PROJECT SELECTION

Broad Contents
Introduction
Project decisions
Types of project selection models
Criteria for choosing project model
The nature of project selection models
Numeric and non-numeric models

11.1 Introduction:
Project selection is the process of choosing a project or set of projects to be
implemented bythe organization. Since projects in general require a substantial
investment in terms of moneyand resources, both of which are limited, it is of vital
importance that the projects that an organization selects provide good returns on the
resources and capital invested. This requirement must be balanced with the need for
an organization to move forward and develop. The high level of uncertainty in the
modern business environment has made this area of project management crucial to
the continued success of an organization with the difference between choosing good
projects and poor projects literally representing the difference between operational life
and death.

Because a successful model must capture every critical aspect of the decision, more
complex decisions typically require more sophisticated models. “There is a simple
solution to every complex problem; unfortunately, it is wrong”. This reality creates a
major challenge for tool designers. Project decisions are often high-stakes, dynamic
decisions with complex technical issues—precisely the kinds of decisions that are most
difficult to model:

• Project selection decisions are high-stakes because of their strategic

implications. The projects a company chooses can define the products it
supplies, the work it does, and the direction it takes in the marketplace.
Thus, project decisions can impact every business stakeholder, including
customers, employees, partners, regulators, and shareholders. A
sophisticated model may be needed to capture strategic implications.
 • Project decisions are dynamic because a project may be conducted over
several budgeting cycles, with repeated opportunities to slow, accelerate, re-
scale, or terminate the project. Also, a successful project may produce new
assets or products that create time-varying financial returns and other
impacts over many years. A more sophisticated model is needed to address
dynamic impacts.

• Project decisions typically produce many different types of impacts on the

organization. For example, a project might increase revenue or reduce future
costs. It might impact how customers or investors perceive the organization.
It might provide new capability or learning, important to future success.
Making good choices requires not just estimating the financial return on
investment; it requires understanding all of the ways that projects add value.
A more sophisticated model is needed to account for all of the different types
of potential impacts that project selection decisions can create.

11.2 Project Decisions:

Project decisions often entail risk and uncertainty. The significance of a project risk
depends on the nature of that risk and on the other risks that the organization is
taking. A more sophisticated model is needed to correctly deal with risk and
uncertainty.

Project selection is 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. This same systematic process can be applied to any area
of the organization’s business in which choices must be made between competing
alternatives. For example:

• A manufacturing firm can use evaluation/selection techniques to choose

which machine to adopt in a part-fabrication process.

• A television station can select which of several syndicated comedy shows to

rerun in its 7:30 p.m. weekday time-slot
• A construction firm can select the best subset of a large group of potential
 projects on which to bid
• A hospital can find the best mix of psychiatric, orthopedic, obstetric, and
other beds for a new wing.

Each project will have different costs, benefits, and risks. Rarely are these known with
certainty. In the face of such differences, the selection of one project out of a set is a
difficult task. Choosing a number of different projects, a portfolio, is even more
complex. In the following sections, we discuss several techniques that can be used to
help senior managers select projects. Project selection is only one of many decisions
associated with project management.

To deal with all of these problems, we use decision aiding models. We need such
models because they abstract the relevant issues about a problem from the plethora of
detail in which the problem is embedded. Reality is far too complex to deal with in its
entirety. An “idealist” is needed to strip away almost all the reality from a problem,
leaving only the aspects of the “real” situation with which he or she wishes to deal. This
process of carving away the unwanted reality from the bones of a problem is called
modeling the problem. The idealized version of the problem that results is called a
model.

The model represents the problem’s structure, its form. Every problem has a form,
though often we may not understand a problem well enough to describe its structure.
We will use many models in this book—graphs, analogies, diagrams, as well as flow
graph and network models to help solve scheduling problems, and symbolic
(mathematical) models for a number of purposes.

Models may be quite simple to understand, or they may be extremely complex. In

general, introducing more reality into a model tends to make the model more difficult
to manipulate. If the input data for a model are not known precisely, we often use
probabilistic information; that is, the model is said to be stochastic rather than
deterministic.

Again, in general, stochastic models are more difficult to manipulate. We live in the
midst of what has been called the “knowledge explosion.” We frequently hear
comments such as “90 percent of all we know about physics has been discovered since
Albert Einstein published his original work on special relativity”; and “80 percent of
what we know about the human body has been discovered in the past 50 years.” In
addition, evidence is cited to show that knowledge is growing exponentially.

