Show them the money!
As Project Managers, we are always looking for ways to insure the success of our projects. Often we focus on PM techniques from the PMBOK®, people management skills, etc. But how many projects become stalled or are even cancelled because it was not clear the business value that the project might bring? There are two main areas why projects typically stall or fail.
The goals of project management methodologies are typically aimed at addressing the “How” side of the table in Exhibit 1. However, as much of the time projects get stalled because of a factor on the “What” side of the table.
By the time the Project Manager is brought in to start the project, it is assumed that someone else has done a proper job of business justification. Far too often when a Project Manager is asked, “What specific business strategy is this project linked to?”—The response is “I'm not sure” or “That has already been taken care of by someone else.” Often this justification is done from a high level (using data collected from other sources), without any way to bring the value home to the specific company. It's no secret that many companies struggle with decisions about which projects to fund and which to pass on. This is particularly true in today's business world, where markets and companies are being forced to adjust and change at an almost blinding pace. CEOs and CFOs are placing projects under a microscope and typically use financial metrics to decide which projects to keep and which projects to cancel. All too often projects are funded in times when budgets are freer, but when budgets become tight, projects with vaguely defined business benefits or no clear demonstratable strategic benefits find themselves being cancelled or significantly slowed down. The key then is to make sure the project is clearly aligned with business goals and, more importantly, to have an empirical methodology that will calculate in financial terms the specific business value the project brings to the company.
Metrics and Strategic Alignment
Alfred P. Sloan of GM was quoted as saying, “General Motors is not in the business of making cars—General Motors is in the business of making money.” Therefore it stands to reason that projects are undertaken either to save money or to make money—or both. Especially in light of the dotCom bubble bursting in the last few years, pie-in-the-sky justifications for projects fall on deaf ears these days. So CFOs and Executives want to know:
• How much cash will this project cost?
• How much cash will this project make?
• How soon will it make it?
In addition, the benefits associated with a project can usually be placed into four distinct categories:
• Increase Revenue
• Reduce Costs
• Avoid Future Costs
• Business Flexibility
It is important to understand what are the motivations and hot buttons of those responsible for funding projects. The explanations below then are intended to give a high-level overview of financial analysis methodologies and show how those techniques can more closely tie project benefits to business objectives.
Why Is This Important to PMs?
First and foremost there is an element of self-preservation. By insuring that our projects are clearly aligned with the business strategy we insure that our projects will continue to be funded and that we can continue to practice our profession.
Secondly, there are many papers and dissertations on the resistance of individuals to change. Many times this is because the change is something that is being imposed from without. The techniques outlined in this paper ensure that we get the input of those people our projects will affect. If someone feels part of the process, they are more likely to support it and the projects tend to move more smoothly from this perspective.
Finally, there is always the challenge within a project of controlling “scope creep.” This is particularly true when the goals of the project are not clearly defined. The process of financial justification and aligning the project benefits with strategic goals insures that scope is very clearly defined. The more clearly defined the scope, the less likely the need to deal with scope creep.
Approaches to Calculating Business Value
This paper is not intended to be an in depth explanation or education on the different financial techniques. However it is important for us to do at least a high-level review on some of the different methodologies so we have an understanding of the concepts. There are literally dozens more of other techniques that could be discussed (Economic Value Add, Modern Portfolio Theory, etc.), but for our purposes we'll explore some of the better known ones below.
Payback is the easiest to understand and perhaps easiest to calculate. As the name implies, this method of calculating financial value has to do with the number of periods to pay back the initial investment. This technique is good when risk needs to be minimized and/or the business landscape changes quickly. Using the payback method, the shorter the payback period, the more attractive the investment. An example of this would be as follows:
A company is contemplating an investment of $100,000. The expected annual return on the investment is calculated to be $40,000. Finally, the payback “hurdle” defined by the company is 36 months—that is for any investment to be approved, it needs to pay for itself in 36 months or less. To calculate payback in this example, divide the initial investment of $100,000 by the annual return of $40,000 to get 2.5 years. Since this is less than the payback period hurdle set by the company, the investment should be made.
