Technical Terms Used in Project Portfolio Management (Continued)

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probability encoding

A formal, interview-based process for extracting and quantifying judgments about an uncertainty in the form of a probability distribution. Probability encoding is routinely used within the field of decision analysis to convert the specialized or general knowledge held by experts into probability distributions that represent the judgments of those experts. Although there are variations, most approaches to probability encoding are multi-step and use recognized techniques for reducing errors and bias. For example, a common approach includes stages or elements designed to motivate, structure, condition, encode, and verify.

productivity index (PI)

Various metrics intended to represent the efficiency of a project, and which are often used for project prioritization. The productivity index (PI) is the ratio of some quantity to be maximized and some quantity that is a constraining resource. For example, a construction company might select "earned value" (as defined, for example, by earned value management) as the numerator for the PI. The denominator might be the number of labor hours needed to complete the project. Thus, a productivity index could be defined as:

The ratio expresses the dollar earnings available from the project per hour of labor required. Projects are ranked according to the productivity index and approved from the top down, until the constraining resource (in this case, labor) 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 constraints for the resource defined by the denominator.

As another example, if R&D budget is the presumed constraining resource, a 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:

This, 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.

The recommended project 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. In contrast, note that in the above two examples the cost in the denominator is subtracted within the numerator (since NPV is project value minus project costs). Thus, these PI's do not exactly express benefit-per-unit-of-cost (the ratio typically recommended for ranking projects). However, such a PI effectively expresses a ratio of benefit-to-cost and then subtracts one unit from it, which results in the same priority rankings.

Like other ranking metrics, at best, a PI is an approximation 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.

profitability index (PI)

A specific type of productivity index used to measure the financial attractiveness of a project. The profitability index (PI) is normally defined as the ratio of the present value (PV) of the project's projected future cash flows divided its required initial investment:

(If the required investment takes place over several years, the denominator may be replaced by the PV of required investments.) The measure is used to rank projects based on projected financial value created per dollar of required investment.

Since the project NPV includes the cash flow deduction for the initial project costs,

A PI of 1.0 is logically the lowest value for an acceptable projects, which would correspond to an NPV = 0. Any value less than one would signal a project with a present value less than its costs.

Like other productivity indexes, the profitability index provides a simple way to rank projects that compete for limited capital. Its weakness is that it ignores project interdependencies. Also, the profitability index fails to account for project benefits other than future cash flows. The profitability index is also sometimes called the profit investment ratio or the value investment ratio.

program

A suite of related projects managed as a whole. Typically, the program manager is responsible for providing overall direction and coordination to teams responsible for the individual projects and a central point of contact for the client or sponsor of the related projects .

project

A unique, temporary endeavor undertaken by an organization to produce some desired benefit (e.g., a project to enhance a product or service). Projects vary greatly in size and complexity, typically involve activities outside the routine operations of an organization, and often draw on resources from different parts of the organization for the duration of the project.

project based organization

An organization that executes much of its business through conducting projects. Project based organizations typically adopt an organizational structure that facilitates the formation and support of project teams, as well as the reassignment of individuals following the completion of projects.

project management

A set of principles and practices for successfully completing projects. A major focus of project management is maintaining project quality while adhering to time, scope, and budget constraints. Typical steps in project management include initiation, planning, executing, controlling, and closing. Project management is typically the responsibility of a project manager who is supported by a project team.

The era of modern project management began in the early 1960s, as organizations began to see the benefit of organizing work around projects. The Project Management Institute (PMI) has created "A Guide to the Project Management Body of Knowledge" (PMBOK), which contains well-accepted standards and guidelines for project management.

In contrast with project portfolio management, which is aimed at simultaneously managing whole collections of projects, project management is focused on successfully completing individual projects.

project planning

The process of creating a project plan, recognized as a critical initial step of project management. Like other types of business planning, project planning is aimed at obtaining the greatest benefit from the project while minimizing risk and making the wisest use of available resources.

Key steps in project planning include establishing project goals, defining project deliverables, creating a list of project tasks and a work break down structure (WBS), identifying the people and other resources needed to carry out each task, creating a project schedule, and identifying risks and developing a risk management plan. The amount of effort and detail appropriate to each step depends on the size and complexity of the project. Gantt charts and PERT charts are often used to plan and subsequently report progress with regard to project tasks. Inadequate project planning is often cited as the main reason that high percentages of projects fail.

project portfolio management (PPM)

A formal, tool-supported process intended to help businesses and other organizations to select projects and better manage project portfolios using techniques similar to those employed by financial managers to optimize investment portfolios. A project portfolio is a collection of projects (and, perhaps, other work) grouped together to facilitate the effective management of that work. PPM may also be 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 a project based 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 mathematical 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.

project portfolio management office (PPMO)

One or more people in an organization assigned responsibility for project portfolio management (PPM). Activities include evaluating project proposals and making recommendations to senior management regarding what projects to conduct, recognizing the limitations on available resources. The PPMO is distinct from a project management office (PMO) in that the latter is focused on improving project management performance as it relates to individual projects. See the section of the of the paper on the project portfolio management office for more detail.

