selection tool or trap?
by Stephen Smith and Joh Barker, PMP
IN AN ATTEMPT TO MANAGE the complexity of the project selection decision, some IT consultancies are applying a powerful tool from the finance discipline: the Benefit-Cost Ratio (BCR). However, a number of concerns have risen regarding BCR as a measure of both project acceptability and project selection. (While many project managers may find this a useful shortcut for project robustness, the financial literature suggests that extreme care should be exercised where this is used as a basis for project selection.) BCR is derived from the mathematics of Net Present Value (NPV) and is subject to the assumptions of the discounting model. These assumptions are not always valid for technology projects. Likewise, for project selection, technology is often an enabler rather than a measure of direct revenue gain or attributable cost savings. For such projects, degree of alignment with business strategy is the more important criterion.
BCR and Project Acceptability
The BCR, or profitability index, divides the NPV of the cash inflows by the NPV of the cash outflows, such that:
and k is the required rate of return.
Projects with a BCR of 1 or more are potentially acceptable.
Projects with a BCR of less than 1 should be rejected.1
Stephen Smith lectures in information systems at the University of Melbourne. Prior to joining the university, he was the financial accountant for the Australian subsidiary of Square D Company. He can be contacted at [email protected].
Joh Barker has over 20 years experience in information technology and finance. She has worked as a senior project management and in director roles, and is chief financial officer with SMS Consulting Group. She can be contacted at [email protected].
The discounting of cash flows is used to account for the time value of money.2 This provides a built-in estimate for the opportunity cost of those inflows that require borrowing or investing throughout the life of the project. As indicated above, the usual acceptance criterion for the BCR method is that any project returning a ratio of 1 or more is potentially acceptable, although at least one text recommends setting a hurdle ratio of 1.33. Regardless of whether the hurdle ratio is set at 1 or something higher, BCRs that exceed the hurdle ratio are of net benefit to the sponsor. Anything less than the hurdle ratio should be rejected.
Problems With BCR
Powerful as the BCR is, financial analysts generally don't use it in isolation. Why not?
Problem 1: BCR is a Relative Measure. First, the BCR indicates only the relative profitability of a project, but when comparing different projects, the absolute contribution to shareholder wealth must also be considered. Any project with a BCR of 1 or more is profitable at the minimum acceptable rate of return, but the calculation doesn't show the size of returns. A $10 project could show a BCR of 10, while a $10-million project might only show a BCR of 1. Clearly, the absolute size of the project matters.
Given that absolute size matters, and projects with a BCR of 1 or more meet the minimum required rate of return, profitable projects should be ranked by absolute size. To do otherwise could mean rejecting the projects providing the greatest increase in wealth in favor of those that seem to have the greatest rate of return. Most business managers and shareholders would not regard such a practice as good business decision-making.
Interestingly, however, some of the literature supporting BCR seems to recommend exactly that. At least one text suggests that projects with a BCR of less than 1.33 should be rejected. It is not entirely clear to us why the hurdle ratio has been set at 1.33. Yet, to reject any project with a BCR of 1 or more is to reject profitable business opportunities. Common sense indicates that projects with the highest rates of return are often the riskiest. Rejecting all but the most profitable projects therefore exposes the business to more risk than is necessary, as well as limiting growth. In order to force a worthwhile project to cross the extra hurdle, project managers might also need to sacrifice quality for short-term gains (for example, by using cheaper, lower-quality equipment) and possibly even inadvertently engineer a situation where the project becomes a financial burden in the long run.
Problem 2: BCR is Subject to the Assumptions of the Net Present Value Formula. The second problem with BCR is that it is derived from the NPV formula. The NPV was designed to model an environment where there is a substantial up-front investment followed by an ongoing revenue stream; cost and revenues are easily traced to the investment decision; and the size of the investment and the size of the revenue stream are known with some degree of certainty.
