Technical Terms Used in Project Portfolio Management (Continued)

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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.

Rank reversal example

This result occurs with some multi-criteria analysis scoring models, most notably for the analytic hierarchy process (AHP), where the inclusion or exclusion of even a poorly ranked project (an irrelevant alternative) can cause project scores (which are derived from pairwise comparisons across all alternatives) to change in such a way that project rankings change. Although there is debate over the matter, rank reversals based on irrelevant alternatives are generally regarded to be inconsistent with rational decision making. (Why should my preference for one option over another change if an option I don't want is removed from consideration?). 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 logical questions involved.

ranking curve

A graph derived from a ranked list of projects, where the ranking is based on the ratio of some measure of project benefit to project cost. Specifically, the curve is a plot of cumulative cost (as projects are added to the project portfolio in rank order) vs. cumulative benefit (obtained by cumulating the benefit measure). Most project portfolio management tools provide a ranking curves as outputs. As explained in the paper on efficient frontiers vs. ranking curves, ranking curves appear similar to, but are different than, the efficient frontier of project portfolios.

Ranking curve

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 to cut losses, 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 that are available.

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 flexibility and limit downside risks. Although in most 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.

regression analysis

A statistical technique applied to data to determine the degree of correlation among one or more variables; that is, to quantify the extent to which the variables tend to move together. Typically, regression analysis seeks an equation, called a regression equation or regression function, that relates a dependent variable to one or more independent variables. In this way, regression analysis may be used to suggest potential cause-effect relationships, although it cannot by itself be used to prove such relationships.

relational database

A collection of data elements organized into separate tables (sometimes referred to as "relations") of predefined categories in a way that makes it easier to access and combine data elements. The structure allows data from different tables to be accessed and reassembled in different ways without having to reorganize the tables.

The concept of a relational database was developed in 1970 by Edgar Codd, of IBM, whose objective was to accommodate in an efficient way a user's ad hoc request for selected data. The standard application program used to interface to a relational database is the structured query language (SQL). Most business database management systems use relational databases and project portfolio management tools are often advertised as storing data in a relational database.

release management

The coordination and bundling of projects and project tasks for the purpose of optimally synchronizing the release of new products and services. Release management can be important when business value depends on interdependent projects, or when launch date serves as a rally point for the completion of the projects. The term originated in the field of software engineering, where it involves managing the IT project lifecycle, including development, testing, deployment and support of software releases.

For projects focused on new products, release management and project portfolio management are closely related, since shifting projects dates for the purpose of resource balancing can have a significant impact on the value of the portfolio.

resource balancing

A component of resource management focused on balancing the supply and demand for the resources needed for conducting projects. Key inputs for efficient resource balancing are forecasts of the demands for various resources and the supply of those resources. The general goal is to achieve near 100% resource utilization without over-allocating resources across projects. Also, called resource leveling, the process mainly involves leveling or smoothing the demand for resources by adjusting the start and end dates for projects or the tasks that make up those projects so as to reduce peaks and valleys in resource demand.

Various software tools are available to support resource balancing. However, as explained in the section of the paper on tools for resource balancing, such tools rarely if ever attempt to optimize the selection of projects based on the people and other resources that are available. Instead, the typical approach is to select projects subject only to a constraint on total project costs (including labor costs), and then to phase the selected projects by shifting start and end dates for tasks. Since it is typically undesirable to delay project completion dates, resource balancing mainly looks for ways to shift work that is not on the critical path, and network analysis techniques, including PERT charts, are often used to aid the process.

resource management

The field concerned with effectively managing an organization's resources, including people, money, materials, equipment, and services. A key focus is resource allocation, the efficient deployment and use of the organization's resources. Human resource management refers to the special case of managing people resources, and the topic is typically defined to include the management of payroll and benefits, education and professional development, and other human resource functions. Resource balancing is a key technique used for resource management.

return on investment (ROI)

The ratio of project income to project cost. Typically, project income is specified as the average annual net income from a project, and project cost is the total invested capital:

For example, a project that costs $100,000 and is expected to return $20,000 annually would have an ROI of 20%.

As indicated by its definition, ROI is a measure of the financial benefits obtained from a project over a specified time period in return for the required investment, with the result expressed as a percentage. ROI is widely used (especially in the private sector) both to justify a proposed project and to evaluate, after the completion of the project, the extent to which the desired return was achieved.

ROI is similar to internal rate of return (IRR) in that it provides a measure of "bang-for-the-buck." However, it is even simpler in that in that it does not distinguish, nor is it sensitive to, the time at which project cash flows occur.

Like IRR, ROI is most often used as a go/no-go screen for selecting projects. A minimum required ROI is specified, referred to as the hurdle rate. The hurdle rate is often based on the company's weighted average cost of capital (WACC), the average return on a portfolio of all the firm's securities (equity and debt). Alternatively, the hurdle rate may be set higher or lower depending on the company's appetite for risk and shareholders' expectations for company performance. Projects with ROI's less than the hurdle rate are rejected.