Such statements emphasize the importance of the management of change. To survive,

firms should develop strategies for assessing and reassessing the use of their resources.
Every allocation of resources is an investment in the future. Because of the complex
nature of most strategies, many of these investments are in projects.

To cite one of many possible examples, special visual effects accomplished through
computer animation are common in the movies and television shows we watch daily. A
few years ago
they were unknown. When the capability was in its idea stage, computer companies as
well as the firms producing movies and television shows faced the decision whether or
not to invest in the development of these techniques. Obviously valuable as the idea
seems today, the choice was not quite so clear a decade ago when an entertainment
company compared investment in computer animation to alternative investments in a
new star, a new rock group, or a new theme park.

The proper choice of investment projects is crucial to the long-run survival of every
firm. Daily we witness the results of both good and bad investment choices. In our
daily newspapers we read of Cisco System’s decision to purchase firms that have
developed valuable communication network software rather than to develop its own
software. We read of Procter and Gamble’s decision to invest heavily in marketing its
products on the Internet; British Airways’ decision to purchase passenger planes from
Airbus instead of from its traditional supplier, Boeing; or problems faced by school
systems when they update student computer labs—should they invest in Windows-
based systems or stick with their traditional choice, Apple®. But can such important
choices be made rationally? Once made, do they ever change, and if so, how? These
questions reflect the need for effective selection models.
Within the limits of their capabilities, such models can be used to increase profits,
select investments for limited capital resources, or improve the competitive position of
the organization. They can be used for ongoing evaluation as well as initial selection,
and thus, are a key to the allocation and reallocation of the organization’s scarce
resources.

11.2.1 Modeling:

A model is an object or concept, which attempts to capture certain aspects of the real
world. The purpose of models can vary widely, they can be used to test ideas, to help
teach or explain new concepts to people or simply as decorations. Since the uses that
models can be put are so many it is difficult to find a definition that is both clear and
conveys all the meanings of the word. In the context of project selection the following
definition is useful:
“A model is an explicit statement of our image of reality. It is a representation of the
relevant aspects of the decision with which we are concerned. It represents the decision
area by structuring and formalizing the information we possess about the decision and,
in doing so, presents reality in a simplified organized form. A model, therefore,
provides us with an abstraction of a more complex reality”. (Cooke and Slack, 1991)

When project selection models are seen from this perspective it is clear that the need
for them arises from the fact that it is impossible to consider the environment, within
which a project will be implemented, in its entirety. The challenge for a good project
selection model is therefore clear. It must balance the need to keep enough
information from the real world to make a good choice with the need to simplify the
situation sufficiently to make it possible to come to a conclusion in a reasonable length
of time.

11.3 Criteria for Choosing Project Model:

When a firm chooses a project selection model, the following criteria, based on Souder
(1973), are most important:

1. Realism:
The model should reflect the reality of the manager’s decision situation, including the
multiple objectives of both the firm and its managers. Without a common
measurement system, direct comparison of different projects is impossible.

For example, Project A may strengthen a firm’s market share by extending its facilities,
and Project B might improve its competitive position by strengthening its technical
staff. Other things being equal, which is better? The model should take into account
therealities of the firm’s limitations on facilities, capital, personnel, and so forth. The
model should also include factors that reflect project risks, including the technical
risks of performance, cost, and time as well as the market risks of customer rejection
and other implementation risks.

2. Capability:
The model should be sophisticated enough to deal with multiple time periods, simulate
various situations both internal and external to the project (for example, strikes,
interest rate changes), and optimize the decision. An optimizing model will make the
comparisons that management deems important, consider major risks and constraints
on the projects, and then select the best overall project or set of projects.

3. Flexibility:
The model should give valid results within the range of conditions that the firm might
experience. It should have the ability to be easily modified, or to be self-adjusting in
response to changes in the firm’s environment; for example, tax laws change, new
technological advancements alter risk levels, and, above all, the organization’s goals
change.

4. Ease of Use:
The model should be reasonably convenient, not take a long time to execute, and be
easy to use and understand. It should not require special interpretation, data that are
difficult to acquire, excessive personnel, or unavailable equipment. The model’s
variables should also relate one-to-one with those real-world parameters, the
managers believe significant to the project. Finally, it should be easy to simulate the
expected outcomes associated with investments in different project portfolios.
 5. Cost:
Data gathering and modeling costs should be low relative to the cost of the project and
must surely be less than the potential benefits of the project. All costs should be
considered, including the costs of data management and of running the model. Here,
we would also add a sixth criterion:

6. Easy Computerization:
It should be easy and convenient to gather and store the information in a computer
database, and to manipulate data in the model through use of a widely available,
standard computer package such as Excel, Lotus 1-2-3, Quattro Pro, and like
programs. The same ease and convenience should apply to transferring the
information to any standard decision support system.

