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Importance of the Efficient Frontier

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Suppose we construct the efficient frontier as described in the previous sections. 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 and/or on other resources?
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 48 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 business unit. As shown in Figure 47, 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 47:   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 48, 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 48:   The project portfolios selected by organizations can typically be improved significantly.

Better project portfolios are 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.

A Real Efficient Frontier

Part 6:  Achieving Best Practice