Selecting the Projects

Project selection can be regarded as the process of evaluating individual projects or groups of projects and then choosing to implement some set of them so that the objectives of the parent organization will be achieved. In order to select the right projects, decision-aiding models are used in practice. Let us consider the following types of models that can be used in the screening process:

• Quantitative Models
• Qualitative Models

Quantitative Model

Quantitative or Numeric Models invariably focus on financial data to support a project proposal. The data generated varies widely, but may include information on:

• Return on investment
• Return on net assets
• Breakeven and payback period
• Cost of risks
• Net present value and/or internal rate of return
• Cost/benefit analysis
• Sensitivity analysis
• Market data

A large number of organisations using project evaluation and selection models use profit/profitability as the sole measure of acceptability. The main disadvantage of these models is that it focuses on one decision criterion alone, eg. Payback period. Other numeric/quantitative models often used are scoring models, where a variety of criteria/factors is considered and scored to determine whether a project qualifies or not. The criteria can also be weighted according to their value in contributing to the company objectives at the time.

A detailed list of factors can be developed as appropriate based on:

• Technology
• Marketing
• Finance
• Manufacture
• Personnel
• Administration

Cost Break-Even Analysis

Click here to view a video that explains the break-even analysis - how to calculate your safe point.

Your project manufactures a product which sells for R15 each. The variable cost per unit is R5, which covers labour and material, leaving R10 per unit as a contribution towards fixed costs. The fixed costs is R75 000 per year, which covers all the overhead costs. The break-even point is reached when the contribution equals the fixed costs.

Break-even = Fixed Costs / Contribution/Unit

= R75 000 / R10

= 7500 units

The following is a graphic display of the break-even calculation above, displaying every cost and when the contribution towards overheads starts turning into profit.

Payback Period

This is a determining factor for projects where it is important to have a short time for the financial return to equal the original investment. Consider the following example as a demonstration of the next numeric models.

This is a very simple and easy method to use and uses available accounting information to determine cash flow. It gives a fair idea of future cash-flow requirements and helps in making decisions about the project. The biggest problem with this method is that is does not consider the time value of money.

Return on Investment (ROI)

To determine the return on investment (ROI) it is important to first calculate the average annual profit (A.A.P.), which is the investment deducted from the total gains, divided by the number of years the project is running.

A.A.P. = (Total gains) – (Total outlay)

Number of years

ROI = A.A.P.       x       100

Investment            1

ROI is expressed as a percentage, thus what is the percentage return on the original investment for or on behalf of any investor into the project.

Net Present Value (NPV)

The previous numeric models did not consider the time value of money, meaning that there is a cost of capital (known as inflation) that lowers the value of money over time. It is thus important for projects running over a long time to consider this fact. This is called the Net Present Value of the project returns, in other words, the net value of the money earned by the project over the period.

To calculate the NPV it is important to determine the discount cash-flow (DCF), as a multiplier per year for the estimated income produced by the project. The following example is based on a 10% cost of capital.

Internal Rate of Return (IRR)

Where NPV considered or assumed that the inflation or cost of capital would not change over the period of time, the IRR calculation does consider that it might or will change over time.

Internal Rate of Return based on Discount rate 10%

Internal Rate of Return (IRR) based on Discount rate 14%

Internal Rate of Return (IRR) based on Discount rate 18%

The following graph is a display of the results from the IRR calculations displaying that Vendor A is performing much better than Vendor B against the constraints of the cost of capital.

NPV for Vendors A and B

Therefore, the project from Vendor A would be chosen based on the internal rate of return on capital.

Qualitative Model

Qualitative or Nonnumeric Models, as the name implies, do not use numbers as inputs. There are four numeric models that are commonplace in many organisations:

The Sacred Cow

Where a senior and powerful official in the organisation suggests a project and the project is undertaken regardless of the possibility of failure. The project is” sacred” in the sense that it will be maintained until successfully completed or until the official personally recognises the idea as a failure and terminates it.

The Operating Necessity

Where a project is funded in order to protect or maintain an operating system under threat. An example could be the installation of additional power generators as backup where a problem with regular power failures is experienced. Cost/benefit analysis is often used in the decision-making process.

The Competitive Necessity

Where a project is undertaken to maintain the organisation’s competitive position. The refurbishment of a hotel is an example of such a project. Investment in an operating necessity project takes precedence over a competitive necessity project, but both types of projects may bypass the more detailed numeric analysis used for projects deemed less urgent or important to the survival of the organisation.

Comparative Benefit Model

This model is often used when a variety of projects important to the organisation need to be considered and no formal method of selecting projects exists. A selection committee then decides which projects will benefit the company most and those projects are then funded. A rating system is often used to prioritise projects in order of importance.

Many organisations use more than one model to select projects. Quantitative and qualitative models can be used in combination with one another or two numeric models can be used simultaneously. The main objective is to ensure that the right project(s) is selected and funded. Once a project is selected, a process is required to start-up the project. A project manager is appointed at this stage, who needs to manage the process from this point onwards.