In what follows, we first examine fundamental types of project selection models and
the characteristics that make any model more or less acceptable. Next we consider the
limitations, strengths, and weaknesses of project selection models, including some
suggestions of factors to consider when making a decision about which, if any, of the
project selection models to use. We then discuss the problem of selecting projects when
high levels of uncertainty about outcomes, costs, schedules, or technology are present,
as well as some ways of managing the risks associated with the uncertainties.

Finally, we comment on some special aspects of the information base required for
project selection. Then we turn our attention to the selection of a set of projects to help
the organization achieve its goals and illustrate this with a technique called the
ProjectPortfolio Process. We finish the chapter with a discussion of project proposals.

11.4 The Nature of Project Selection Models:

There are two basic types of project selection models, numeric and nonnumeric.
Both are widely used. Many organizations use both at the same time, or they use
models that are combinations of the two. Nonnumeric models, as the name implies, do
not use numbers as inputs. Numeric models do, but the criteria being measured may
be either objective or subjective. It is important to remember that the qualities of a
project may be represented by numbers, and that subjective measures are not
necessarily less useful or reliable than objective measures.

Before examining specific kinds of models within the two basic types, let us consider
just what we wish the model to do for us, never forgetting two critically important, but
often overlooked facts.

• Models do not make decisions—people do. The manager, not the model,
bears responsibility for the decision. The manager may “delegate” the task of
making the decision to a model, but the responsibility cannot be abdicated.

• All models, however sophisticated, are only partial representations of the

reality they are meant to reflect. Reality is far too complex for us to capture
more than a small fraction of it in any model. Therefore, no model can yield
an optimal decision except within its own, possibly inadequate, framework.

We seek a model to assist us in making project selection decisions. This model should
possess the characteristics discussed previously and, above all, it should evaluate
potential projects by the degree to which they will meet the firm’s objectives. To
construct a selection/evaluation model, therefore, it is necessary to develop a list of the
firm’s objectives.

A list of objectives should be generated by the organization’s top management. It is a

direct expression of organizational philosophy and policy. The list should go beyond
the typical clichés about “survival” and “maximizing profits,” which are certainly real
goals but are just as certainly not the only goals of the firm. Other objectives might
include maintenance of share of specific markets, development of an improved image
with specific clients or competitors, expansion into a new line of business, decrease in
sensitivity to business cycles, maintenance of employment for specific categories of
workers, and maintenance of system loading at or above some percent of capacity, just
to mention a few.

A model of some sort is implied by any conscious decision. The choice between two or
more alternative courses of action requires reference to some objective(s), and the
choice is thus, made in accord with some, possibly subjective, “model.” Since the
development of computers and the establishment of operations research as an
academic subject in the mid -1950s, the use of formal, numeric models to assist in
decision making has expanded. Many of these models use financial metrics such as
profits and/or cash flow to measure the “correctness” of a managerial decision. Project
selection decisions are no exception, being based primarily on the degree to which the
financial goals of the organization are met. As we will see later, this stress on financial
goals, largely to the exclusion of other criteria, raises some serious problems for the
firm, irrespective of whether the firm is for profit or not-for-profit.

When the list of objectives has been developed, an additional refinement is

recommended. The elements in the list should be weighted. Each item is added to the
list because it represents a contribution to the success of the organization, but each
item does not make an equal contribution. The weights reflect different degrees of
contribution each element makes in accomplishing a set of goals.

Once the list of goals has been developed, one more task remains. The probable
contribution of each project to each of the goals should be estimated. A project is
selected or rejected because it is predicted to have certain outcomes if implemented.

These outcomes are expected to contribute to goal achievement. If the estimated level
of goal achievement is sufficiently large, the project is selected. If not, it is rejected.

The relationship between the project’s expected results and the organization’s goals
must be understood. In general, the kinds of information required to evaluate a project
can be listed under production, marketing, financial, personnel, administrative, and
other such categories.

The following table 11.1 is a list of factors that contribute, positively or negatively, to
these categories.

In order to give focus to this list, we assume that the projects in question involve the
possible substitution of a new production process for an existing one. The list is meant
to be illustrative. It certainly is not exhaustive.
 Table 11.1: Factors Contributing to Various Organizational
Categories

Some factors in this list have a one-time impact and some recur. Some are difficult to
estimate and may be subject to considerable error. For these, it is helpful to identify a
range ofuncertainty. In addition, the factors may occur at different times.

