCE) from the business overall
- past returns from projects
- the company's cost of capital.
- Simplicity â€“ As with the payback period, it is easily understood and easily calculated.
- Link with other accounting measures â€“ Return on capital employed, calculated annually to assess a business or sector of a business (and therefore the investment decisions made by that business), is widely used and its use for investment appraisal is consistent with that. The ARR is expressed in percentage terms with which managers and accountants are familiar. However, neither this nor the preceding point necessarily justify the use of ARR.
There are a number of specific criticisms of the ARR.
- It fails to take account of either the project life or the timing of cash flows (and time value of money) within that life.
- It will vary with specific accounting policies, and the extent to which project costs are capitalised. Profit measurement is thus 'subjective', and ARR figures for identical projects would vary from business to business.
- It might ignore working capital requirements.
- Like all rate of return measures, it is not a measurement of absolute gain in wealth for the business owners.
- There is no definite investment signal. The decision to invest or not remains subjective in view of the lack of an objectively set target ARR.
It is concluded that the ARR does not provide a reliable basis for project evaluation.
The payback period
The payback period is the time a project will take to pay back themoney spent on it. It is based on expected cash flows and provides ameasure of liquidity.
This is the time which elapses until the invested capital isrecovered. It considers cash flows only. Unlike DCF techniques, it isoften assumed that the cash flows occur evenly during the year.
- Compare the payback period to the company's maximum return time allowed and if the payback is quicker the project should be accepted.
- Faced with mutually-exclusive projects choose the project with the quickest payback.
Further details on the payback period
Calculation â€“ Constant annual flows
A payback period may not be for an exact number of years. Tocalculate the payback in years and months you should multiply thedecimal fraction of a year by 12 to the number of months.
Calculations â€“ Uneven annual flows
However, if cash inflows are uneven (a more likely state ofaffairs), the payback has to be calculated by working out the cumulativecash flow over the life of a project
As a concept, it is easily understood and is easily calculated.
- Rapidly changing technology
If new plant is likely to be scrapped in a short period because of obsolescence, a quick payback is essential.
- Improving investment conditions
When investment conditions are expected to improve in the nearfuture, attention is directed to those projects that will release fundssoonest, to take advantage of the improving climate.
- Payback favours projects with a quick return
It is often argued that these are to be preferred for three reasons.
- Rapid project payback leads to rapid company growth â€“ but in fact such a policy will lead to many profitable investment opportunities being overlooked because their payback period does not happen to be particularly swift.
- Rapid payback minimises risk (the logic being that the shorter the payback period, the less there is that can go wrong). Not all risks are related to time, but payback is able to provide a useful means of assessing time risk (and only time risk). It is likely that earlier cash flows can be estimated with greater certainty.
- Rapid payback maximises liquidity â€“ but liquidity problems are best dealt with separately, through cash forecasting.
Unlike ARR it uses cash flows, rather than profits, and so is lesslikely to produce an unduly optimistic figure distorted by assortedaccounting conventions which might permit certain costs to be carriedforward and not affect profit initially.
- Project returns may be ignored â€“ In particular, cash flows arising after the payback period are totally ignored.
- Timing ignored â€“ Cash flows are effectively categorised as pre-payback or post-payback, but no more accurate measure is made. In particular, the time value of money is ignored.
- Lack of objectivity â€“ There is no objective measure as to what length of time should be set as the minimum payback period. Investment decisions are therefore subjective.
- Project profitability is ignored â€“ Payback takes no account of the effects on business profits and periodic performance of the project, as evidenced in the financial statements. This is critical if the business is to be reasonably viewed by users of the accounts.
Net present value (NPV)
The net benefit or loss of benefit in present value terms from an investment opportunity.
The NPV represents the surplus funds (after funding the investment)earned on the project. This means that it tells us the impact onshareholder wealth. Therefore:
- Any project with a positive NPV is viable.
- Projects with a negative NPV are not viable.
- Faced with mutually-exclusive projects, choose the project with the highest NPV.
Further details on NPV
What the NPV tells us
Suppose, in an investment problem, we calculate the NPV of certaincash flows at 12% to be â€“ $97, and at 10% to be zero, and yet at 8%the NPV of the same cash flows is + $108. Another way of expressing thisis as follows.
- If the funds were borrowed at 12% the investor would be $97 out of pocket â€“ i.e. the investment earns a yield below the cost of capital.
- If funds were borrowed at 10% the investor would break even â€“ i.e. the investment yields a return equal to the cost of capital.