Typically this is not the situation confronting IT project managers. Usually IT projects are of short duration and have complex interdependencies and high uncertainties. Market forces continue to pressure IT projects into delivery timetables of less than 12 months. Frequently, stage gates are introduced as a basis for risk containment and project evaluation. These stage gates identify milestones throughout a project's life where the decision is to continue, change direction or cease the assignment. Stage gates are also useful in containment or at least explicit identification of scope changes. Scope changes are often more keenly experienced in IT where market and technology pressures mean the final project delivery may vary significantly from the initial charter. All these pressures add uncertainty to the measurement of cost streams, the identification of revenue streams, and the relevance of time value for investment.
The short timetables for IT projects also cause the project manager to become a negotiator for resources—rather than an owner, as in a functional organization. This results in short-term teams, which are built to achieve a task and then returned to their functional home base—be it the IT department, the customer, or the process environments. Cost allocation for short-term, often part-time, shared resources is a highly complex and inexact area of management accounting. The fixed-cost nature of much of the resource cost means that the project charges often reflect an organization's allocation policies rather than a true measure of resource consumption or opportunity cost.
Uncertainty in the project management world is managed through risk identification, risk quantification, and risk response development. The latter is concerned with avoidance, mitigation and/or acceptance of the risk consequences. With all responses, a contingency value should be estimated and included in the planned cash outflows. Given that the risk responses are identified, and valued in the cash flows, care must be exercised to ensure that the discount factor reflects interest forgone rather than the business risk already included in the cash flow estimates.
A more technical explanation of risk is covered by the term, cost of capital. Companies often establish a preferred discount factor based on their corporate cost of capital. This cost of capital is equivalent to the return that financiers require for investment in the business. It includes three factors: a return for deferred consumption, an allowance for inflation, and a return for the systematic risk or variability inherent with the proposal.3 Where BCR uses the company cost of capital as the relevant discount factor, and has included contingencies in the cash outflows, then the financial penalties of risk are overstated.
The BCR and Project Risk Management
The above discussion on the selection of an appropriate discount factor indicates that approving and funding projects is a very inexact science. Therefore, if those providing the funds seem overly cautious, it is probably because they have good reason to be prudent: funds providers rely heavily on the performance of the project and so, by providing finance, they expose themselves to some risk. As a result, project financing is more expensive than conventional financing because of the time managers and technical experts spend evaluating and monitoring the project, the charges made by lenders for assuming additional risks, and insurance coverage.
A common method financiers use to manage their exposure to project risk is to fund a project portfolio. Ideally, the projects in the portfolio should be independent. If they are dependent on each other, risk increases, because when one fails, the others are at more risk of failure. If they are independent, risk is reduced, because not only do failures not have flow-on effects, it is likely that some—hopefully most—projects will succeed and compensate for the failures. Of course, projects often incorporate dependencies (for example, ERP system implementations), so it might be possible to diversify away only a small amount of the risk.
The BCR and Portfolio Selection
So how should we select projects for a portfolio? Resource constraints mean that only some technically feasible and economically attractive projects can be selected. At the same time, managers want to ensure that as much as possible of the available resources are used profitably. In a quantitative sense, the real project selection decision, therefore, is not whether to accept or reject a given project, but how to maximize return and resources used, while minimizing risk. The subjective nature of these constraints has led one author to liken the project selection process to choosing a Miss World—highly subjective and, at best, able to provide a reasonable (probably not exactly correct) result.
Until the late 1960s, some influential finance authors argued that the BCR is ideal for identifying the most efficient projects (those with the highest ratios). However, more recent finance texts state that unless a complex modification is made to the formula, the BCR is inaccurate when used with interdependent or mutually exclusive projects. Furthermore, it cannot aggregate several small projects to displace one large project so as to achieve a better risk, return, and resource usage profile.4 To make matters worse, there is no foolproof substitute procedure for ranking investments either. The problem is that ranking implies the use of a cutoff rate above the cost of money and a rejection of investments that would be acceptable except for the rationing situation. Also, the opportunity cost of future time periods may well be different from that of the present, as capital becomes either scarcer or more freely available.