And some factors may have thresholds, critical values above or below which we might
wish to reject the project. We will deal in more detail with these issues later in this
chapter.

Clearly, no single project decision needs to include all these factors. Moreover, not only
is the list incomplete, it also contains redundant items. Perhaps more important, the
factors are not at the same level of generality: profitability and impact on
organizational image both affect the overall organization, but impact on working
conditions is more oriented to the production system. Nor are all elements of equal
importance.

Change in production cost is usually considered more important than impact on

current suppliers. Shortly, we will consider the problem of generating an acceptable
list of factors andmeasuring their relative importance. At that time we will discuss the
creation of a Decision Support System (DSS) for project evaluation and selection.

The same subject will arise once more in the next lecture(s) when we consider project
auditing, evaluation, and termination.

Although the process of evaluating a potential project is time-consuming and difficult,

its importance cannot be overstated. A major consulting firm has argued (Booz, Allen,
and Hamilton, 1966) that the primary cause for the failure of Research and
Development (R and D) projects is insufficient care in evaluating the proposal before
the expenditure of funds. What is true for such projects also appears to be true for
other kinds of projects, and it is clear that product development projects are more
successful if they incorporate user needs and satisfaction in the design process
(Matzler and Hinterhuber, 1998). Careful analysis of a potential project is a sine qua
non for profitability in the construction business. There are many horror stories
(Meredith, 1981) about firms that undertook projects for the installation of a computer
information system without sufficient analysis of the time, cost, and disruption
involved.

Later, we will consider the problem of conducting an evaluation under conditions of

uncertainty about the outcomes associated with a project. Before dealing with this
problem, however, it helps to examine several different evaluation/selection models
and consider their strengths and weaknesses. Recall that the problem of choosing the
project selection model itself will also be discussed later.
30.6 Types of Project Selection Models:
Of the two basic types of selection models (numeric and nonnumeric),
nonnumeric models are older and simpler and have only a few subtypes to
consider. We examine them first.

• Non-Numeric Models:

These include the following:

1. The Sacred Cow:
In this case the project is suggested by a senior and powerful official in the
organization. Often the project is initiated with a simple comment such as, “If you have
a chance, why don’t you look into . . .,” and there follows an undeveloped idea for a
new product, for the development of a new market, for the design and adoption of a
global database and information system, or for some other project requiring an
investment of the firm’s resources. The immediate result of this bland statement is the
creation of a “project” to investigate whatever the boss has suggested.
The project is “sacred” in the sense that it will be maintained until successfully
concluded, or until the boss, personally, recognizes the idea as a failure and terminates
it.

2. The Operating Necessity:

If a flood is threatening the plant, a project to build a protective dike does not require
much formal evaluation, which is an example of this scenario. XYZ Steel Corporation
has used this criterion (and the following criterion also) in evaluating potential
projects. If the project is required in order to keep thesystem operating, the primary
question becomes: Is the system worth saving at the estimated cost of the project? If
the answer is yes, project costs will be examined to make sure they are kept as low as is
consistent with project success, but the project will be funded.
 3. The Competitive Necessity:
Using this criterion, XYZ Steel undertook a major plant rebuilding project in the late
1960s in its steel bar manufacturing facilities near Chicago. It had become apparent to
XYZ’s management that the company’s bar mill needed modernization if the firm was
to maintain its competitive position in the Chicago market area. Although the planning
process for the project was quite sophisticated, the decision to undertake the project
was based on a desire to maintain the company’s competitive position in that market.
In a similar manner, many business schools are restructuring their undergraduate and
Masters in Business Administration (MBA) programs to stay competitive with the
more forward looking schools. In large part, this action is driven by declining numbers
of tuition paying students and the need to develop stronger programs to attract them.
Investment in an operating necessity project takes precedence over a competitive
necessity project, but both types of projects may bypass the morecareful numeric
analysis used for projects deemed to be less urgent or less important to the survival of
the firm.

4. The Product Line Extension:

In this case, a project to develop and distribute new products would be judged on the
degree to which it fits the firm’s existing product line, fills a gap, strengthens a weak
link, or extends the line in a new, desirable direction.
Sometimes careful calculations of profitability are not required. Decision makers can
act on their beliefs about what will be the likely impact on the total system
performance if the new product is added to the line.

