Project Options - Explained
How to Choose Between Project Options?
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Table of ContentsHow to Choose a Project? What are Benefit Measurement Methods?What is the Benefit/Cost Ratio?What is Economic Value Added (EVA)?What is the Scoring Model?What is the Payback Period?What is the Net Present Value (NPV)?What is the Internal Rate of Return (IRR)?What is Opportunity Cost?What are Constrained Optimization Methods?What is the Weighted Decision Matrix?
How to Choose a Project?
Generally, upper management (such as the Steering Committee, Project Management Office (PMO), Project Selection Committee, etc.) chooses projects to be undertaken.
While evaluating the project they will evaluate many areas, such as:
- Whether they are capable of doing it or not
- If they have all resources required to complete the project
- If it will help them achieve their objective (recognition and maximum profit)
There are various methods which help you choose your project. These methods can be divided into two categories:
- Benefit Measurement Methods
- Constrained Optimization Method
What are Benefit Measurement Methods?
Benefit measurement methods of selecting a project are based on the present value of estimated cash inflow and outflow.
Here, you calculate the cost and benefits, and then compare them with other projects to make a decision.
The following is a list of techniques used in benefit measurement methods:
- Benefit/Cost Ratio
- Economic Model (Economic Value Added)
- Scoring Model
- Payback Period
- Net Present Value
- Discounted Cash Flow
- Internal Rate of Return
- Opportunity Cost
What is the Benefit/Cost Ratio?
This technique is also known as Cost/Benefit Ratio.
As the name suggests, it is the ratio between the present value of inflow (cost invested to the project) and the present value of outflow (value of return form the project). If the budget is not a constraint, the project with a higher Benefit-Cost Ratio (BCR) will be selected.
What is Economic Value Added (EVA)?
Economic Value Added (EVA) is a performance metric that calculates the worth creation for the organization, and defines the return on capital (ROC). It is the net profit after deducting all taxes and capital expenditure.
If you have many projects, the project with the higher Economic Value Added (EVA) will be selected. Keep in mind that EVA is expressed in dollar value, not in a percentage.
What is the Scoring Model?
This is more like an objective technique. Here, the project selection committee will list a few relevant criteria, weigh them according to their priorities and importance, and then will add all these weighted values.
Once you complete scoring the projects, the project with the highest score will be selected.
What is the Payback Period?
This is the ratio of total cash out with an average per period cash in. You can also say that it is the time required to recover the cost invested in the project.
If other parameters are the same, the project with the minimum payback period will be selected.
What is the Net Present Value (NPV)?
This is the difference between the current value of cash inflow and the current value of cash outflow of the project. Net Present Value (NPV) should always be positive, and the project with the highest NPV will be the better option.
What is the Internal Rate of Return (IRR)?
This is the interest rate at which the Net Present Value becomes zero. In other words, you can say that it is the rate at which the present value of the outflow is equal to the present value of inflows.
If you have many projects to choose from, you will select the project with the highest IRR.
What is Opportunity Cost?
This is the cost that we are giving up by choosing some other project. If you have many projects, you will choose the project with the lesser opportunity cost.
These are the few benefits measurement techniques used in the selection of projects. In general, for most organizations benefits measurement methods are enough to lead them to a decision.
What are Constrained Optimization Methods?
This model is also known as the Mathematical Model of project selection, which is used for large projects requiring complex mathematical calculations.
The following is the list of techniques used in the Mathematical Model of project selection:
- Linear Programming
- Non-linear Programming
- Integer Programming
- Dynamic Programming
What is the Weighted Decision Matrix?
A weighted decision matrix is a decision tool used by decision makers.
A basic decision matrix consists of establishing a set of criteria for options that are scored and summed to gain a total score that can then be ranked.
A decision matrix is basically an array presenting on one axis a list of alternatives, also called options or solutions, that are evaluated regarding, on the other axis, a list of criteria, which are weighted depending on their respective importance in the final decision to be taken.
A weighted decision matrix operates in the same way as the basic decision matrix but introduces the concept of weighting the criteria in order of importance.
The resultant scores reflect the importance to the decision maker of the criteria involved. The more important a criterion, the higher the weighting it should be given.
Each of the potential options is scored and then multiplied by the weighting given to each of the criteria to produce a result.
A weighted decision matrix therefore allows decision makers to structure and solve their problem by:
- Specifying and prioritizing their needs with a list a criteria; then
- Evaluating, rating, and comparing the different solutions; and
- Selecting the best matching solution.