Project Management Institute

Calculating commitment

THE BUSINESS | of Projects

Before considering execution risk, be sure to scrutinize investment risk.

BY GARY R. HEERKENS, MBA, CBM, PMP, CONTRIBUTING EDITOR

I often refer to an age-old project management adage: “It doesn't matter how well you execute a project if you're working on the wrong project.”

Translation: It is much more important and impactful to do the right project than it is to do the project right. There are few areas within project management where this principle is more valid than risk analysis.

Unfortunately, risk analysis often evaluates the effects of uncertainty after a project has been approved. For some projects, this may be too late.

SETTING THE STAGE

From a business perspective, the decision to approve a project can put into jeopardy as much as 10 to 20 times as many dollars as the post-approval risk analysis, according to my calculations. Here's why: Post-approval risk management prevents relatively minor project execution pitfalls, which is likely to save us about 5 to 10 percent of the project execution costs (i.e., about 10 to 20 times our savings). But if an unworthy project gets approved because we did not properly examine the investment risk, all of the money spent on the project will have been wasted. If we instead consider investment risk, the organization can save considerable money and time.

A good risk analysis explores a variety of input values and paints a picture of a variety of possible outcomes and the probability of occurrence of those outcomes.

Among the more popular measurements of a project's financial attractiveness is net present value (NPV). NPV evaluates the extent to which a project's benefits (cash inflows) would exceed the costs incurred by that project (cash outflows) over its life and for some amount of time into the future. A positive NPV indicates that a project would generate excess cash flow. In a way, that project would be “making money.” A negative NPV would mean that an organization would actually be spending more on a project than it would be getting back.

Let's now assume that we are considering approving a project that has a positive NPV of US$125,000. For many companies, this would seem like a good project investment, right? Maybe. Only an investment risk analysis can help us know for sure.

THE CONCEPT OF INVESTMENT RISK

The aforementioned NPV calculation represents the “base case,” which is the most likely NPV determined by using all most likely values as inputs.

The inputs used to calculate these business metrics are called “sensitivity factors.” When considering the benefits side of the benefit-versus-cost equation, logical possibilities might include increase in revenue, increase in margins, head count reduction, materials savings, lower distribution costs and cost avoidance (precluding legal/regulatory penalties). Sensitivity factors related to short- and long-term items of cost could be project implementation costs, increase in operating costs, increase in support costs, cost of poor quality, productivity losses and warranty work.

As is the case with most estimates, the base case is built upon such sensitivity factors, but like most estimates, these factors are assumed values. This prompts a critical question: What would the NPV be if some of the cost and benefit inputs turned out to be much larger or smaller than our base case assumed?

Enter investment risk analysis. A good risk analysis explores a variety of input values and paints a picture of a variety of possible outcomes and the probability of occurrence of those outcomes.

In the case of investment risk analysis, the outcomes we seek to understand will be expressed in terms of business metrics such as NPV, internal rate of return, payback period or total cost of ownership.

BACK TO THE ISSUE

Let's return to our example project with a positive NPV of US$125,000. On the surface, this modest return makes the project seem like a good, safe investment. However, organizations that routinely assess investment risk discover that projects like this could actually result in a financial loss (a negative NPV) if the benefits were to fall short of expectations and costs were greater than expected. Further, they now have a sense of whether the chance of financial loss is closer to 5 percent or 45 percent.

These organizations may still choose to approve such projects, but with a proper risk analysis done before a project's launch, executives can approve them with a good understanding of all potential and probable business outcomes and the chances that those outcomes could occur. And that's the point. PM

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Gary R. Heerkens, MBA, CBM, PMP, president of Management Solutions Group Inc., is a consultant, trainer, speaker and author with 25 years of project management experience. His latest book is The Business-Savvy Project Manager.

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.

JUNE 2014 PM NETWORK

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