PROMETHEE

A multi-criteria analysis method that, like ELECTRE, is based on comparing potential actions while applying different criteria. A so-called outranking method characteristic of the "European school" of multi-criteria methods, PROMETHEE does not require a utility function for quantifying decision-maker preferences. Instead, it ranks options and determines which is most preferred by systematically analyzing the results of the individual comparisons.

PROMETHEE was originally developed in Belgium around 1984 and stands for Preference Ranking Organisation METHod for Enrichment Evaluations. Like ELECTRE, it comes in various "versions." PROMETHEE has been used for project prioritization and some project portfolio management tools are advertised as supporting the method.

Q

quadratic programming

Similar to linear programming, except that the goal of the optimization is to maximize or minimize a quadratic function of the decision variables, for example:

As with a linear program, there can be one or more linear constraints, for example,

There are many practical applications of quadratic programming. For example, modern portfolio theory identifies optimal investment portfolios by minimizing a quadratic function representing portfolio risk (the sum of the variances and covariances of the individual investments) subject to a linear constraint (a minimum expected return from the portfolio).

quality assurance (QA)

The methods that are designed and used by an organization to ensure that the activities it conducts and their results meet necessary quality standards.

R

rank reversal

Arises when adding or deleting an alternative (e.g., a candidate project) to the list of options under consideration causes the ranking of other (independent) alternatives to reverse. This result occurs with some multi-criteria analysis methods, most notably for the analytic hierarchy process (AHP), where the inclusion or exclusion of a poorly ranked project (an irrelevant alternative) can cause the ranking of other projects to change. Although there is debate over the matter, rank reversals based on irrelevant alternatives is generally regarded as inconsistent with rational decision making. Project portfolio management tools based on AHP may include a mode of operation that prevents rank reversals from occurring, however this "fix" does not address the fundamental methodological questions involved.

real options analysis

A method for valuing projects and assets based on concepts originally developed to value financial options. Real options analysis is most useful for large capital budget decisions in situations involving significant uncertainties (especially market uncertainties) and where management has flexibility to adapt decisions to unexpected developments. For example, real options analysis is often used for mergers and acquisitions, facility expansion decisions, oil exploration, contract valuation, and prioritizing R&D projects.

Real options analysis is based on the recognition that there is an important similarity between financial investments and business projects. In finance, a stock option (specifically, a "call-option contract") allows (but does not force) the owner to buy a fixed number of shares of the stock at a specified date for a specified price. The owner will want to exercise the option and buy the stock if its price goes up, but not if the stock price goes down. Similarly, projects involve options. For example, a project to construct a new factory provides options to postpone construction if the economy slows. Building a new factory also includes options to temporarily shut down or abandon the plant, as well as to expand its size to meet an unexpected demand for more production. The options inherent in physical assets are termed "real" to distinguish them from classic financial options.

In the 1997, Robert Merton, Myron Scholes, and Fischer Black won a Nobel price for deriving a model for computing the price of call- and other types of options. This work provided the foundation for developing an analogous method for valuing the options (flexibility) inherent in projects. As with financial options, the value of the options implicit in a project increases the value of that project. For example, a factory with operating options is more valuable than an identical factory that does not include options, and the extra value is the value of the options.

Traditional financial valuation methods, including net present value (NPV), typically under-value projects because they fail to adequately account for the value of management flexibility to exercise the project's inherent options. Expected net present value (ENPV) can include the value of flexibility (if "downstream decisions" are represented in the decision tree), and most authors include ENPV as subset of the methods available for real options analysis. Similarly, multi-attribute utility analysis (MUA) can account for the value of management flexibility by including project evaluation criteria related to the option value of the project. However, real options analysis also includes solution methods that derive option values from the market prices of underlying assets. Thus, for example, a real options analysis of an oil drilling project could derive the project's value in part based on market prices for barrels of oil, similar to the way the value of a call option on a stock can be derived from the behavior of the market price of that stock.

A major benefit of real options analysis is the insights that it provides for managing projects so as to leverage uncertainty and limit downside risks. Although in many cases it may not be practical or even possible to apply the most sophisticated real option solution techniques to value many projects, real options theory has shown how simpler methods, including ENPV and MUA can be used to more accurately account for option value by recognizing multiple decision pathways and better accounting for the cost of risk.