Why finance matters for project managers

Traditionally, the Project Manager’s focus was to bring a project in on time and on budget. In today’s changing environment, the scope of the Project Manager’s job is becoming increasingly broader. As organizations become increasingly project based, Project Managers need to be more financially savvy. Not only must projects be on time and on budget, but they also need to contribute to both shareholder value and the long-term financial success of the business. Looking at projects as “ventures” will require Project Managers to better understand the company’s cash cycle and how each project fits into it.

Cash Cycle of the Firm and the Project

Every company and every project has a cash cycle. There are four phases of the cash cycle: Financing, Investing, Operating, and Returning. The cash cycle is the process in which a business or a project acquires the cash it needs to begin, uses the cash to grow and operate, and returns the cash it owes to its creditors and owners.

Financing Phase begins when a business attracts the capital it needs to get started from financial institutions and investors. The business moves into the Investing Phase when it invests this capital in the labor and equipment necessary for development. As the company begins to use funds generated by operations in addition to raised capital, it is in the Operating Phase. In the final or Returning Phase, the company pays back interest on loans or provides a return on investment to shareholders.

A successful start-up business venture is a project, or group of projects, with a definite beginning and middle; however, contrary to our usual thinking about projects, it does not have an end. As upper management makes internal decisions about how to invest the company’s money, a project must first attract funds from upper management. Project selection and approval is equivalent to the Financing Phase of the cash cycle. The Project Manager invests in developing a product, service or other outcome that will eventually generate more cash. The project itself is in this way, the equivalent of the Investing Phase. Often, the official end of the project occurs well before the project outcome produces cash. Operations of the Project Outcome Lifecycle (POL) constitute the Operating Phase. Only in this phase will upper management be able to assess whether they have made a sufficient return on their investment. The Returning Phase of the cash cycle for a project is at the end of the useful life of the outcome that the project produced. A major problem for a Project Manager occurs when their project is conceptually and managerially isolated from the company’s cash cycle. If the project’s outcome is pooled with all of the other operating assets, it becomes difficult to isolate the cash cycle for each individual project. However, for the company as a whole, the cash cycle depends on the ongoing portfolio of projects; if projects do not generate sufficient cash, the company cannot succeed.

Companies that do not generate enough cash take on capital. The cost of capital for financing is driven by the expectations of lenders and shareholders. Lenders issue debt and shareholders own equity. The cost of capital is a combination of the cost of debt and the cost of equity. The cost of debt is recorded on the Income Statement on the line item—called Interest Expense. This is the payment owed to lenders during the period covered by the Income Statement. (Note: It is common to refer to the cost of debt as a percentage. This is calculated by dividing the interest expense by the total amount borrowed.) Determining the cost of debt is basic, the banks tell the company what their expectations are, and the company agrees to pay the amount.

The cost of equity is the return that shareholders expect on their investment. This return is more than a simple payment of interest; it includes dividends and the appreciation of the value of the stock. Determining the cost of equity is more difficult than determining the cost of debt. While the payment of dividends is recorded in the Cash Flow Statement and the Balance Sheet, there is no line item on any of the financial statements that expresses the value that shareholders expect. Although shareholders are not guaranteed a return on investment, they expect one. On average, when shareholder expectations are met or exceeded, the price of the stock rises. When shareholder expectations are not met, the price of the stock falls. Shareholders, in general, expect a return that is 6% higher than that available on long-term U.S. treasury bonds, since those are considered nearly risk free. (Ibbotson, Roger C., & Rex A. Sinquefield, “Stocks, bonds, bills, and inflation: Historical returns (1926–1987), Charlottesville, VS, Research Foundation of the Institute of Chartered Financial Analysts, 1989.) However, a company may be more or less risky than the typical company, so the amount expected by shareholders needs to be adjusted accordingly. If the company does not meet its shareholders expectations, the price of the stock will fall, making it more difficult to find potential shareholders willing to invest the next time the company tries to raise capital. Even if the company manages to find investors, the investors will probably be willing to pay less money for a larger percentage of the business.

Project Managers need to keep in mind that from a financial perspective, their company is no more than the sum of the projects in which it invests. If these projects do not produce a Return

On Investment (ROI) that meets or exceeds the Weighted Average Cost of Capital (WACC), then it is unlikely that the company will be able to produce a significant return.

