Which Model Will Work Best For Project Selection?
When it comes to project management, it is likely that an organization will have several different assignments going on simultaneously. Of course, this is crucial to staying in business! It is not possible to only focus on one task at a time, especially if you are a larger organization. This is why it is so important to analyze all of the possible risks and project constraints that might impact the overall outcome of your project. PMP outlines best practices when it comes to project selection, which is the process of deciding the best plan for attack when it comes to completing deliverables.
Using a comparative approach is also a great idea. Reviewing possible benefits, risks, outcomes, and challenges are all factors that need to be considered prior to choosing the best execution process.
Processes you can consider:
- Murder board
- Peer review
- Scoring models
- Economic model
The most commonly used process listed above is the economic model. This is because it is used by project managers who are focused on beginning a project or the project initiation process. In this blog, we will uncover best practices for using the economic model while covering five options for making the most of this method.
In order to calculate the present value that will be paid during the project or act as a return on investment, it is important to understand that money depreciates in value over time. This is why there is time value of money, which is the backbone of the economic model.
To make the most of today’s dollar, it is important to invest in different assets. Some examples include shares of a company, interests, or other resources. If you invest your funds in one of these entities, you will have more money to play with in the future. If you do not invest your funds, the value of your dollar will depreciate over time.
The present value economic model helps you better understand the value you are a dollar will have in the future. Interest rates are the most important calculation to use when solving for present value.
Present Value Economic Model:
In order to solve for present value, you will need to take the value of money divided by 1+ the interest rate over N. In this formula, FV represents future value, while PV represents present value. We will represent your interest rate and will represent the number of periods you are analyzing.
Let’s take a look at a real-life example to better understand this model. Take a look at the sample below, which contains three different installments:
- 1st Installment: $100,000 will be paid at the beginning of the project.
- 2nd Installment: $100,000, that will be paid at the end of 1st year.
- 3rd Installment: $100,000, which will be paid at the end of 2nd year.
The Interest Rate is 10% per year.
- At the beginning of your project, you will need to pay the first installment. This means that the present value will be the same as the actual value.
- The next installment must be paid at the end of the first year of project operation. You can also substitute the future value for the interest rate!
- The final installment will be paid by the organization at the end of the second year of operation.
You all notice in the figure above that the present value of the installments decreases over time.
Net Present Value
Next, we will explore how to calculate the net present value. This calculation will solve for the total input and output of a project. To solve for this figure, you will take the present value of total benefits, and subtract this number from the cost over a period of time. You can use the abbreviation NPV, which stands for net present value.
Remember, if the net present value that you solve for is bigger than zero, this means that your project will be profitable and make money. When working to select the proper projects to embark on, it is wise to choose those with a higher net present value, as these will produce a bigger profit for the organization.
If the organization has a long list of potential projects, they wish to start, using the net present value is an easy way to select which assignments to move forward with first!
The bulleted list below shows the present value that will be retained and the present value of the total project cost.
- In the first payment, the net present value will be greater than the cost.
- In the second payment, the present value will be less than the total cost for that year.
- In the third payment, the present value will be greater than the cost for the previous year. As a result, you will notice a positive net present value.
If you add the net present values for all three years, you will notice that the project receives more money than initially invested in the total cost. You can subtract these two numbers to find your total net present value, which is the difference between what the project received, and the total cost paid.
Rate of Return
The next economic model we will explore is the internal rate of return. The internal rate of return shows the percent of return on a project, and this figure can be abbreviated as IRR.
For example, if $50,000 is needed for the start of a project and the rate of return is 6% in a single year, this means the project will produce a total of $6000 in profit. This profit will occur at the end of the first year. Thus, projects with higher IRRs should be selected, as this means they have a higher chance of producing more profit.
Next, we will explore the payback period. This figure shows the number of times a period must occur in order to earn back the initial investment of a project. So, projects with a shorter payback time should be chosen.
For example, if a company invests $50,000 into a project, and the payback is a three-month timeline, the outcome of the project will bring $50,000 in three months. This will ensure that the project is profitable and, therefore, should be selected first.
Remember, the timeline of your payback will be the duration of when the project will cover initial investments to final completion.
You’ve likely heard of the benefit-cost ratio, which is another economic model used in the field of project management. This model helps estimate what work needs to be done to keep the project on track. First, the benefits will be estimated within a project, as done in the economic model. Next, the project’s benefits are compared to the cost of the same project to analyze the difference between the two. Next, the project manager will consider benefits as revenue and output that will be returned on the investment of starting the project.
- If this figure is greater than one, the project’s benefits will be greater than the cost.
- If this figure equals one, the benefits of the project or equal to the cost of the project, so neither outweigh the other.
If the figure ends up being lower than one, the project’s benefits are less than the project’s cost. This means it is probably not worthwhile to start this assignment.
So, projects with a higher benefit-cost ratio should be selected and started first. This way, the project manager can ensure that the benefits outweigh the project initiation cost and that the project will likely bring in revenue. Suppose the benefit-cost ratio does come out to be less than one. In that case, it is highly recommended that the project manager advises against starting this project, as it will not be profitable or generate revenue for the organization.
We have now covered all five economic model types. You are now ready to advise your organization on which projects will be worthwhile and which will not be!
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