5. Comparative Benefit Model:

For this situation, assume that an organization has many projects to consider, perhaps
several dozen. Senior management would like to select a subset of the projects that
would most benefit the firm, but the projects do not seem to be easily comparable. For
example, some projects concern potential new products, some concern changes in
production methods, others concern computerization of certain records, and still
others cover a variety of subjects not easily categorized (e.g., a proposal to create a
daycare center for employees with small children).

The organization has no formal method of selecting projects, but members of the
selection committee think that some projects will benefit the firm more than others,
even if they have no precise way to define or measure “benefit.”

The concept of comparative benefits, if not a formal model, is widely adopted for
selection decisions on all sorts of projects. Most United Way organizations use the
concept to make decisions about which of several social programs to fund. Senior
management of the funding organization then examines all projects with positive
recommendations and attempts to construct a portfolio that best fits the organization’s
aims and its budget.

PROJECT SELECTION (CONTD.)

Broad Contents
Q-Sort Model
Pay-back Period
Average Rate of Return
Discounted Cash Flow
Internal Rate of Return (IRR)

11.1 Types of Project Selection Models (Continued):

• Non-Numeric Models:

• Q-Sort Model:
Of the several techniques for ordering projects, the Q-Sort (Helin and Souder, 1974) is
one of the most straightforward. First, the projects are divided into three groups—
good, fair, and poor—according to their relative merits. If any group has more than
eight members, it is subdivided into two categories, such as fair-plus and fair-minus.
When all categories have eight or fewer members, the projects within each category are
ordered from best to worst. Again, the order is determined on the basis of relative
merit. The rater may use specific criteria to rank each project, or may simply use
general overall judgment. (See Figure 12.1 below for an example of a Q-Sort.)

Figure 11.1: Example of a Q-Sort

The process described may be carried out by one person who is responsible for
evaluation and selection, or it may be performed by a committee charged with the
responsibility. If a committee handles the task, the individual rankings can be
developed anonymously, and the set of anonymous rankings can be examined by the
committee itself for consensus. It is common for such rankings to differ somewhat
from rater to rater, but they do not often vary strikingly because the individuals chosen
for such committees rarely differ widely on what they feel to be appropriate for the
parent organization.

Projects can then be selected in the order of preference, though they are usually
evaluated financially before final selection.

There are other, similar nonnumeric models for accepting or rejecting projects.
Although it is easy to dismiss such models as unscientific, they should not be
discounted casually. These models are clearly goal-oriented and directly reflect the
primary concerns of the organization.

The sacred cow model, in particular, has an added feature; sacred cow projects are
visibly supported by “the powers that be.” Full support by top management is certainly
an important contributor to project success (Meredith, 1981). Without such support,
the probability of project success is sharply lowered.

• Numeric Models: Profit/Profitability

As noted earlier, a large majority of all firms using project evaluation and selection
models use profitability as the sole measure of acceptability. We will consider these
models first, and then discuss models that surpass the profit test for acceptance.

1. Payback Period:
The payback period for a project is the initial fixed investment in the project divided by
the estimated annual net cash inflows from the project. The ratio ofthesequantities is
the number of years required for the project to repay its initial fixed investment. For
example, assume a project costs $100,000 to implement and has annual net cash
inflows of $25,000. Then
This method assumes that the cash inflows will persist at least long enough to pay back
the investment, and it ignores any cash inflows beyond the payback period. The
method also serves as an (inadequate) proxy for risk. The faster the investment is
recovered, the less the risk to which the firm is exposed.

2. Average Rate of Return:

Often mistaken as the reciprocal of the payback period, the average rate ofreturn is the
ratio of the average annual profit (either before or after taxes) to the initial or average
investment in the project. Because average annual profitsare usually not equivalent to
net cash inflows, the average rate of return does not usually equal the reciprocal of the
payback period. Assume, in the example just given, that the average annual profits are
$15,000:

Neither of these evaluation methods is recommended for project selection, though

payback period is widely used and does have a legitimate value for cashbudgeting
decisions. The major advantage of these models is their simplicity, but neither takes
into account the time-value of money. Unless interest rates are extremely low and the
rate of inflation is nil, the failure to reduce future cash flows or profits to their present
value will result in serious evaluation errors.