WACC = (Percent of Debt Financing) x (Cost of Debt) x (1 – tax rate) + (percent of Equity Financing) x (Cost of Equity)

The company determines the WACC by first determining the total amount of debt and equity it has. It then calculates the Cost of Debt and the Cost of Equity. The cost of debt is the interest expense on the loans the company possesses. The cost of equity is the risk premium associated with the shareholders’ investment in the company. The cost of capital follows as the percentage of cost of debt and the percentage of cost of equity to the whole and then averages the expected return of each weighted by its percentage. Admittedly, WACC depends on factors such as stock price and the cost of debt, which Project Managers do not influence in the short term. However, good projects do reduce the cost of capital over the long run. Project Managers should pay attention to rate of return for project selection, and to the factors that may influence that rate of return as they manage the project. In addition, Project Managers should focus on cash flow and increasing the rate of cash flow when making decisions to help lower the WACC over the long run.

Remember, finance matters throughout the project management process because shareholders matter. Project Managers should remember that ultimately shareholders own the company, and projects are instrumental in creating shareholder value. Companies that create more shareholder value are more productive, and the numbers of employees grow faster than other companies (Bughin & Copeland, p.157). At a national level, shareholder value has been linked to overall economic performance (Bughin & Copeland, p. 163). This means that sound business management should be applied to the total project and the POL. This should include sound financial and business analysis in project selection, thoughtful financial and business reasoning in the Planning of all projects, and judicious financial and business management as an important element of Controlling and Executing all projects. With the advent of new information systems and techniques like data warehousing, it will become much easier to measure projects according to their contribution to EVA® and shareholder value (Zweig, p. 3).

The most important part of project initiation is selection. A project plan should look like a business plan. The analysis that led to project selection should be refined and amplified as the project planning process uncovers more information. The project plan can then become a better guide for managing the project as a total enterprise, rather than an isolated piece of work separated from its outcome. With a business-oriented project plan, the Project Manager can better Execute and Control the project with the end in mind, the end being to optimize EVA® for increasing shareholder value. The most important principle should be that the project stays open until the POL is complete. While this is difficult in the turbulence of today’s business environment, it is essential to compare the results of the project outcome with the assumptions and plans generated during the project. A traditional “lessons learned” session at the end of a project is missing this vital element because, in most cases, the project outcome has not yet happened; the end of a project is usually the beginning of the POL. Did the financial analysis that justified the investment in the first place really happen? Could the project have been managed better to make it happen or make it better? These are very important questions. Without answers, it becomes very difficult for a company to improve EVA® at its source—namely, the project portfolio.

The fundamental question for any Project Manager who understands why finance matters is, “So what do I do now?” To help provide a clear answer to this question, let’s engage in a “thought experiment.” Thinking this through will help you to experience the practical implications of finance and project management as a business process. After completing this exercise, you will be ready to consider a Project Venture Development Process that should serve as an ideal desired state for project management in the future. The process is based on business principles and takes the concept of the project-based organization to its logical conclusion. This paper will conclude by offering a list of things you should focus on, and execute, at each stage of a project to think more like an entrepreneur and act like a CEO.

A Thought Experiment

A “venture” is defined as a potential business that the company will invest in to realize a return on its investment. Imagine a company that has organized all of its work around ventures. The venture consists of a project and a POL coupled to constitute a viable business model with the potential of providing the best return on investment in comparison to any other venture that is competing for funding in the company. The venture team consists of the project team and the implementation team—every-one necessary to develop, and operate, the venture throughout its life cycle. Compensation for the project and implementation managers will be heavily dependent on the success of the venture, thus giving them financial incentive to drive the venture to succeed. A venture failure would leave them with less compensation than they would normally expect, but a venture success would be very rewarding. The team members would be compensated in a similar fashion, but in general, they would have a smaller percentage of their compensation at risk. Any manager or team member could choose to increase the amount of their compensation at risk, which would increase the potential reward for success or loss from failure.

How would you manage your project given this kind of environment? Let’s suggest some principles that would underlie your management behavior:

The venture should be a viable business that combines all of the elements of a value chain necessary to serve a customer base that will sustain the business over the long run.

If a core project team consists of a person from every function necessary to produce the project outcome, then the venture core team should consist of one person from each link in the value chain necessary to produce customer satisfaction. This may require including suppliers and intermediary customers on the core team.

Those responsible for the implementation of the POL will want to be on the venture core team to give their input. Since your ultimate success will depend on them as they operate the POL, it would behoove you to include them on the team.

Both project and POL team members will be very concerned about a perfect handoff of the project outcome to the POL team so that implementation begins as soon as possible and revenue flows in as soon, and as fast, as possible. One of the teams blaming the other for problems and delays won’t help anyone. The incentive built into the system is for everyone to roll up their sleeves and fix whatever goes wrong.

