Technical Terms Used in Project Portfolio Management (Continued)

net present value (NPV)

The traditional method for quantifying the financial attractiveness of a project. NPV, also called discounted cash flow (DCF), represents the amount in today's dollars (present value) by which all income projected from the project exceeds all costs.

Basically, NPV attempts to answer the question, "What is the equivalent, lump-sum worth of this project?" According to NPV logic, given two projects, the one with the larger NPV should be preferred. Also, any project with a positive NPV should be viewed as a good investment.

NPV computes the present value for a project by discounting estimated future incremental cash inflows and outflows. Typically, the discount rate is chosen to represent a required rate of return or target yield for the capital invested. To accurately calculate a project's NPV, it is necessary to estimate the life-cycle cash flows that would result from doing the project— not just the project costs, but also all of the financial benefits that would result from the project. For example, if a project improves productivity, the future cost savings that would result should be included in the estimated cash stream. Cost estimates reflect the total cost of ownership (TCO) perspective. Thus, costs include project investment costs, future operating costs, and any "exit" costs associated with ultimately phasing out whatever it is that the project produces. Since taxes can have a significant impact, cashflows are often calculated "after-tax," accounting for depreciation, working capital, and other considerations.

NPV cannot be used directly as a metric for ranking projects because it ignores the size of the projects being compared. Larger projects tend to have larger NPV's. Thus, projects with large NPV's tend to consume greater portions of the available budget. However, NPV can be used to translate the financial benefits expected from a project into an equivalent dollar value which, if divided by the project cost, can be a useful metric for ranking projects (assuming the projects are independent).

By requiring that a single, nominal cash flow be identified for the project, NPV ignores uncertainty. This limitation may be addressed by using NPV in conjunction with simulation. If alternative project cash flows are simulated, they may be used to generate a range or distribution of project NPV's. This distribution may be interpreted as describing the uncertainty over the actual value that the project will generate. See expected net present value (ENPV) for more discussion.

The major limitation of NPV for project prioritization is that it underestimates the true value of projects (e.g., the impact of a project on shareholder value) because it leaves out "intangible" project benefits that are difficult to express as incremental cash flows. One such omitted component of value is "option value," the value associated with options embedded in or created by the project which may allow management to better respond to future risks and take advantage of future opportunities. See real options analysis for an explanation of option value. One method for addressing this bias is to add to the estimated project cash flows additional dollar amounts that represent the equivalent dollar value of the non-financial project benefits. See multi-attribute utility analysis for a method for doing this.

Another problem with NPV is that it is not always clear what discount rate should be chosen. According to finance theory, the correct rate is the return available from investing in securities equivalent to the risk of the project being evaluated. Research on real options shows that the discount rate ought to be adjusted over time depending on how uncertainties are resolved and on the project-management strategy. Using a constant discount rate for a project implicitly assumes that uncertainty increases over time in a specific way (geometrically). If the discount rate is adjusted upwards to account for the risk of the project, there will be a bias toward short-term, quick payoff projects because project benefits that occur in the more distant future will be severely discounted.

payback period

The amount of time it takes for the cumulative cash flows from a project to equal the initial investment. An investment will have paid for itself in the year, or month, where the cumulative cash flow first becomes positive. Payback period is a popular metric for evaluating projects because of its simplicity, emphasis on liquidity, and obvious responsiveness to external financing pressures. However, because payback period does not provide a measure of project or portfolio value, it cannot be used as a metric for prioritizing projects.

Another major limitation of the payback period method is that it ignores cash flows after the payback period. For example, a small project may have a break-even point at six month from the start of the project. A larger project that costs twice as much may not break-even until 12 months after the start of the project. Based on the analysis of the payback periods, the company may choose to go with the smaller project. The analysis would ignore the fact that after two years, the larger project would have produced three times the dollar savings as the smaller project. Also, as no discounting is involved, the payback period overlooks the time value of money (cost of capital).

portfolio mapping

Various graphing and charting techniques generally used to portray the "balance" of a project portfolio by displaying how the various projects perform on two or more dimensions or criteria. The most popular portfolio mapping diagram displays project risk and reward—the x-axis is labeled probability of success and the y-axis is labeled payoff. Projects are plotted on the diagram according to their estimated success probabilities and payoffs (if successful).

In one popular version of the risk-reward portfolio mapping, projects are categorized according the quadrant that they fall into. The 4 quadrants of the diagram are labeled "pearls," "oysters," "bread & butter," and ""white elephants." Pearls have a high probability of success and yield high payoffs. Oysters are long shots, but with high payoffs. Bread & are low-risk projects with low reward. White elephants are low probability and low payoff projects.