The problem with the payback method is that its simplicity ignores some other factors that need to be considered, such as the time value of money (TVM will be explored in an example below).
Return on Investment (ROI)
ROI is another easy to understand and easy to calculate method of showing the value of a project. It measures the percent of return a particular project expects to yield and is most often calculated by dividing the total benefits by the initial investment. Given the example above:
A company is contemplating an investment of $100,000. The expected annual ROI is calculated to be $40,000 over four years. Dividing the benefits ($160,000) by the initial investment ($100,000) gives and ROI of 160%.
ROI is used quite extensively in sales literature because it is easy to show a large payback percent. However this method is generally not very well respected in the financial community and still fails to recognize the TVM.
Net Present Value (NPV)
NPV is a method of justifying an investment that takes into account the time value of money as well as the fact that there is always an Opportunity Cost of Capital (e.g., Other investments could have yielded a 20% return in four years). In addition, TVM simply recognizes that $1 today is not the same as $1 received in the future. Everyone is aware of this concept from our understanding of inflation and/or cost of living. The NPV method then measures the net difference between the present value of an investment's benefits and the present value of the costs. If the NPV is positive, then it is decided to proceed with the investment. NPV is widely accepted and respected by finance professionals. Taking the same example explored above:
A company is contemplating an investment of $100,000. The expected annual return on the investment is calculated to be $40,000 for four years. The organization has defined an OCC of 20% So NPV is the annual rate of return multiplied by the relevant interest factor (taken from well established financial tables) minus the required investment: ($40,000 x 2.589) – $100,000 = $3,560. Since NPV is positive, the investment is justified.
Internal Rate of Return
IRR analysis is similar to NPV except that it uses an approach that determines the interest rate and then compares that rate to the “risk adjusted rate of return.” IRR then is a rate of return that could be expected from this particular project expressed as a percent. The calculated project rate of return is then compared against the corporation's “hurdle rate” (typically around 12%) and if it exceeds it, the decision is made to move forward. Since IRR is a rate, it is much better at comparing unlike investments (such as the decision to invest in an R&D initiative vs. an IT initiative) and is able to level across investments of various sizes. Using the example above we would solve for the relevant interest rate ($100,000=$40,000 x relevant interest factor). Since the interest factor turns out to be 2.5, using established financial tables the IRR rate is 22%. This is higher than the corporations hurdle rate of 12% so the investment is justified.
Real Options Approach
The Real Options approach takes into account the idea that when to decide to decide to invest in a particular endeavor is equally as important as determining whether there will be a tangible positive cash flow. In addition, for many new projects and systems implemented, there is increasingly recognition there are optional benefits that could be realized. The Real Options approach is based upon well-known finance techniques such as Black-Scholes Option analysis. Traditional ROI techniques such as those explored above typically focus in on the potential cost savings or cost avoidance—they are less suited to calculating potential added value generated by a project. And just like a stock option, Real Options analysis techniques realize there is a cost associated to exercising the option in order to realize this optional value (Amram & Kulatilaka, 1999).
Final Word Regarding Business Value Calculations
Each of the techniques presented above have their advantages and disadvantages. It is important however not to get hung up on debating the finer points of which one is the best. What is more important is the process that is used to collect the information and present it. It is this process that allows the key stakeholders of the project and the Project Manager to identify the factors that are important to the business, and provide the link between the benefits of the project to the business objectives.
Project Initiation Steps—A Seven-Step Program to Project Success
Now that we have an understanding some of the ways of calculating the potential business value of a project, how does this begin to apply in practical terms to project initiation? Typically in the initiation phase of a project includes identifying the key stakeholders and project team members. This team is brought together to define the scope of the project, determine team organization and roles, evaluate project approach, draft a project charter, etc. Would this not also be an ideal time to talk about how the project will align with business goals? By aligning the goals of the project directly with the business goals, the project team can ensure that the project will be able to demonstrate specific business benefits, and also help the team to avoid “scope creep.” The way to identify, align and quantify the business benefits follows the seven-step program outlined next.