The project team would strive to keep costs down during the project, in the design of the POL, and during POL operations without sacrificing the quality of outcome for customer satisfaction; thus, jointly optimizing revenue and maximizing EVA®.

The project team would want to be available as long as necessary to get the POL started successfully, as long as the cost to keep them available did not outweigh the gain from their help.

Throughout the course of the project, you would want to make decisions with the end in mind. Whenever there was a tradeoff between time, cost and quality, you would choose the solution that jointly optimized them to maximize EVA® and shareholder value.

In short, all members of the venture team would strive to maximize EVA®. Why? Because they now have the same interests as shareholders. The more value they create with the venture as a whole, the more they will earn for themselves.

If you, the Project Manager, can close your eyes and immerse yourself in these imagined circumstances, it will help to drive home the impact on both your motivation and your behavior in terms of managing a project as if shareholders mattered. It also suggests some practical implications to your job as a Project Manager. You will need to manage projects like business ventures, and less like a technical or scientific undertaking. In the end, project management is not a technical process—it is a business process. To thrive, it needs to be incubated in a business-oriented environment.

The Process

To support a venture oriented project management system, we recommend a business-oriented process that is modeled to some extent on the Venture Capital system that has become so ubiquitous in the high-tech world of e-commerce and the dot-coms. Think of the company as a Venture Incubator, an environment that is structured specifically to promote the growth and well being of new ventures. Ventures, of course, are the projects coupled with their POL’s defined in such a way to constitute a viable business model worthy of investment. The project selection process is run as a venture capital selection process, and the Project Office becomes the Project Venture Development Center. Venture team members own their ventures through a system of virtual stock options that convey rights to virtual stock in the venture valued according to its contribution to the EVA® of the company. (For examples of corporate venture compensation plans see Block & MacMillan, 1995, pp. 125–143.) How different would the process be in this environment? It would be different enough to promote and emphasize managing the project for business results. Highlights of the process include:

Initiation

The Business Case is developed by the venture core team. This team would include one member from each link in the value chain from initial process to the customer led by the Project Manager and POL manager.

An internal venture capital board chooses to either funds or reject projects as part of developing and maintaining a portfolio of ventures. Critical selection criteria include strategic fit, competitive advantage, and potential Return On Investment (ROI) of the venture. (Block & MacMillan, 1995, p. 57) Board members’ incentives are based on how well the portfolio of their investments fare over the long run.

Ventures are staffed with the end in mind to support the total POL so as to assure that all links in the value chain are represented on the core team and will participate in the overall planning.

Planning

The venture team will refine the business case and convert it to action steps and major milestones. The team will develop a business plan to guide the venture to the end of the POL.

The team plans phases of the project with more detail than phases for the POL, which are planned at a higher level of detail by major milestones at first.

As the project rolls out, the venture team adds detail to the POL part of the plan.

All aspects of the venture become part of the budget, schedule and specifications.

The plan is constructed from the perspective of the venture as a whole rather than from the project perspective.

Execution and Control

The venture team implements the business plan.

The team treats all assumptions of the business plan as their working hypothesis and the venture as an experiment.

At each major milestone, the team checks their assumptions against what has happened. If there is a gap, they change their assumptions accordingly and retest the plan for feasibility. At this point, they decide to continue or stop. (Block & MacMillan, 1995, p.171)

Transition (Closing the Project)

The project subteam hands off the project outcome to the implementation team.

Key members of the project team are linked to the POL implementation team to support the transition for as long as they are needed to facilitate a fast, cost-effective start-up.

Operation and Evaluation

The organization endeavors to broaden lessons learned to include the business execution as well as the project implementation. The goal is better ventures for a greater return on the investment of capital.

A process is set up to monitor the POL in order to compare its business results to the expectations stated in the business plan, and to conduct lessons learned sessions at useful stages of the POL.

Systems are in place to measure contribution to EVA® on a venture-by-venture basis. When ventures return a positive EVA®, the venture team is compensated accordingly.

Immediate Application of Principles

Not all companies will embrace the principles put forth in this paper. For most readers, the most immediate question is, “What can I do now given a conventional corporate environment for projects?” Here are a few suggestions:

1. Develop a business case for each project. Many companies use business cases for project selection purposes. One example is a client company in financial services. Although most of their projects are IT-based internal projects, they require a business case for each one. The case template requires that the project is built on specific client needs and what the competition is likely to do to meet those same needs. The business case should address the following issues at the very least:

Where do the numbers for estimated price, sales volume, production, and operating costs come from?

How accurate are the numbers?

What are assumptions that drive the numbers?