3. Discounted Cash Flow:

Also referred to as the Net Present Value (NPV) method, the discounted cash flow
method determines the net present value of all cash flows by discounting them by the
required rate of return (also known as the hurdle rate, cutoff rate, and similar terms) as
follows:
To include the impact of inflation (or deflation) where pt is the predicted rate of
inflation during period t, we have

Early in the life of a project, net cash flow is likely to be negative, the major outflow
being the initial investment in the project, A 0. If the project is successful, however,
cash flows will become positive. The project is acceptable if the sum of the net present
values of all estimated cash flows over the life of the project is positive. A simple
example will suffice. Using our $100,000 investment with a net cash inflow of $25,000
per year for a period of eight years, a required rate of return of 15 percent, and an
inflation rate of 3 percent per year, we have

Because the present value of the inflows is greater than the present value of the
outflow— that is, the net present value is positive—the project is deemed acceptable.

For example:
PsychoCeramic Sciences, Inc. (PSI), a large producer of cracked pots and other cracked
items, is considering the installation of a new marketing software package that will, it
is hoped, allow more accurate sales information concerning the inventory, sales, and
deliveries of its pots as well as its vases designed to hold artificial flowers.

The information systems (IS) department has submitted a project proposal that
estimates the investment requirements as follows: an initial investment of $125,000 to
be paid up-front to the Pottery Software.

Corporation; an additional investment of $ 100,000 to modify and install the software;

and another $90,000 to integrate the new software into the overall information
system. Delivery and installation is estimated to take one year; integrating the entire
system should require an additional year.

Thereafter, the IS department predicts that scheduled software updates will require
further expenditures of about $15,000 every second year, beginning in the fourth year.
They will not, however, update the software in the last year of its expected useful life.

The project schedule calls for benefits to begin in the third year, and to be up-to-speed
by the end of that year. Projected additional profits resulting from better and more
timely sales information are estimated to be $50,000 in the first year of operation and
are expected to peak at $120,000 in the second year of operation, and then to follow
the gradually declining pattern shown in the table 12.1 below.

Project life is expected to be 10 years from project inception, at which time the
proposed system will be obsolete for this division and will have to be replaced. It is
estimated, however, that the software can be sold to a smaller division of
PsychoCeramic Sciences, Inc. (PSI) and will thus, have a salvage value of $35,000. The
Company has a 12 percent hurdle rate for capital investments and expects the rate of
inflation to be about 3 percent over the life of the project. Assuming that the initial
expenditure occurs at the beginning of the year and that all other receipts and
expenditures occur as lump sums at the end of the year, we can prepare the Net
Present Value analysis for the project as shown in the table 12.1 below.

The Net Present Value of the project is positive and, thus, the project can be accepted.
(The project would have been rejected if the hurdle rate were 14 percent.) Just for the
intellectual exercise, note that the total inflow for the project is $759,000, or $75,900
per year on average for the 10 year project. The required investment is $315,000
(ignoring the biennial overhaul charges). Assuming 10 year, straight line depreciation,
or $31,500 per year, the payback period would be:
A project with this payback period would probably be considered quite desirable.
Table 11.1: Net Present Value (NPV) Analysis

4. Internal Rate of Return (IRR):

If we have a set of expected cash inflows and cash outflows, the internal rate of return
is the discount rate that equates the present values of the two sets of flows. If At is an
expected cash outflow in the period t andRtis the expectedinflow for the period t , the
internal rate of return is the value of k that satisfies the following equation (note that
the A 0 will be positive in this formulation of the problem):
The value of k is found by trial and error.

5. Profitability Index:
Also known as the benefit–cost ratio, the profitability index is the net present value of
all future expected cash flows divided by the initial cash investment.
(Some firms do not discount the cash flows in making this calculation.) If this ratio is
greater than 1.0, the project may be accepted.

6. Other Profitability Models:

There are a great many variations of the models just described. These variations fall
into three general categories. These are:
 a) Those that subdivide net cash flow into the elements that
comprises the net flow.
b) Those that include specific terms to introduce risk (or
uncertainty, which is treated as risk) into the evaluation.
c) Those that extend the analysis to consider effects that the
project might have on other projects or activities in the
organization.

11.1.1 Advantages of Profit-Profitability Numeric Models:

Several comments are in order about all the profit-profitability numeric models. First,
let us consider their advantages:

• The undiscounted models are simple to use and understand.

• All use readily available accounting data to determine the cash flows.
• Model output is in terms familiar to business decision makers.
• With a few exceptions, model output is on an “absolute”
profit/profitability scale and allows “absolute” go/no-go decisions.
• Some profit models account for project risk.