When used to rank projects, ROI has significant limitations. If project income varies from year to year, ROI will depend significantly on the period chosen for computing average income. ROI also has most of the limitations of IRR. It ignores non-financial project benefits, can't properly account for project risks and interdependencies, and does not provide a basis for quantifying the value of alternative project portfolios. Since future cash flows are not discounted, ROI ignores the preference that should be given to projects whose cash inflows occur sooner in time. Thus, ROI is particularly unsuitable for ranking projects that produce incremental revenues or cost savings that persist over multiple years.

return on net assets (RONA)

A measure of the financial performance for a company:

Net income is after tax profit and working capital is current assets minus current liabilities. Asset intensive businesses often use RONA to indicate how effectively the firm's asset base is being used to create profit.

risk

A characteristic of a situation or action wherein a number of outcomes are possible, the particular one that will occur is uncertain, and at least one of the possibilities is undesirable.

risk adjusted discount rate

A discount rate intended for application to a risky (uncertain) future cash flow. A risk adjusted discount rate is higher than a risk free discount rate. If an investment involves risk, then it will have to provide a higher rate of return to compensate for that risk.

The risk-free discount rate is often selected to be the return available from market investments that involve little or no risks, such as the rate of return available from short term US treasury securities. The risk adjusted discount rate can be regarded as the risk-free rate plus a risk premium appropriate given the level of risk.

Risk adjusted discount rates represent one of two popular methods for accounting for risk when valuing projects that produce uncertain future returns. With risk-adjusted discount rates, the expected value generated by the project is estimated in each future time period. The time stream of expected values is then discounted at the risk adjusted rate to obtain the project net present value (NPV). A competing approach is to compute the certain equivalent of each uncertain value, and then to discount the certain equivalents at the risk free discount rate. Both approaches involve questionable assumptions related to the way they attempt to disentangle risk and time preference. However, estimating a risk adjusted discount rate is particularly problematic in that, for example, it can be shown that it is not appropriate to use the same rate for cash flows that occur in different time periods.

risk adjusted value

A measure of value that accounts for risk or uncertainty. Due to risk aversion, people and organizations typically assign a lower value to assets or investment opportunities that have more risk than to otherwise similar investments that are less risky. The most common way of adjusting for risk is to compute a reduced value for the investment that is said to be "risk adjusted." Various methods are available for computing a risk adjusted value, including real options analysis, certain equivalents, using risk-adjusted discount rates, or applying subjective "haircuts" to forecasted returns.

risk aversion

The preference that humans commonly have that causes them to prefer certain or sure consequences over comparable uncertain ones. A decision maker is said to display risk aversion if, when faced with the choice between the expected value of the uncertain consequences to a risky project and the uncertain consequences themselves, he or she would choose the expected, certain value. The degree of risk aversion can be quantified by measuring decision maker risk tolerance.

risk free rate

The rate of return available from riskless investments, usually taken to be short-term US government securities.

risk matrix

A graphic display for visualizing and comparing risks. Initially adopted by the US military, the tool is currently used by many organizations as a simple means for analyzing risks. The idea behind the risk matrix is to distinguish various levels for the two main dimensions of risk, (1) likelihood of occurrence and (2) magnitude of impact. For example:

A basic risk matrix

Each cell in the risk matrix represents a possible combination of likelihood and impact. Since the seriousness of a risk is roughly related to the product of likelihood and impact, colors (e.g., green, yellow, and red) are often used to emphasize this result. The number of rows and columns and the particular way in which they are defined (e.g., quantitatively or qualitatively) can be varied depending on the application.

To use the risk matrix, a list of relevant risks is generated. For example, if a company is considering introducing a new consumer product, a possible risk might be that a customer could be injured by that product. For each identified risk, the likelihood of the risk event (e.g., not very likely versus very likely) and the seriousness of the consequences (e.g., minor cut versus serious permanent disability) are estimated. The results are then used to place each risk within the appropriate cell of the risk matrix. Risks can then be prioritized from top-right down to bottom left.

The main benefit of the risk matrix is that it provides a visual display that differentiates high-probability/low-impact and high-impact/low-probability risks. Because multiple risks can be displayed simultaneously, the approach benefits from the comparative ease that people have in making pairwise comparisons as opposed to the greater difficulty associated with drawing absolute judgments. Within a risk management process, the matrix provides documentation demonstrating that risks have been identified and deliberately evaluated. Also, the matrix can be used to show how the likelihood and impact of risks change and therefore move within the matrix, for example, over time at different stages in a project's investment life cycle or as a result of candidate risk mitigation strategies.

Another attractive characteristic is that the matrix works well in a group decision-making environment. For example, the risk matrix can be drawn on a white board or pages taped together from a flip chart. Post-It Notes can then be used to place risks within the matrix. The exercise promotes brainstorming and a team approach helps avoid the extremes of too pessimistic or too optimistic views that might be expressed by individuals.

The main limitations of the risk matrix relate to the simplistic, subjective way by which risk is measured. Poor resolution often results because rows and columns are often defined qualitatively, so that the same cells can be assigned to risks of very different magnitude. Also, due to errors in either the assessment of risks or the cells in which they are placed, the risk matrix can mistakenly assign higher qualitative ratings to quantitatively smaller risks. The risk ratings assigned to cells are typically just a function of the product of likelihood and impact, so the approach ignores the fact that very high consequence/low probability risks are generally of greater concern to organizations than the product would suggest, and the error is greater for organizations with lower risk tolerance. Effective allocation of resources to risk-reducing countermeasures cannot be based solely on the category ratings assigned by risk matrices—the effectiveness of the risk-reducing measures must be considered as well. These and other limitations imply that risk matrices should be used with caution, and only with careful explanations of underlying judgments.

risk mitigation

Actions taken to reduce risks based on lowering the probability and/or impact of a risk to below some acceptable level or threshold. In the context of project management, risk mitigation typically involves revising the project's scope, budget, schedule or objectives.

risk premium

An incremental return that compensates an investor for accepting an investment considered to be risky. The risk premium is the difference between the expected return from the risky investment and the return available from a risk free investment.