When the DIPP dips

a P&L index for project decisions

INTRODUCTION

Few management decisions are more difficult than to determine whether to keep funding a project or to abandon it. And few decisions are more crucial to corporate health: a sick project can be a sinkhole into which enormous amounts of money disappear with little hope of return.

Methodologies are appearing to help identify and evaluate troubled projects. Suresh K. Tadisina [1] performed statistical discriminant analysis on data for about 220 R&D projects. By categorizing them as successes or failures, he isolated 23 major factors which seemed to be suitable predictors. With the possible caveat of tautologous reasoning (projects which were abandoned were automatically listed as failures, without examination of whether or not the decision was correct), this technique maybe useful for in-depth analysis once a potential problem has been identified.

But the Tadisina system is complex, and its data not easily accessible. It requires many subjective judgments (complexity of the project, implications for users), and is generally unsuitable as a monitoring index. Similarly, Shafer and Mantel [2] recommend a weighted model to support decisions. Again, their model is complex, and suggests that a decrease in a project's “score” from one period to the next might justify its termination, when, in reality, a project's historical data should be part of the decision only insofar as it is used to establish reliability about current data and forecasts. The decision to go on or stop should always be based on current status and forecasts, not history.

Meredith [3] proposes an ongoing “audit” of the project based on several criteria. But these criteria also suffer from subjectivity (e.g., Is commitment dissipating? Is there organizational inertia?) and complexity. Profit-and-loss, which can be quantified and should be at the heart of the decision, is only one of many factors.

These articles emphasize the need for some sort of index of project profitability. Tadisina says: “To be useful, the monitoring mechanism should be inexpensive and easy to implement and operate.” None of the methodologies seem to respond fully to that need. What follows is a system whose index is easily comprehended, and which can be computed quickly.

THE METHODOLOGY

Earned value calculations allow management to measure the amount of work that has been performed, the “bang” they've been getting for their “buck,” and to estimate future costs. These methodologies are readily available; but their implications for a “go/no-go” decision are rarely quantified.

There is no dispute that the go/no-go decision must always involve considerations beyond dollars. Factors such as the media fall-out of abandoning a well-publicized project, legal implications, losing a market niche, the human costs in layoffs, morale damage and internal cynicism need to be analyzed. These and other issues may often outweigh the purely financial evaluation. However, the economic considerations should be isolated from the other factors and kept in focus at the center of the discussion. All other data should be treated as modifiers, brightening or darkening the picture which counting the dollars has painted. In that way, management will be in a position to say, “Yes, we're going to take a loss of $X on this project. But that seems a small price to pay for...”

In trying to establish precisely where to start the search for meaningful data, it is important to consider the project life cycle. Figures 1, 2, and 3 show a typical product development project at different points in the life cycle. This type of project serves as a suitable paradigm because the financial numbers involved in product development (whether in construction, software development, pharmaceuticals, engineering, or publishing) are often a little clearer than in other types of projects.

For our example, we will consider a hypothetical four-year, $100 million project to develop, manufacture and market a product expected to generate $150 million in sales. For simplicity's sake, we will assume that all dollars are “real” dollars (zero inflation during the life of the project) and that the sales revenue will be received as soon as the product is delivered.

We will now analyze three “real world” problems. You are the CEO who must make the decisions. For purposes of this exercise, you should consider only the economics of the situation.

1. In Figure 1, at time A, 18 months after start, our project is on schedule and on budget. We have achieved one quarter of the project's total earned value, with actual costs of $25 million. However, new market research shows that a competitor will beat us to market by a full year with a similar product. This is expected to cut our total market share and our contribution margin to $70 million. Should you approve further expenditure on this project or abandon it?

2. In Figure 2, at time B, after two years, the latest market study shows projected sales holding steady and the contribution margin at $70 million. However, our project has run into problems. Instead of being half finished, we have completed only 40 percent of the work. We have already spent $60 million, and we now estimate that it will cost another $65 million to complete it. Go? Or no go?