Do not accept simple outcome, cost and schedule. Go back to all of the business assumptions that went into the origination of the project.

Most importantly, what is the business model that will make this a sound investment for the company?

3. Think strategically. Consider your project in its wider context. What are the links in the value chain that connect this project to the ultimate customer and end user? How does it fit into the wider strategy of the company such that it either supports existing sustainable competitive advantage, or creates a new one?

What is the big picture?

What type of strategy is this project supporting?

How is it promoting the strategy of the company?

In what ways will it help to sustain the competitive advantage of the company?

What other projects are part of the strategy implementation?

How does fulfilling the business case implement the strategy?

Relate the numbers of the business case to the strategy.

4. Turn the business case into a true business plan to guide the project. This means that you will need to incorporate all of the elements of the business case into a plan for action, and integrate that plan with the rest of the project planning process. All of this needs to be done with the team—not in isolation.

Remember you are responsible for the project and POL performance—not just the project.

Even if the project is internal and seems remote from customers and competition, trace it through the value chain. Determine the net return on investment for doing the project against not doing it.

Refine the numbers and then refine them again. Assign risk probabilities; force yourself to if possible.

Conduct sensitivity analysis. When you think you have done enough, do more.

Do more market research. Ascertain market demand figures as best as you can and gather more competitor information.

Think about your budget as an investment rather than as an expense. How are you going to use it to get the best return possible?

Assemble the core team and do all of your business planning with them.

Make sure that the core team includes important POL implementers like: Manufacturing Engineering, Technical support, Sales, and Training.

Trace through the value chain of the project and identify everything that must happen outside the boundaries of the project to make the POL a success.

Identify major milestones where it would be best to stop and review your assumptions.

5. Execute and control the projects through the business plan. There was a reason why you spent all of that time integrating the business plan into the project plan. It should be an integral part of project control. Do not make the mistake of doing all of that business analysis on the front end, but using only Triple Constraint thinking to control the project.

Employ the language of the business plan to negotiate with upper management.

Focus on the POL rather than the end of the project.

Manage the risks for the POL, as well as the project itself.

Use quick prototyping to maintain a pulse on to the market and the end users.

Constantly check in with customers and end users.

Internal projects have competitive implications as well. They affect a company’s ability to compete in the marketplace.

At each major milestone, compare the outcome thus far with your assumptions. What changes in assumptions must you make? How will this affect the rest of the project?

Keep the ultimate business objectives in mind by making all decisions as tradeoffs with the business equation. Which alternative will ultimately provide the best competitive advantage and economic value?

The correct response to a request for a change is no longer “next version,” or simply “No, it is too late.” Rather it is, “What is the effect on economic value if we incorporate this change at this late date?”

Act strategically by constantly checking to ensure that the project is staying aligned with its strategic objectives.

6. Closing out the project. This phase is really misnamed. It should be called Transition or perhaps even “birth.” This is not an end, but rather a beginning. The project team needs to support the new toddler to prevent it from falling down.

Track the POL and make sure that project team members stay available to the implementation team as long as they are needed. Balance their cost against the cost of a slower start-up if they would not be available to get support for the POL.

Write a final project report with numbers, projections and assumptions that everyone signs off on and is checked with reality over the life of the POL to promote organizational learning.

7. Operate and evaluate. (This term come from Chevron, Inc.—Chevron Project Development and Execution Process.)

“It ain’t over ‘til the POL is over.”

Review the major milestones of the POL to check assumptions. Take corrective action to improve performance if necessary and possible.

When the POL is over, write a final venture report based on comparing the actual POL performance with the assumptions in the final project report. Disseminate to promote organizational learning.

Compensate the venture team according to venture performance.

Celebrate success. Learn from failure.

References

Block, Zenas, & MacMillan, Ian C. (1995). Corporate venturing. Boston: Harvard Business School Press.

Bughin, Jacques, & Copeland, Thomas E. (1997). The virtuous cycle of shareholder value creation. McKinsey Quarterly, 2, 156–167.

Ibbotson, Roger C., & Sinquefield, Rex A. (1989). Stocks, bonds, bills, and inflation: Historical returns (1926–1987). Charlottesville, VS, Research Foundation of the Institute of Chartered Financial Analysts.

SMG, Inc. (1997). Why finance matters: Understanding finance and shareholder value. SMG, CD-ROM Interactive Learning Program. Zweig, Phillip L. (1996, Oct. 28). Beyond bean-counting. Business Week.

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 or any listed author.

Proceedings of the Project Management Institute Annual Seminars & Symposium
September 7–16, 2000 • Houston, Texas, USA

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