Exhibit 2. User Profile Matrix
Step 1: Understand the Business/Assess the Need
During this step, the project manager gathers information about key stakeholders, their critical success factors (CSF) and key performance indicators (KPI). This step ensures that the needs of the stakeholders are clearly understood and can be expressed in business terms. Each of these business goals should be mapped to the four categories of business benefit outlined in the introduction section above.
Step 2: Understand the Solution
After there is a clear understanding of the business drivers, it is important to understand the potential benefits that will be introduced by the project. It may seem to be self-obvious about the benefits a particular project, technology or product might bring, but it is not always the case that each potential benefit maps directly to business goals (look again to the dotCom situation for a clear illustration of this point).
Step 3: Understand/Map the Benefits
Perhaps this step is the most important because it creates the important linkage between the business goals and strategies and the particular areas of benefit created by this particular solution. By mapping these benefits into the four benefit categories (Increase Revenue, Reduce Costs, Avoid Future Costs, Business Flexibility), the framework for quantifying these benefits using any of the financial analysis techniques like those shown above begins to emerge. Remember that benefits can be expressed in many ways, but the key is to express those benefits that match the business needs of the organization in question. In the case study presented in the following section it will be seen how a 4X7 benefits matrix was used to map the business goals to the areas the solution would provide value.
Step 4: Understand the Costs
This cost analysis step identifies all the costs associated with implementing and operating the solution to achieve the anticipated benefits. These costs should be inclusive of the overall project costs as well as often overlooked ongoing maintenance costs (if applicable). Again, map these costs to the four benefit categories.
Step 5: Understand the Risks
All too often projects may do a good job of identifying benefits and costs, only to fail to account for the element of risks. To present a more full picture of the project impacts, the risk inherent in the project as well as the risks of not proceeding forward need to be factored in. Some of the financial methodologies above do a better job of accounting for risk.
Step 6: Understand the Financial Metrics
Once the benefits, costs, and risk are better understood, they can be linked together to present the final result of the value to the corporation. Primarily this is a financial justification; however, other factors such as business alignment and risk may either discount or amplify the final value calculations. It is also advisable to use more than one financial metric calculation (e.g., an IRR analysis as well as a Real Options approach). This shows due diligence and with each method having its own strengths and weaknesses, it makes for a more compelling case if each method used shows the investment should be undertaken.
Step 7: Present the Business Case
With all the other steps completed this should be a simple matter of writing up the report and creating the presentation for the senior executives. Make sure to re-review the assumptions with a financial or business person to make sure they are supportable because senior management will typically challenge the assumptions—rarely do they find fault with the methodology or financial calculations.
Case Study Illustration of the Project Value Approach
So how does all this theory apply to in real life? The example we will examine involved a $22M global Microsoft Office 2000 migration project at a large pharmaceutical firm with 18,000 employees in 74 countries. While the company was still using an older version of Microsoft Office, traditional ROI analysis would have been hard pressed to justify this project. In addition, it was important for project approval that the specific business value be clearly articulated—the typical intangible descriptions of benefits such as “Improved customer service” or “Faster turn around” were not sufficient arguments for a project of this size. This approach used a Real Options methodology, which not only accounted for Risk in the calculations, but also was able to identify areas of optional value that would not be realized right away.
Exhibit 3. Business Benefit Matrix. (Note: Shaded areas indicate additional options value created.)
