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Importance of the Efficient Frontier

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Suppose we construct the efficient frontier as described in the previous section. The result is useful for several reasons.

The Efficient Frontier Answers Key Questions

The efficient frontier allows us to answer four important questions:

1. What are the best project choices given a specified constraint on the available budget?
2. If, for political or other reasons, we choose a specific, non-optimal set of projects (a project set not on the efficient frontier), by how much are we over-spending and how much potentially achievable value are we losing?
3. Based on the total value obtained for the total dollars spent, are we over- or under-spending on projects?
4. How should we allocate the total budget across organizational units or to different types of projects?

The best project choices (Question 1) are, of course, those contained in the portfolio that lies on the efficient frontier at the cost level at, or just below, the cost constraint. The losses resulting from choosing a non-optimal portfolio (Question 2) are the horizontal and vertical distances from the selected portfolio to the efficient frontier (see Figure 41 below). With regard to Question 3, an organization is overspending on projects if the chosen portfolio lies on that portion of the curve where the slope is less than 1.

Question 4, how to allocate resources among organizational units can be answered if a separate efficient frontier is constructed for the projects proposed by each unit. As shown in Figure 40, the optimal allocation funds portfolios on the respective curves where the slopes are equal. This result provides a useful approach for developing tiered priority systems for organizations with decentralized project prioritization processes.

Figure 40:   The optimal allocation matches slopes on the efficient frontier.

Evidence that Finding the Efficient Frontier Adds Considerable Value

In real-world applications, it is sometimes possible to compare the performance of a current portfolio with optimal portfolios that are on the efficient frontier. Figure 41, derived from an actual application, shows that an alternative portfolio was found that increased value by over 30% without increasing costs. Similarly, an alternative portfolio was found that reduced costs by 40% without decreasing value. This result is typical for organizations with difficult-to-value projects. Application of the efficient frontier approach shows that current project portfolios are often well below their potential.

Figure 41:   The project portfolios selected by organizations can typically be improved significantly.

Better project portfolios is not the only benefit of the efficient frontier. Calculating the efficient frontier creates a new perspective, one that helps managers throughout the organization to fully appreciate the reality that resources are limited, better understand the relationship between value created and costs incurred, and, when the opportunity is great enough, find ways to break the constraint on costs.

The Efficient Frontier Depends on the Quality of Project Options

The efficient frontier improves if project alternatives improve. Figure 42 shows what happened when project proponents were asked to submit 3 alternative versions for each project proposal (the original proposal, a reduced cost - reduced scope proposal, and an enhanced cost - enhanced scope proposal).

Figure 42   More (and better) project options improve the efficient frontier.

Additional project options allow better project portfolios to be constructed, especially when costs are highly constrained. Thus, the efficient frontier moved up and to the left. By adjusting the spending levels for projects, portfolio value was increased by another 14%.

The Efficient Frontier Moves over Time

Regardless of the number of project alternatives analyzed, the efficient frontier tends to improve over time. Organizations continually face the challenge of finding project alternatives that advance the frontier. As project managers better understand the link between their project designs and the value derived by the organization, they create better project proposals. Also, better technology creates new opportunities that create more value for less cost. This causes the efficient frontier to move up. The fundamental goal, though, remains the same-create as much value as possible using as little capital as possible. To do this, you must find the efficient frontier.

The Efficient Frontier

Part 6:  Achieving Best Practice