- If funds were borrowed at 8% the investor would be $108 in pocket â€“ i.e. the investment earns a return in excess of the cost of capital.
In other words, a positive NPV is an indication of the surplusfunds available to the investor now as a result of accepting theproject.
The time value of money
The required return (cost of capital) aims to take account of thetime value of money. There are three main reasons for the time value ofmoney.
Potential for earning interest
If a capital investment is to be justified, it needs to earn atleast a minimum amount of profit, so that the return compensates theinvestor for both the amount invested and also for the length of timebefore the profits are made. For example, if a company could invest$80,000 now to earn revenue of $82,000 in one week's time, a profit of$2,000 in seven days would be a very good return. However, if it takesfour years to earn the money, the return would be very low.
Therefore money has a time value. It can be invested to earn interestor profits, so it is better to have $1 now than in one year's time.This is because $1 now can be invested for the next year to earn areturn, whereas $1 in one year's time cannot. Another way of looking atthe time value of money is to say that $1 in six years' time is worthless than $1 now.
Impact of inflation
In most countries, in most years prices rise as a result ofinflation. Therefore funds received today will buy more than the sameamount a year later, as prices will have risen in the meantime. Thefunds are subject to a loss of purchasing power over time.
The earlier cash flows are due to be received, the more certainthey are â€“ there is less chance that events will prevent payment.Earlier cash flows are therefore considered to be more valuable.
Assumptions used in calculations
- All cash flows occur at the start or end of a year.
Although in practice many cash flows accrue throughout the year,for discounting purposes they are all treated as occurring at the startor end of a year. Note also that if today (T0) is 01/01/20X0,the dates 31/12/20X1 and 01/01/20X2, although technically separatedays, can be treated for discounting as occurring at the same point intime, i.e. at T1.
- Initial investments occur at once (T0), other cash flows start in one year's time (T1).
In project appraisal, the investment needs to be made before thecash flows can accrue. Therefore, unless the examiner specifiesotherwise, it is assumed that investments occur in advance. The firstcash flows associated with running the project are therefore assumed tooccur one year after the project begins, i.e. at T1.
Advantages of NPV
When appraising projects or investments, NPV is considered to be superior (in theory) to most other methods. This is because it:
- considers the time value of money â€“ discounting cash flows to PV takes account of the impact of interest, inflation and risk over time. (See later sessions for more on inflation and risk.) These significant issues are ignored by the basic methods of payback and annual rate of return (ARR)
- is an absolute measure of return â€“ the NPV of an investment represents the actual surplus raised by the project. This allows a business to plan more effectively
- is based on cash flows not profits â€“ the subjectivity of profits makes them less reliable than cash flows and therefore less appropriate for decision making. Neither ARR nor payback is an absolute measure
- considers the whole life of the project â€“ methods such as payback only consider the earlier cash flows associated with the project. NPV takes account of all relevant flows associated with the project. Discounting the flows takes account of the fact that later flows are less reliable which ARR ignores
- should lead to maximisation of shareholder wealth. If the cost of capital reflects the investors' (i.e. shareholders') required return, then the NPV reflects the theoretical increase in their wealth. For a company, this is considered to be the primary objective of the business.
Disadvantages of NPV
However, there are some potential drawbacks:
- It is difficult to explain to managers. To understand the meaning of the NPV calculated requires an understanding of discounting. The method is not as intuitive as techniques such as payback.
- It requires knowledge of the cost of capital. The calculation of the cost of capital is, in practice, more complex than identifying interest rates. It involves gathering data and making a number of calculations based on that data and some estimates. The process may be deemed too protracted for the appraisal to be carried out.
- It is relatively complex. For the reasons explained above, NPV may be rejected in favour of simpler techniques.
Internal rate of return (IRR)
This is the rate of return at which the project has a NPV of zero.
- If the IRR is greater than the cost of capital the project should be accepted.
- Faced with mutually-exclusive projects choose the project with the higher IRR.
The advantage of NPV is that it tells us the absolute increase inshareholder wealth as a result of accepting the project, at the currentcost of capital. The IRR simply tells us how far the cost of capitalcould increase before the project would not be worth accepting.
Further details on the IRR
Using the NPV method, PVs are calculated by discounting cash flowsat a given cost of capital, and the difference between the PV of costsand the PV of benefits is the NPV. In contrast, the IRR method of DCFanalysis is to calculate the exact DCF rate of return that the projectis expected to achieve.