3. In Figure 3, the project has reached time C. It has been one problem after another. We have already spent $100 million. Our estimate-to-complete stands at an additional $30 million. Further delays have lowered our market share to the point where we can expect to make only one-third of our original contribution margin of $150 million. Fish? Or cut bait?

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Figure 1.

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Figure 2.

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Figure 3.

These decisions are all painful ones. In every case the company is going to lose money, and, in situations two and three, a great deal of money. In such dilemmas, there are two very human temptations: to let the inertia of the project dictate a “non-decision” decision, thus allowing it to finish; or, with a macho decisiveness, to shut one's eyes to the numbers and one's ears to the screams while amputating the offending project.

Yet this decision is precisely the kind that can save a company millions. It should be analyzed and reasoned with clearest logic, and hard numbers should be relied upon wherever possible.

Situation One. In situation one, we have a project that has been Proceeding smoothly, with neither schedule nor cost variance. Yet suddenly, due to an unforeseen occurrence in the marketplace, our anticipated contribution margin from the finished product has fallen by $80 million. Obviously, there is no longer much chance of producing the cool $50 million in contribution margin we had hoped for. But should we abandon the project?

Table 1. Economic Analysis of Situation 1

Millions of Dollars
Actual cost-to-date 25
Estimate-to-complete 75
Total cost at completion 100
Total project contribution margin 70
Total contribution if completed (100 - 70) 30
Total contribution losses if halted 25
Relevant contribution if halted −5
DIPP = .933

First, we must divest ourselves of all consideration of what went before. Yes, we have already invested $25 million. And yes, this project is doomed to lose money. But those are not the issues. Sunk costs are not relevant costs. In this and all other such cases, the discussion must be pared down to this question: “From this moment on, can we save the company more money by proceeding or by halting?”

Table 2. Economic Analysis of Situation 2

Millions of Dollars
Actual cost-to-date 60
Estimate-to-complete 65
Total cost at completion 125
Total project contribution margin 70
Total contribution if completed (125 - 70) 55
Total contribution losses if halted 60
Relevant contribution if halted + 5
DIPP = 1.077

When examined in this light, we discover the numbers in Table 1.

Halting the project will therefore save the company $5 million. Unless an alternative can be found which will alter the current outlook (shorten the project duration and beat the competitor to market, for instance), the project should probably be abandoned.

An important lesson maybe drawn from this example. The fact that a project is proceeding smoothly is not necessarily an indication that it should be completed. The implication of this is that, in a product development project, tie project manager needs to keep one eye on the marketplace at all times. An appropriate tool for doing this will be suggested later.

Table 3. Economic Analysis of Situation 3

Millions of Dollars
Actual cost-to-date 100
Estimate-to-complete 30
Total cost at completion 130
Total project contribution margin 50
Total contribution if completed (130 - 50) 80
Total contribution losses if halted 100
Relevant contribution if halted + 20
DIPP = 1.667

Situation Two. In the second situation, the project has fallen behind schedule and is also over budget. You might assume that this should seal its fate all the more. Yet we cannot be sure without again examining the numbers (Table 2).

In this case, if the project is halted, it will cost the company $5 million more than to complete it according to the present plan. The reason for the change is that the project's estimate-to-complete has been reduced as work has gone on. With much of the course already run, it probably makes economic sense to complete the product.

Situation Three. In the third situation, we can expect to make only $50 million, down $100 million from our original lofty goal. Surely we should cut this one loose! But let us again scrutinize the numbers (Table 3).

This time, if the project is halted it will cost the company $20 million more than to complete it according to the present plan. Obviously, as the project nears completion, the expected revenues needed to justify its completion shrink to a tiny fraction of the original projections, In this case, a bare $30 million, or 20 percent of the original estimate would have been the fulcrum.