A bubble diagram is a popular variant of portfolio mapping that uses a circle or ellipse to identify each project instead of a single point. The size, shape, color or shading of the circle is varied to provide additional information about the corresponding project. For example, the size of the circle may represent the initial cost of the project.

Numerous, versions of portfolio mappings and bubble diagrams are in use and often provided as outputs in project portfolio management software. The chosen axes represent characteristics relevant to the specific application area. For example, for new-product-development projects, popular variations of the risk-reward plot include ease-attractiveness (plots showing the trade-offs between technical feasibility versus some measure of market attractiveness, such as growth potential), cost- timing (cost to complete versus time to benefits), and focus-benefit (consistency with organizational strengths versus some measure of project benefit, such as expected net present value (ENPV)).

Portfolio mapping tools are useful devices for displaying project characteristics, but they do not provide a basis for deciding either how to tradeoff those characteristics nor what balance or distribution among the various characteristics is best for the project portfolio.

productivity index (PI)

Variously defined metrics, intended to represent a project's efficiency, that are proposed for ranking projects. Typically, the productivity index is the ratio of some quantity to be and a measure for some quantity that serves as a resource constraint. For example, contribution to financial performance, as measured by NPV, might be selected as the numerator for the PI. The denominator might be selected as people-days needed to complete the project. Thus the productivity index could be defined as:

Projects are ranked according to the specified productivity index and approved, from the top down, until the constraining resource (in this case, people time) is exhausted. The approach is intended to maximize the productivity of the selected project portfolio (as defined by the measure used in the numerator) while staying within the selected resource constraint (the denominator).

The ranking metric described in our paper on mathematical methods, project benefit divided by project cost (bang for the buck), is an example of a productivity index.

As another example, if R&D budget is the presumed constraining resource, the productivity index might be defined as:

A form of the productivity index sometimes proposed for ranking new product-development projects is the development productivity index (DPI), defined as:

The above (and related approaches that involve assigning probabilities to the achievement of the measure to be maximized) may alternatively be described as a probability-adjusted productivity index.

At best, ranking projects using a productivity index is a heuristic that may, in some cases, reasonably approximate the project portfolio that would be obtained based on constrained optimization (i.e., maximizing the measure in the numerator subject to the constraint represented by the denominator). However, errors are often made in formulating the productivity index, and the approach will not work if there are dependencies that cause a project's productivity index to change depending on what other projects are conducted.

project portfolio management (PPM)

A formal, tool-supported process intended to help businesses and other organizations to better manage projects by applying techniques similar to those employed by financial managers to optimize investment portfolios. PPM is also often referred to as enterprise project management or multi-project management.

The goal of financial investing is to select the best portfolio of available stocks, bonds, and other financial investments. By analogy, the goal of the project-oriented organization is to invest in the best possible set of projects. In both cases, the "best" portfolio is the one that is expected to return the most value, taking risk into account. Good financial portfolio management requires monitoring investment performance and periodically restructuring the portfolio. Poor-performing investments, for example, may be sold and the proceeds redirected to other investments that are expected to perform better. Similarly, with PPM, projects are monitored and those that are performing below expectations (e.g., because of cost overruns, benefit erosion, or changing needs) may be terminated so that the resources may be directed toward new or other existing projects. (Despite these similarities, be aware that there are some important differences between financial and project portfolios—see the discussion under modern portfolio theory).

PPM tools vary greatly in their capabilities. However, all such tools collect and organize into a central database pertinent information about proposed and ongoing projects (data such as project names, objectives, resource needs, timelines, etc.). The tool gives users (typically managers or senior executives) a bird's eye view of projects, making it easier to spot inefficiencies in the project portfolio (for example, redundant projects). Being able to quickly access, review, and compare a large number of projects aids project funding decisions and other key financial and business choices that the organization must make.

Of course, financial portfolio management involves much more than simply putting the information sheets for candidate investments in front of the decision maker. Professional investors rely on sophisticated models to forecast the performance of individual investments. Many also use advanced optimization techniques to construct investment portfolios that maximize expected risk-adjusted return, accounting for the risk tolerance of the investor.

Despite the analogy with financial investing, very few PPM tools incorporate rigorous methods for valuing projects, assessing project and portfolio risk, or optimizing the project portfolio. Instead, most PPM tools use simpler but inappropriate methods for prioritizing projects, such as balanced scorecards and strategic alignment. A common approach is to rank projects based on the degree of judged alignment between the project and elements of corporate strategy. Strategic alignment, of course, has little if anything to do with project value or risk. Thus, customers should take care to not be misguided by faulty recommendations provided by inadequate PPM tools.