Nobody would invest in something if he or she would not believe to get more back than was put in. This is the foundation of the economic world and everything derives from this principle. Portfolio Management is not an exception here.
Unlike financial investments in shares and bonds, projects can deliver non-financial benefits as well. The financial return of an investment can be further divided in to productivity increases and cost avoidance.
- Class A - Productivity: Tangible Benefits that directly impact on Profit and Loss and can be measured against an existing cost base line. The productivity input flows into the NPV, ROI or break-even calculation.
- Class B - Cost Avoidance: Tangible Benefits that do not impact the Profit and Loss but the predicted costs in the future, e.g. the budget. Even this is a financial figure it is rarely used in any financial KPI calculation.
- Class C - Non-financial hence intangible benefits which cannot be measured using financial KPI
For Class A and B the classic financial investment methods can be used such as
- Net Present Value
- Return on Investment
- Pay Back Duration
- Break Even
Of course for the Class C projects where no direct nor indirect financial impact can be assigned the above methods cannot be considered. The value can only accessed in qualitative terms and evaluated through scoring methods.
Let's have a quick look at the financial investment measurement methods.
Net Present Value (NPV)
The Net Present Value is defined is defined as the sum of the present values (PVs) of the individual cash flows of the same entity
Whereas t is the period when the cash flow is generated, i is the discount rate and Rt is the net cash flow in the period t. For the evaluation of projects the net cash flow is simply calculated as the difference between the net profit before and after the project deliverables have been implemented minus the costs of the project itself.
The cashflow Rt can be calculated in different ways. Basically it is defined as difference of the expected changes in income and costs of the future periods, so in general
The impact can be calculated as well as the changes in probabilities and impact due to project deliverables such as we can find within stabilization projects.
Whereas the first part shows the impact on the likelihood and the second the cost impact itself.
A project generates a NPV benefit when the overall value is positive or a loss when negative. In case of a negative NPV other benefits need to be identified (see non-financial benefits) or the project request should be rejected. The NPV returns an absolute value of the total gain or loss of an investment respectively project, it does not tell the portfolio manager how profitable a request is. For getting the profit/loss in relation to the project costs the Return of Investment (ROI) is the KPI to use.
Return on investment (ROI)
A high ROI means the investment gains compare favorably to investment cost. As a performance measure, ROI is used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. In purely economic terms, it is one way of considering profits in relation to capital invested.
The net gain is basically the differrence between the income and the costs before and after the project Dincome - Dcost. If we replace net gain in the formula above we get Dincome - Dcost - project cost which is nothing else than our simplified cash flow calculation R. So we can reformulate the formula to
The ROI is a percentage and the higher this figure is the more profitable is the investment respectively the project. If the net gain is smaller than the project costs the ROI would be negative indicating the project should be rejected from a pure financial side. The signs of NPV and ROI of a particular project are always the same. As time horizons in the modern economic world are getting shorter and shorter it is also important to understand when a certain project product is starting to pay off.
The smaller the period variable t is the sooner the project is delivering an allover benefit. The value N represents the maximum time periods an organization is willing to wait to get any profit. This is the already mentioned time horizon.
There is a special case when t is equal to zero so the project deliverable will pay off in the very first period. As the first period is usually the next budget year the project request is called budget neutral. These projects should – if they don't take away resources from even more important projects – put on the project candidates list.
Unfortunately these methods are not applicable for all kind of projects but working well for those where cost savings or turnover increases are the goal.
Synergy Effects are located between direct and indirect effect. The measurable effect are the production costs per unit that will be lowered by the project deliverable. Adding the project costs to the production costs an increase of produced units is necessary to cover the project. The project would make sense if in future more units will be used or sold.sy to deal with. First the impact can directly be budgeted as cost decrease of a service or function or turnover increase of a product. After the deliverables of the projects are in place the impact can be tracked directly using the accounting system.
The measurable effect are the production costs per unit that will be lowered by the project deliverable. Adding the project costs to the production costs an increase of produced units is necessary to cover the project. The project would make sense if in future more units will be used or sold.
If x is higher than the currently produced number then it needs to be investigated if x products can really be sold. Keep in mind that Priceunit and Costsunit are the new production costs after implementing the project deliverables.
For a non-profit business unit providing services to other functions the Priceunit and Costsunit are the same and the formula won't work. In this case the net profit are the savings between old cost per unit and new one after the project, hence the formula can be modified to
Class A Projects - Productivity
Productivity based benefit is defined as
- Impact on P&L against the previous year baseline
- Cost savings or profit gains are sustainable and
- Basing on process changes resp. improvements
In this category we can find the classic restructuring projects with the goal to increase the efficency of the organization by reducing the resource consumption through process optimization. The effect is measured as impact on the cash flow R for the period t (Rt). For example:
- The relocation certain steps to low cost countries the process is optimized to produce the same output but with lower cost. This improvement is sustainable and shows a cost reduction versus the previous year baseline.
- Through a project to stabilize the production the probability of major outages can be reduced and so the costts to recover the production lowered. If this is sustainable then it classifies the project as a Class A one.
- One other form of Class A projects are those that not necessary lower the cost but on the other side increase the sales. This could be marketing projects to enter a new product market.
Class A projects can be tracked through the accounting system. There might be some enhancements needed to better indentify the impacted costs or sales bookings.
Class B Projects - Cost / Sales Reduction Avoidance
The impact of Class B projects is measured against a future baseline like the next year budget.
A service that is running out of maintenance could negotiate with the vendor for an extendend mainteance service contract. Usually this would higher the costs dramatically and a project to upgrade to the most actual version of service would avoid these extra costs. Here we don't see an impact against the last year baseline, but without doing something the costs will go up in the next year.
In a sales scenario one could decide to start a marketing project because new players are joining market and it becomes likely that the sales or average prices will go down.
The picture below shows both Class A Productivity and Class B Cost Avoidance in combined scenario.
A service is running out of support due to not use the latest software version. To get extended support from the supplier would cost and additional fee of $60'000. It is decided to upgrade to the latest software version and in the same time relocate FTE's in in a low-cost country which would save another $30'000. As this is a process change (people working now in a different country) and the impact is measurable against the last year base line the resulting benefit can be classified as Class A Productivity.
Both combined will show the total benefit of the project ($90'000). In most cases only the productivity is measured in the organizations which is then not showing the total benefit impact. And this can lead easily to wrong project decisions.
Class C Projects - Non-financial benefits
Projects in this category can either measured directly nor indirectly in financial terms but still the investor expects (or hopes) that it will have a positive effect on the EBIT of the company.
For example a marketing project should improve the image of an organization and hence increase the turnover. At the end it is always hard to determine if the increase was because of the marketing project or has other reasons.
One other common example are technology projects which should enable a company to make usage of more sophisticated processes and tools to gain market shares or become more efficient. The project deliverables are not linked to any product or services but are white papers that will be used in follow-up projects.
For non-financial benefit driven projects it is key to establish with the project request measures and goals, so the impact can be measured in the end.
There can be as much different measurements and metrics as project requests which makes it very hard to compare.
The only way to bring these project into a relationship so that they can be compared is to establish a scoring system like the one described in the Evaluation of project requests.
For example a Proof of Concept project that is not implementing anything that can directly be used by the organization and hence is not generating any tangible or intangible benefit can be measured in two ways
- At project end, delivered the project a whitepaper for the new technology?
- One year later, has a project been started to implement the new technology?
If so the Class C project delviered a benefit to the orgnaization otherwise it was a waste of resources.