Exhibit 4. Return on Investment Analysis
In order to understand the business needs, a steering committee for the study was formed consisting of the CIO, CFO, Senior IT executives and a Finance representative. The Key Performance Factors and Critical Success factors were identified and a Project Charter was drafted and approved. In addition, in order to more effectively assess the needs of the business and represent the varied environment in a large global corporation, a User Profile Matrix was created and a representative from each of the areas was identified to be interviewed (refer to Exhibit 2). This ensured that a broad range of business issues and areas for improvement would be covered.
After this, the Project Manager and study leader performed one on one interviews with each of the identified representatives. Some of the actual comments gathered are as follows:
HR: “We process a lot of documents in Word in this department and it seems that we spend a significant amount of time just converting documenting, fixing up margins, etc. We estimate each person in the department spends at least two hours per week on these types of activities.”
Marketing: “We prepare a lot of PowerPoint presentations and it seems that we spend at least four hours a week reformatting presentations between different versions of Office.”
Research and Development: “We have the capability of increasing throughput in High Throughput Screening of drug compounds by a factor of 10 but our vendor tells us that we need to upgrade to a 32-bit version of Excel in order to realize these benefits since the data analysis is done in Excel.”
Once these problem “hot spots” were uncovered, the areas where the proposed solution of migrating to Office 2000 were easy to identify. Understand that the process of identifying where the key areas Office 2000 would provide benefit needed to be understood by the Project Manager so that when certain business problems were expressed, the right probing questions could be asked to reveal where the solution provided value.
The actual costs of the solution and the potential benefits were mapped out in the Benefits Matrix (refer to Exhibit 3). Since there were specific hours of potential savings identified by the users, a simple calculation of the fully loaded costs of an employee's salary was used and multiplied by the actual hour estimates of potential time saved. In addition there were negative costs included in the calculations such as training costs and initial potential loss of productivity by rolling out new technology. Optional areas or benefit were also mapped onto the Benefits Matrix.
Once these costs had been mapped out, a calculation of Net Present Value as well as IRR was straightforward (refer to Exhibit 4).
In addition, Real Options analysis was performed to help quantify some of the optional benefits that might be gained by the deployment of Office 2000 as well as factoring in risk. As a result of this analysis an additional $11.98M of benefit might be realized if these options were exercised (see Exhibit 5).
Exhibit 5. Real Options Model
By including these techniques and by combining the optional benefits of the technology, the CFO was able to see in real financial terms the potential benefits of the project. As a result the funding for the project was approved. In addition, the specific technologies deployed by the project were tightly aligned with the corporation's business strategy, and it made the decisions as to which features to deploy and which to defer much easier. This type of analysis made it much easier to create very specific scope statements that enabled the project to be delivered on time and on budget with minimum “scope creep.” Finally, because the various aspects of the business were included in the analysis, business buy-in was much stronger and made acceptance of the new environment less of a hurdle.
As Project Managers it is important to realize that we are responsible not only for improving our expertise in the techniques of how to manage projects, but also to insure that our projects have clear relevance to the businesses they are intended to benefit. The process outlined above insures that the projects are aligned with the company strategic goals and can be articulated to the project stakeholders; that the scope of the project is dictated directly from those goals; and perhaps most importantly, that the project will be funded from inception through to completion. If you asked a Project Manager what his or her worst fear is, the response would probably be “a project that failed.” A worse scenario however would be to have a project cancelled. We can always learn from a failed project and improve for the future—it is not possible to take many lessons away from a project that is never allowed to finish.
Amram, Martha, & Kulatilaka, Nalin. 1999. Real Options: Managing Strategic Investment in an Uncertain World. Harvard Business School Press.
Gardner, Christopher. 2000. The Valuation of Information Technology: A Guide for Strategy Development, Valuation, and Financial Planning. John Wiley and Sons.
Thacker, Ronald J. 1979. Accounting Principles. Prentice Hall Inc.
Hutchins, Greg. 2002, March. Doing the Numbers. PM Network 16 (3), p. 20.
Proceedings of the Project Management Institute Annual Seminars & Symposium
October 3–10, 2002 • San Antonio, Texas, USA