11.1.2 Disadvantages of Profit-Profitability Numeric Models:

The disadvantages of these models are the following:
• These models ignore all non-monetary factors except risk.
• Models that do not include discounting ignore the timing of the cash
flows and the time–value of money.
• Models that reduce cash flows to their present value are strongly
biased toward the short run.
• Payback-type models ignore cash flows beyond the payback period.
• The internal rate of return model can result in multiple solutions.
• All are sensitive to errors in the input data for the early years of the
project.
• All discounting models are nonlinear, and the effects of changes (or
errors) in the variables or parameters are generally not obvious to
most decision makers.
• All these models depend for input on a determination of cash flows,
 but it is not clear exactly how the concept of cash flow is properly
defined for the purpose of evaluating projects.

11.1.2 Profit-Profitability Numeric Models – An Overview:

A complete discussion of profit/profitability models can be found in any standard work
on financial management—see Ross, Westerfield, and Jordan (1995), for example.

In general, the net present value models are preferred to the internal rate of return
models. Despite wide use, financial models rarely include non-financial outcomes in
their benefits and costs. In a discussion of the financial value of adopting project
management (that is, selecting as a project the use of project management) in a firm,
Githens (1998) notes that traditional financial models “simply cannot capture the
complexity and value-added of today’s process-oriented firm.”

The commonly seen phrase “Return on Investment,” or ROI, does not denote any
specific method of calculation. It usually involves Net Present Value (NPV) or
InternalRate of Return (IRR) calculations, but we have seen it used in reference to
undiscounted average rate of return models and (incorrectly) payback period models.

In our experience, the payback period model, occasionally using discounted cash flows,
is one of the most commonly used models for evaluating projects and other investment
opportunities. Managers generally feel that insistence on short payout periods tends to
minimize the risks associated with outstanding monies over the passage of time. While
this is certainly logical, we prefer evaluation methods that discount cash flows and deal
with uncertainty more directly by considering specific risks. Using the payout period as
a cash-budgeting tool aside, its primary virtue is its simplicity.

Real Options: Recently, a project selection model was developed based on a

notionwell known in financial markets. When one invests, one foregoes the value of
alternative future investments. Economists refer to the value of an opportunity
foregone as the “opportunity cost” of the investment made.

The argument is that a project may have greater net present value if delayed to the
future. If the investment can be delayed, its cost is discounted compared to a present
investment of the same amount. Further, if the investment in a project is delayed, its
value may increase (or decrease) with the passage of time because some of the
uncertainties will be reduced. If the value of the project drops, it may fail the selection
process. If the value increases, the investor gets a higher payoff. The real options
approach acts to reduce both technological and commercial risk. For a full explanation
of the method and its use as a strategic selection tool, see Luehrman (1998a and
1998b). An interesting application of real options as a project selection tool for
pharmaceutical Research and Development (R and D) projects is described by Jacob
and Kwak (2003). Real options combined with Monte Carlo simulation is compared
with alternative selection/assessment methods by Doctor, Newton, and Pearson
(2001).

PROJECT PROPOSAL

11.2 Introduction:
Project Proposal is the initial document that converts an idea or policy into details of a
potential project, including the outcomes, outputs, major risks, costs, stakeholders and
an estimate of the resource and time required.

To begin planning a proposal, remember the basic definition: a proposal is an offer

or bid to doa certain project for someone. Proposals may contain other
elements – technical background,recommendations, results of surveys, information
about feasibility, and so on. But what makes a proposal a proposal is, that it asks the
audience to approve, fund, or grant permission to do the proposed project.

If you plan to be a consultant or run your own business, written proposals may be one
of your most important tools for bringing in business. And, if you work for a
government agency, non-profit organization, or a large corporation, the proposal can
be a valuable tool for initiating projects that benefit the organization or you the
employee proposed (and usually both).

A proposal should contain information that would enable the audience of that proposal
to decide whether to approve the project, to approve or hire you to do the work, or
both. To write a successful proposal, put yourself in the place of your audience – the
recipient of the proposal, and think about what sorts of information that person would
need to feel confident having you do the project.

It is easy to get confused about proposals. Imagine that you have a terrific idea for
installing some new technology where you work and you write up a document
explaining how it works and why it is so great, showing the benefits, and then end by
urging management to go for it. Is that a proposal? The answer is “No”, at least not in
this context. It is more like a feasibility report, which studies the merits of a project
and then recommends for or against it. Now, all it would take to make this document a
proposal would be to add elements that ask management for approval for you to go
ahead with the project. Certainly, some proposals must sell the projects they offer to
do, but in all cases proposals must sell the writer (or the writer's organization) as the
one to do the project.

