Finance plays a crucial role in project management, and understanding key finance terms is essential for effective project planning and decision-making. In this article, we will explore six finance terms commonly used in project management. By familiarizing yourself with these terms, you will gain insights into financial analysis, cost estimation, and investment evaluation, allowing you to make informed financial decisions throughout your projects with this finance terms used.
Economic Value Added (EVA)
Have you ever heard of EVA? This term stands for economic value-added and relates to the Total return on a project in relation to company cost. For example, if a project costs $200,000 the company will have benefited if the value of the project exceeds this number. If the project is valued at $250,000, the economic value-added for the project will be $50,000.
Economic value-added is the amount of value that the product adds to the company, as seen by stakeholders. The added value can depend on financial or intangible assets related to the company or key stakeholders.
As an example, you can run a campaign to increase brand awareness and trust, although it might not bring revenue to your business. This would be considered economic value-added.
One of the most important terms related to project selection is called opportunity cost. Opportunity cost is evaluated when one project is selected over another for any reason. This can happen to several projects within a single company. Some project constraints may occur such as scheduling, budget, or resource constraints, which can cause some projects to be selected over others.
Develop Project Charter Opportunity Costs
- The opportunity given up by selecting one project over another
- Project A equals 200000 Project B equals 150000
- The project is selected, then opportunity costs selection project day is 150,000
Next, we will consider that there are two projects within your business that stakeholders are considering starting. The net present value of project a is $100,000 and the net present value of Project B is $50,000. Both of these projects can be started because they both generate a positive Net Present Value. Keep in mind, if only one of the projects is selected, a would be more reasonable since it will produce a higher net present value for the company overall.
By selecting project a, the opportunity cost of selecting this project it’s $50,000. By selecting project B will not be started, therefore the net present value of $50,000 it would have been gained from Project B will not be accumulated.
Sunk costs are expended costs. During a project, the sunk cost can represent all of the money that has been spent up until a certain point in a project. For instance, if there have been one hundred thousand dollars spent until now on the project, this will count for the sunk cost. Sunk costs are not taken into account when deciding whether to continue with a challenging project. This is because the money that has been put into the project has already been spent.
For example, the project might have been $300,000 while it was being planned. However, your team has spent $200,000 on the work so far. This can be considered a big variance, and Senior Management of the company might have to evaluate the project due to this discrepancy. However, as they consider termination, the money has already been spent, so it is not taken into account. If future work starting from now will bring benefits to the company, stakeholders might decide to continue the project.
Law of Diminishing Returns
One of the most common ways of increasing team productivity is by boosting resources. For example, if two workers paint a house faster than one worker this is considered a boost in productivity.
Keep in mind that the law of diminishing returns states that after a certain point, adding more resources will not necessarily produce an increase in overall productivity.
Sometimes, two workers will paint the house and they will need to do so in a coordinated way which requires soft skills and excellent communication. In some ways, they might interact in a negative way which will affect their productivity. Next, we will go over an example of how to better understand the law of diminishing returns.
Let’s think of a painting project. In each first column, you will see the number of painters slightly increasing. In the second column, you will see the painted area per day, while the third column shows the average painted area per day. As you can see, the painted area per day will increase as the number of painters also increases. The average painted area per day decreased because there might not be effective communication happening on the job site. Management should re-evaluate this organizational structure and see if all of the resources are truly necessary to get the job done.
One of the most important financial terms to understand as a project manager is called working capital. This is calculated by understanding current assets and subtracting them from liabilities in a business model. This money is then used to invest in a company. Business apps that can include liquid money, properties, shares, and other investment tools. Liabilities are typically referred to as debt of the company, these can be rental fees, payments to suppliers, salaries, and more.
Deprecation is the next term on our list. If your business requires large assets, such as vehicles or heavy equipment, these are more likely to lose value over time. For example, the minute you drive a car off the lot, it decreases in value immediately. The value of the car decreases over time continuously, and this is called deprecation. If you want to calculate the current assets of a company, it is important to take depreciation into consideration. Any tool that will be purchased will not be able to be sold at the same value in the future.
Here are the two most common ways to calculate depreciation:
- Straight-line depreciation, where it is assumed that the same amount of depreciation will happen year-over-year continuously.
- Accelerated depreciation, where the value of a tool, equipment, and more depreciates faster than a straight line. Deprecation here is typically higher during the first years of business operations.
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Understanding finance terms used in project management is crucial for making informed financial decisions and effectively managing project finances. By familiarizing yourself with concepts such as NPV, ROI, IRR, Payback Period, Cost of Capital, and Cost-Benefit Analysis, you will be better equipped to evaluate project profitability, assess investment opportunities, and make data-driven financial decisions. Incorporate these finance terms into your project management toolkit to enhance your financial acumen and drive successful project outcomes.
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