A clear pattern has emerged: in every case, the margin on which the decision rests is the difference between the total projected sales and the estimate-to-complete. This not only emphasizes that sunk costs are not meaningful when making the go/no go decision on a project; it also provides us with an important and easily generated index:

Devaux's Index of Project Performance (DIPP) =

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The DIPP should be used as a threshold index for all product development projects. Whenever the DIPP dips below 1.0 (in other words, total projected sales become equal to or less than estimate-to-complete), it will almost certainly cost more to complete the project than to halt it. But the simple fact that the DIPP is above 1.0 does not necessarily mean that the project is still profitable: other considerations which bear on profitability should be examined and, wherever possible, quantified. Some of these are listed below.

Refinement 1: Opportunity Cost (OC)

If resources were unlimited, this would never be a factor. However, since most companies are constrained by available labor, equipment, materials, and/or finances, opportunity cost is a commonly invoked reason for abandoning a project.

Yet all too often this is merely a rationalization. Opportunity cost should only be factored into the equation if there really is no other way of obtaining a resource. If the resource can be duplicated, but only at great expense, then the expense incurred should be included in the equation as an opportunity cost. But just because the same resource can be used on another project does not justify canceling the original project if, in so doing, an unnecessary loss is incurred. If it is possible to. duplicate the resource, then both projects should be completed.

The inclusion of opportunity cost amends the DIPP as follows:

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In situation 2, if the opportunity cost of completing the project is estimated at $5 million, this would lower the DIPP to exactly 1.0.

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Table 4. Effect for Opportunity Cost and Cannibalization

Millions of Dollars
Estimate-to-complete 65
Total project contribution margin 70
Opportunity cost 5
Cannibalization worth 2
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Table 5. Effect of Opportunity Cost and Project Termination Cost

Millions of Dollars
Estimate-to-complete 65
Total project contribution margin 70
Opportunity cost 5
Cannibalization worth 2
Project termination cost 3
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Table 6. Effect of Net Present Value on Cash Flow

Millions of Dollars
TPCMnpv Now =    5.0 / 1.0 5.0
TPCMnpv Yr 1 =    25/1.1         = 22.7
TPCMnpv Yr 2 =    25/1.21       = 12.4
TPCMnpv Yr 3 =    10 / 1.33     = 7.5
TPCMnpv Yr 4 =    10 / 1.46     = 6.8
TPCMnpv Yr 5 =    5/ 1.61        = 3.1
57.5
Now the total TPR for use in the DIPP equation would be:
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Refinement 2: Cannibalization Worth (CW)

As work is performed on one project (e.g., equipment purchases, landscaping, skill training, acquiring process patents), it frequently has potential value for other projects. The value of the work which can be transferred can affect the DIPP. But (and this is crucial!) only insofar as the transfer destroys the value of the work for the original project. Otherwise, the transfer has no implications for the validity of pursuing the original project.

For instance, let us suppose that we build an access road in preparation for constructing a shopping mall. Then it turns out that an apartment complex would be even more profitable. If there is room on the site for one or the other, but not both, then the value of the road may be transferred to the apartment project. This would increase the return necessary to justify completing the mall. However, if the site is large enough to contain both structures, the road's value should not be cannibalized: the mall project should be considered as separate from the apartment project.

This “movable” value is like opportunity cost, except that it relates to work already completed rather than resources for work to be done in the future. This value is referred to as the “cannibalization worth” (CW) of the project. It has the effect of increasing the level of total projected sales necessary to justify completing the project. It can be included in the DIPP equation as follows:

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In situation 2, a cannibalization worth of $2 million would be sufficient to justify stopping the project (see Table 4).

Refinement 3: Project Termination Cost (PTC)

Frequently, there is cost associated with abandoning a project: materials must be stored, equipment sold, and unemployment insurance paid. All these contribute to the argument for continuing the project. As a result, their cost should be subtracted from the estimate-to-complete in the DIPP formula:

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In situation 2, a PTC of $3 million would send the DIPP for our project back above 1.0 (see Table 5).

