PMP Project Selection Methods
Organizations can use a variety of methods for the selection of projects. The most common methods seek to quantify the monetary benefits and expected costs that will result from a project and compare them to other potential projects to select the ones which are most feasible and desirable.
Such methods are called “benefit measurement methods”.
Project selection methods are used as an input to the PMBOK process develop project charter”.
Other methods applied calculus to solve for maximisations using constrained optimisation. Constrained optimization methods are mathematical and use a variety of programming methods.
If in the exam, you see the terms linear programming or nonlinear programming, then you will know they refer to a type of constrained optimization method and that the questions referring to techniques of project selection.
You will not need to know how to calculate values for constrained optimisation or linear programming for the exam, but you do need to know that they are project selection methods.
Project selection methods are drawn from the fields of economics, managerial accounting, and cost accounting and are sometimes used as tools for project selection.
It is not necessary to memorise these definitions word for word, however it is important to understand what they are and how they are used.
Benefit cost ratio (BCR)
The BCR is the ratio of benefits to costs. For example, if you expect a project to cost one million dollars and you expect or the and were to sell the main deliverable for $1.5 million, then your BCR is $1.5 million divided by one million dollars which gives you a result of 1.5 to 1.
In other words you get $1.50 of benefit for every $1.00 of cost. A ratio of greater than one indicates that the benefits are greater than the costs.
Economic value add (EVA)
When you look at the value of a project, it is sometimes easy to lose sight of the big picture of adding value to shareholders. Economic value add, also called EVA, looks at how much value of project has truly created for its shareholders.
It does more than simply look at the net profits. It also looks at the opportunity costs. By taking all of the capital costs into account, EVA can effectively show how much wealth was created or lost over a period of time.
It takes into account the fact that there are opportunity costs to every financial expenditure, and if the project does not make more money than those opportunity costs, it has not truly added economic value to the organization.
To calculate EVA, start with the after tax profits of the project. Then subtract out the capital invested in that project multiplied by how much that capital cost.
For example a company invested $175,000 in a project, and that project returned a net profit of $10,000 in the first year of operation.
Accountants would probably celebrate the net profit, but what does the EVA tell us about shareholder value?
First we need to determine the real cost of that capital. In this case, we will estimates 6% since your organization can have invested at saint $175,000 and earned a 6% return. When we calculate EVA, we apply the following formula:
After tax profit – (capital expenditures multiplied by the cost of capital), which gives us $10,000 – ($175,000 x 0.06) which equals – $500
Even though the project returned an accounting net profit, it would have been better for the organization to bank the money instead.
In other words the organization passed up $500 as far as EVA is concerned, since they would have earned $10,500 in interest if they had invested in the bank instead of the project.
Internal Rate of Return (IRR)
IRR or “internal rate of return”, is a finance term used to express a project returns as an interest rate. In other words, if this project were an interest rate, what would it be?
Do not worry about the formula for the exam, but you should understand that just like the interest rate on a savings account, bigger is better when looking at IRR
Net present value (NPV)
Present Value (PV) is based on the “time value of money” which is an economic theory that a dollar today is worth more than a dollar tomorrow.
If the project is expected to produce three annual payments of $100,000, then the present value (how much those payments are worth right now) is going to be less than $300,000
The reason for this is that you will not get your entire $300,000 until the third year, but if you took $300,000 in cash and put it in the bank right now, you would end up with more than $300,000 in three years.
PV is a way to take time out of the equations and evaluate how much a project is worth right now. It is important to understand that with PV, bigger is better.
Net present value (NPV) is the same as present value except that you also factor in your costs.
For example, if you have built a building with a PV of $500,000, but it cost you $350,000, in this case your NPV would be $500,000 – $350,000 = $150,000
Remember that a bigger PV or NPV makes a project more attractive, and that NPV calculations have already factored in the cost of the project.
Return On Investment (ROI)
Return on investment is a percentage that shows what return you make by investing in something.
As an example, suppose that a company invests in a project that costs $200,000. The benefits of doing the project save that company $230,000 in the first year alone.
In this case, the ROI would be calculated as the (benefit – cost) divided by the cost. Plugging the figures and gives you $30,000 divided by $200,000 = 15%
Note that you should not worry about memorising this calculation for the exam, but you do need to understand that for ROI, bigger is better.
Return On Invested Capital (ROIC)
The measure of ROIC looks at how an organization uses the money invested in a project, and it is expressed as a percentage. It asks “for every dollar of cash I invest in the project, how much should I expect in return”.
This invested money could be cash on hand or crash that was borrowed. For the purpose of project management, the calculation is as follows:
ROIC = net income after tax form a project divided by the total capital invested in the project
As an example, suppose a project invested $250,000 that generated $60,000 line revenue in its first year, with $200,000 in operational costs and a tax liability of $8750
To calculate the ROIC, first calculate the after tax profits by subtracting the costs from the revenue:
$60,000 – $20,000 – $8750 = $31,250
Applying the ROIC formala or will give you:
ROIC = $31,250 divided by $250,000 = 12.5%
This means that the project is returning 12.5% annually on the cash is invested to perform the project
In this case, the word “agreement” is synonymous with a contract. Not all projects are performed under contract, so this inputs may or may not be relevant.
When the project is performed under contract for another organisation, it is common for the contract to be signed prior to the project beginning. Within the develop project charter process we are ready to start the project and create the charter, so the contract provides and essential input