Reader Service Number 012
A Leap of Faith: British Airways
In 1994, British Airways (BA) discovered that approximately one-third of its customers were in some way dissatisfied with their flights, but less than 10 percent of these unhappy customers made contact with customer relations. The benefits of keeping customers happy had been established: Research indicated that a delay in responding to complaints led to a 30-45 percent decline in the possible intent to reuse BA.1 However, the effect of this decline in possible intent on actual behavior was not clear.
Nevertheless, BA's strategic focus at the time, under the direction of CEO Colin Marshall, was to “put the customer first” (which, of course, meant more than simply taking off and landing on time). As a result, BA invested £4.5 million (approximately US$9 million) in a system that enables customers to register complaints faster.1,2 It must be stressed that the financial benefits were not known, so a cost-benefit ratio analysis would not have produced meaningful results. However, the intangible aspects of the project—fit with business strategy and improved customer information—meant that even if the project generated no additional income itself, it provided the foundation for further projects to win back the estimated £400 million of potentially lost revenue dissatisfied customers represented.3 That is, in this instance, strategic consideration of the project was far more important than short-term emphasis on revenues and costs.
1. Weiser, Charles R. July 1994. “Best Practice in Customer Relations.” Consumer Policy Review, 130-137.
2. Cash, James I. Jr. 1 May 1995. “British Air Gets on Course.” Informationweek, p. 140.
3. Gooding, C. 24 Feb. 1994. “Technology: A Caress for the Customer.” Financial Times, p. 19.
A Final Word on Project Selection
The main issue for project selection is, “Should we do this?” Overreliance on BCR or, indeed, any financial measure emphasizes the tangible over the intangible. This can inhibit a leap of faith that is often critical for information technology projects.
The rate of change and uncertainty in the systems development process means that many technology projects are leading-edge. Leading-edge projects fail to provide the repeatability that reduces risk and guides cost and revenue predictions. Moreover, these projects require an appreciation of as yet unseen and only dimly perceived changes to fundamental processes. This requires a leap of faith. The British Airways case, in the sidebar, illustrates the need for a leap of faith rather than an emphasis on BCR.
An indiscriminate focus on BCR will ignore global, less easily quantifiable, issues such as business strategy, business structure, and technical infrastructure. For project selection this requires a move from highest BCR to a longer-term customer focus and a more broadly based evaluation of current and strategic infrastructure issues. The later requires analysis of how the business process is supported by technology today and tomorrow.
BCR: One Measure Amongst Many
The foregoing arguments are meant to induce caution and to guide the reader against an overemphasis on BCR. While financial considerations play a significant role throughout the life of projects, information technology is usually too uncertain to be captured by a single measure. Probabilistic financial metrics, with reference and constant realignment to specified objectives, are preferable.
BY RECOGNIZING THE INHERENT measurement difficulties with BCR, the project manager can be directed toward a more formal acceptance of the range of outcomes and predicted impact. Such measurement needs to be aligned with the business objectives. Constant focus on the business objectives with adequate appreciation for the range of outcomes will enable the project manager to focus on what the business values. And what the business values is not always the highest BCR.
1. BCR as defined in standard Finance texts:
where k is the required rate of return.
2. In addition to the effect of potential interest forgone on the value of money, inflation expectations have a substantial influence on value via their influence on interest rates overall. It is generally agreed that the nominal, or observed, interest rate on any security includes a premium for inflation. The higher the anticipated inflation, the higher this premium needs to be set. Known as the “Fisher” effect, the nominal interest rate (i) required to generate a real (inflation adjusted) increase in wealth at a given rate (r) regardless of expected inflation (π) can be calculated as I = r + π + rπ.
In most applications, analysts ignore the term rπ and write i = r + π.
3. There are two methods for estimating the cost of capital. The first, Capital Asset Pricing Model, calculates a beta through time series analysis of prior results. The second, Weighted Average approach, calculates the market values from both debt and equity sources.
4. This is actually a weakness of the Net Present Value formula from which the BCR is derived. The NVP does not tell us how much capital had to be committed to the investment. Because of the risk, return, and resource usage considerations outlined above, two or more small investments may well be better than one large investment, even though the large investment has a larger NPV (or BCR) than any one of the small investments.
PM Network May 1999