Refinement 4: Computing Total Project Revenue (TPR)

For simplicity's sake, all of the situations we have examined have treated sales revenue as though it were a lump sum to be received upon completion of the project. But normally the product will be bringing in revenue over several years. Even without allowing for inflation, the value of a dollar received three years hence is not the same as one received today. This is sometimes referred to as the “time value of money.”

Future revenues may be discounted by using net present value analysis. According to this formula, the amount of money received for a product each year after delivery to market is divided by (1 + i) to the power n where i is projected interest rate on the money and n is the number of years after delivery. According to this formula, the TPCM would be derived as shown:

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Thus, if we estimate an annual interest rate of 10 percent, we can break down the TPCM for situation two as shown in Table 6.

CONCLUSION

What are the implications of all this?

First, the circumstances surrounding the re-examination of a troubled project are often chaotic. Emotion can run high, and attention is often focused on issues that are irrelevant. (“We've already spent eleventeen million dollars developing this widget. Let's not waste it.” Or alternatively: “Let's not throw good money after bad!”) The DIPP formula helps reduce some of these issues to quantifiable data.

Second, the DIPP isolates the financial data from other considerations. While much of the effort of previous authors has been to provide a single index which would take all factors into account, I suggest that such an approach might be a mistake. It is important to be able to focus on just the economics of the decision.

Third, the link between product development and the marketplace is drawn all the more tightly. The development project cannot be separated from the sales forecast. This suggests that the project manager on such projects must also be the product manager, keeping one eye on market forecasts at all time. This may allow the product manager to make duration and/or budget changes in the project on the basis of market conditions. For example, a project's DIPP might be below 1.0 when computed on the basis of the current operating plan; but a change in that plan might increase the DIPP. Increases or cuts in scope, in budget, or in project duration, can all affect the total project revenue, the estimate-to-complete, or both.

Perhaps most important, the DIPP should be used as an “early warning” indicator. Reports to senior management should include this index, at least in its simplest form, (i. e., DIPP = TPCM/ETC). The DIPP can then be used to establish an escalation threshold, much as schedule variance (SV) and cost variance (CV) are often used. A suggestion would be that, any time the DIPP falls below 1.0 + .2n (where n = the remaining duration in years or parts of years), senior management be alerted, the refined DIPP computed, and the project plan scrutinized. In other words, if a project is in its final year, its simple DIPP would need to be greater than 1.2; in its last two years, greater than 1.4, and so on. In this way, corrective actions that might forestall the eventual cancellation of the project could be taken.

ACKNOWLEDGMENT

The author would like to express sincere thanks to Wayne Halverson and Walter Frank for their valuable insights and assistance.

REFERENCES

1. Tadisina, S.K. 1986. Support Systems for the Termination Decision in R&D Management. Project Management Journal, XVII, 5, 97-104.

2. Shafer, S.M. and Mantel, S.J. 1989. A Decision Support System for the Project Termination Decision: A Spreadsheet Approach. Project Management Journal, XX, 2, 23-28.

3. Meredith, J.R. 1988. Project Monitoring for Early Termination. Project Management Journal, XIX, 5, 31-38.

4. Staw, B.M. and Ross, J, 1988. Knowing When to Pull the Plug. Harvard Business Review, March-April, 68-74.

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Stephen A. Devaux is president of Analytic Project Management of Bedford, Massachusetts, and is a member of PMI. A former project manager himself in financial services, he has spent the past five years consulting with Fortune 500 clients and teaching project management theory in the aerospace, manufacturing, utility, software development and other industries.

Originally an English teacher, Mr. Devaux has spent the past 13 years in corporate training, and stresses the vital role that education must play in adapting the corporate culture to project management methodologies. He has published articles on instructional design and project management implementation in many periodicals, including Computer world, PMNETwork, Data Traininq and CBT Directions.

*DIPP - (Devaux's Index of Reject Performance) is defined in the text of this article

This material has been reproduced with the permission of the copyright owner. Unauthorized reproduction of this material is strictly prohibited. For permission to reproduce this material, please contact PMI.

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