If an investment has a positive NPV, it means it is earning morethan the cost of capital. If the NPV is negative, it is earning lessthan the cost of capital. This means that if the NPV is zero, it will beearning exactly the cost of capital.
Conversely, the percentage return on the investment must be therate of discount or cost of capital at which the NPV equals zero. Thisrate of return is called the IRR, or the DCF yield and if it is higherthan the target rate of return then the project is financially worthundertaking.
Calculating the IRR (using linear interpolation)
The steps in linear interpolation are:
(1)Calculate two NPVs for the project at two different costs of capital
(2)Use the following formula to find the IRR:
FORMULA FOR IRR
L = Lower rate of interest
H = Higher rate of interest
NL = NPV at lower rate of interest
NH = NPV at higher rate of interest.
- IRR considers the time value of money. The current value earned from an investment project is therefore more accurately measured. As discussed above this is a significant improvement over the basic methods.
- IRR is a percentage and therefore easily understood. Although managers may not completely understand the detail of the IRR, the concept of a return earned is familiar and the IRR can be simply compared with the required return of the organisation.
- IRR uses cash flows not profits. These are less subjective as discussed above.
- IRR considers the whole life of the project rather than ignoring later flows (which would occur with payback for example).
- IRR a firm selecting projects where the IRR exceeds the cost of capital should increase shareholders' wealth. This holds true provided the project cash flows follow the standard pattern of an outflow followed by a series of inflows, as in the investment examples above.
However there are a number of difficulties with the IRR approach:
- It is not a measure of absolute profitability. A project of $1,000 invested now and paying back $1,100 in a year's time has an IRR of 10%. If a company's required return is 6%, then the project is viable according to the IRR rule but most businesses would consider the absolute return too small to be worth the investment.
- Interpolation only provides an estimate (and an accurate estimate requires the use of a spreadsheet programme). The cost of capital calculation itself is also only an estimate and if the margin between required return and the IRR is small, this lack of accuracy could actually mean the wrong decision is taken.
- For example if the cost of capital is found to be 8% (but is actually 8.7%) and the project IRR is calculated as 9.2% (but is actually 8.5%) the project would be wrongly accepted. Note that where such a small margin exists, the project's success would be considered to be sensitive to the discount rate (see session 12 on risk).
- Non-conventional cash flows may give rise to no IRR or multiple IRRs. For example a project with an outflow at T0 and T2 but income at T1 could, depending on the size of the cash flows, have a number of different profiles on a graph (see below). Even where the project does have one IRR, it can be seen from the graph that the decision rule would lead to the wrong result as the project does not earn a positive NPV at any cost of capital.
Links between project appraisal and benefits management
Project appraisal occurs before a project is undertaken. Its roleis to identify the potential (mainly financial) benefits and costs ofthe project and provide decision making criteria.
Benefits management also wants to identify the benefits in aproject, but its role is about ensuring that these benefits actuallyaccrue. It is an ongoing process throughout the life of the project.
There is therefore some link between these processes, but benefitsmanagement extends project appraisal by scope, actions and timeframe.
11 Chapter summary
Test your understanding answers
Test your understanding 1
Visualise a current project. Which of the three constraints is the driver? Which is the weak constraint?
If you ask enough comparative questions, you will develop a hierarchy of the constraints.
The following questions can be used to explore your project.
- If I had to choose between spending more time on the project or cutting quality, which would I choose?
- If I had to choose between delivering the project on time (and spending more money) or keeping the project on budget, which should I choose?
- If the project began running over budget, would I immediately consider cutting features or quality?
- If the project is behind schedule, would I spend more money to get back on schedule?
Test your understanding 2
(1)The risk of a lawsuit should bedealt with my taking out indemnity insurance. The risk is thentransferred to the insurance company.
(2)The risk of pool closure is seriousand since a provision of a pool is clearly essential for the sportscentre, the risk must be avoided instead. This would mean putting inplace a series of controls over the building process to prevent latercracks from occurring â€“ risk avoidance.
(3)The risk of fraud is exactly thetype of risk that a good internal control system would be designed toprevent â€“ risk reduction.
(4)Bad weather will always be a riskwhen dealing with outdoor activities and is probably best accepted andthe lost revenues factored into the initial forecasts.
Created at 5/24/2012 12:56 PM by System Account
(GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London
Last modified at 5/25/2012 12:55 PM by System Account
(GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London
Ratings & Comments
(Click the stars to rate the page)