Lee Merkhofer Consulting Priority Systems
Implementing project portfolio management

Part 6:  Inability to Find the Efficient Frontier

The goal of project portfolio management(ppm) is to select and manage projects so as to derive the greatest possible, risk-adjusted value from the organization's project portfolio, taking into account that available resources are limited. Economists call the set of investments that create the greatest possible value at the least possible cost the efficient frontier. Most organizations fail to find the best project portfolios and, therefore, do not create maximum value. Inability to find the efficient frontier is the fifth reason organizations choose the wrong projects.

If the problems discussed in the previous sections of this paper are addressed, value-maximizing project portfolios can be found. Specifically, if the organization is managing the project portfolio, has the right metrics and models in place, including the ability to measure and value risk, and has taken steps to minimize errors and biases in inputs provided to those models, the capability exists to estimate the value that would be created by conducting any proposed project portfolio. It is a relatively easy last step, then, to find the best combination of projects. The concept of the efficient frontier is highly useful in this regard.

The Efficient Frontier

Suppose that an organization plots some of its available project portfolios on a graph relating total value to total cost, as shown in Figure 37. Economists would describe Portfolio A as inefficient because there is another project portfolio, Portfolio B, that produces more value for the same cost. Similarly, there is also a Portfolio C that produces the same value for less cost. Furthermore, there is a Portfolio D with a combination of these two characteristics.

Value vs. cost for several portfolios

Figure 37:   Different project portfolios have different costs and values.

Now suppose we consider all of the alternative project portfolios that can be constructed from a set of candidate projects. Typically there are many, as suggested by the example of Figure 38. In this case the organization had 30 project proposals under consideration in one budget cycle. Four of those projects were considered mandatory (3 process fixes and a new initiative required by regulators), leaving 26 discretionary projects.

Scatter plot of project portfolios

Figure 38:   Portfolio value versus cost.

In general, if there are N potential projects, there are 2N possible project portfolios. (This is because there are a total of 2N subsets within a set of N items; see Mathematics: Methods for Solving the Capital Allocation Problem for more explanation). Thus, this application required evaluating 226 or approximately 67 million portfolios, far more than shown in the Figure 38! The best portfolios define the efficient frontier. Portfolios along the curve at the frontier are said to be "efficient" because they allow the organization to obtain the greatest possible value from any specified available budget.

Finding the Efficient Frontier

It is relatively easy for a computer, with an efficient optimization engine, to try various combinations of projects and locate the efficient frontier, provided the right algorithms for calculating portfolio value are in place. Essentially, the optimization is run multiple times, each time with a different specified cost constraint. Even though there may be too many possible portfolios for even the fastest computers to try all combinations, approximate methods are available that can ensure sufficient accuracy for practical purposes. The optimization identifies the highest-value portfolio for each cost and the result is plotted. The curve obtained in this way defines the efficient frontier (Figure 39).

The efficient frontier

Figure 39:   The efficient frontier.

The Characteristic Curve of the Efficient Frontier

Notice how the efficient frontier is curved, not straight. This is because the frontier is made up of the best projects; that is, those projects that show up first on the left side of the curve. Such portfolios create the greatest "bang-for-the-buck," and, therefore, the slope of the curve is steepest here. As the cost constraint is relaxed and more projects can be added, the new projects provide less incremental value compared to those included earlier. The slope of the curve encompassing these projects is flatter because the incremental bang-for-the-buck is not quite as high. Thus, there is a declining return in the value obtained with each additional increment of cost. This is what causes the curve to bend as shown in Figure 39. (As described later, however, the efficient frontier will typically not be completely smooth, but will have some bumps in it.)

The 80/20 Rule

Vilfredo Pareto, an Italian economist, was the first to report what has become recognized as a common rule describing how dissimilar objects are often distributed. Specifically, Pareto observed that approximately 20% of the people owned 80% of the wealth. Since then, a similar relationship has been observed in many other areas, including business contexts, for example, 80% of profits come from 20% of customers, 80% of results come from 20% of the effort, and 80% of the value can be achieved from just 20% of the activities. The relationship is not exact, of course, but it is close in a surprising number of situations. It has become known as the "law of the trivial many and the critical few," or, more simply, as the 80/20 rule.

The curvature of the efficient frontier is such that it often corresponds closely to the 80/20 rule. Roughly 80% of the value available from doing all projects may be achieved by doing just 20% of those projects (assuming, of course, that the best projects are chosen). The lesson is similar to other instances where the rule applies—Managers should concentrate on identifying and doing the few things that are critical rather than wasting effort on the many things whose impacts are trivial.

The Efficient Frontier Depends on the Quality and Quantity of Project Options

The efficient frontier improves if project alternatives improve. Figure 40 shows what happened when project proponents were asked to submit 3 alternative versions for each project proposal (the original or base-version proposal, a minimum cost - reduced scope version, and an enhanced scope - incremented cost version).

Projects ordered based on B/C

Figure 40:   More (and better) project options improve the efficient frontier.

Additional project options allow better project portfolios to be constructed. Thus, the efficient frontier moved up and to the left. By adjusting the spending levels for projects, portfolio value was increased by 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 identifying better investment opportunities and 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.