Types of Project Proposals:

Consider the situations in which proposals occur. A company may send out a public
announcement requesting proposals for a specific project. This public announcement,
called a Request for Proposal (RFP), could be issued through newspapers, trade
journals, Chamber ofCommerce channels, or individual letters. Firms or individuals
interested in the project would then write proposals in which they summarize their
qualifications, project schedules and costs, and discuss their approach to the project.
The recipient of all these proposals would then evaluate them, select the best
candidate, and then work up a contract.
But proposals come about much less formally. Imagine that you are interested in doing
a project at work (for example, investigating the merits of bringing in some new
technology to increase productivity). Imagine that you visited with your supervisor and
tried to convince her of this. She might respond by saying, "Write me a proposal and I
will present it to upper management." As you can see from these examples, proposals
can be divided into several categories:

1. Internal Proposal:
If you write a proposal to someone within your organization (a business, a government
agency, etc.), it is an internal proposal. With internal proposals, you may not have
toinclude certain sections (such as qualifications), or you may not have to include as
much information in them.

2. External Proposal:
An external proposal is one written by a separate, independent consultant proposing to
do a project for another firm. It can be a proposal from organization or individual
toanother such entity.

3. Solicited Proposal:
If a proposal is solicited, the recipient of the proposal in some way requested the
proposal. Typically, a company will send out requests for proposals (RFPs) through
themail or publish them in some news source. But proposals can be solicited on a very
local level. For example, you could be explaining to your boss what a great thing it
would be to install a new technology in the office; your boss might get interested and
ask you to write up a proposal that offered to do a formal study of the idea.

4. Unsolicited Proposal:
Unsolicited proposals are those in which the recipient has not requested proposals.

With unsolicited proposals, you sometimes must convince the recipient that a problem
or need exists before you can begin the main part of the proposal.
Table 11.2: Solicited Versus Unsolicited Proposals
 11.3.1 Request for Proposal:
A Request for Proposal (referred to as RFP) is an invitation for suppliers, through a
bidding process, to submit a proposal on a specific product or service.

A Request for Proposal (RFP) typically involves more than the price. Other requested
information may include basic corporate information and history, financial
information (can the company deliver without risk of bankruptcy), technical capability
(used on major procurements of services, where the item has not previously been made
or where the requirement could be met by varying technical means), product
information such as stock availability and estimated completion period, and customer
references that can be checked to determine a company's suitability.

In the military, Request for Proposal (RFP) is often raised to fulfill an Operational
Requirement (OR), after which the military procurement authority will normally issue
a detailed technical specification against which tenders will be made by potential
contractors. In the civilian use, Request for Proposal (RFP) is usually part of a complex
sales process, also known as enterprise sales.

Request for Proposals (RFPs) often include specifications of the item, project or
service for which a proposal is requested. The more detailed the specifications, the
better the chances that the proposal provided will be accurate. Generally Request for
Proposals (RFPs) are sent to an approved supplier or vendor list.

The bidders return a proposal by a set date and time. Late proposals may or may not
be considered, depending on the terms of the initial Request for Proposal. The
proposals are used to evaluate the suitability as a supplier, vendor, or institutional
partner. Discussions may be held on the proposals (often to clarify technical
capabilities or to note errors in a proposal). In some instances, all or only selected
bidders may be invited to participate in subsequent bids, or may be asked to submit
their best technical and financial proposal, commonly referred to as a Best and Final
Offer (BAFO).
 11.3.2 Request for Proposal (RFP) Variation:
The Request for Quotation (RFQ) is used where discussions are not required with
bidders (mainly when the specifications of a product or service are already known),
and price is the main or only factor in selecting the successful bidder. Request for
Quotation (RFQ) may also be used as a step prior to going to a full-blown Request for
Proposal (RFP) to determine general price ranges. In this scenario, products, services
or suppliers may be selected from the Request for Quotation (RFQ) results to bring in
to further research in order to write a more fully fleshed out Request for Proposal
(RFP).

Request for Proposal (RFP) is sometimes used for a Request for Pricing.

11.3.3 Request for Information (RFI):

Request for Information (RFI) is a proposal requested from a potential seller or a
service provider to determine what products and services are potentially available in
the marketplace to meet a buyer's needs and to know the capability of a seller in terms
of offerings and strengths of the seller. Request for Information (RFIs) are commonly
used on major procurements, where a requirement could potentially be met through
several alternate means. A Request for Information (RFI), however, is not an invitation
to bid, is not binding on either the buyer or sellers, and may or may not lead to a
Request for Proposal (RFP) or Request for Quotation (RFQ).