Benefit-Cost Ratio - Inaccurate - Independent Projects | PMI

The Benefit-Cost Ratio (BCR), or profitability index, is a commonly used project management tool often used to identify the most efficient projects. Learning Library Benefit-costratio selectiontoolortrap? Tweet Article Strategy,BenefitsRealization May1999 PMNetwork Smith,Stephen|Barker,Joh Howtocitethisarticle: Smith,S.&Barker,J.(1999).Benefit-costratio:selectiontoolortrap?PMNetwork,13(5),23–26. ReprintsandPermissions byStephenSmithandJohBarker,PMP INANATTEMPTTOMANAGEthecomplexityoftheprojectselectiondecision,someITconsultanciesareapplyingapowerfultoolfromthefinancediscipline:theBenefit-CostRatio(BCR).However,anumberofconcernshaverisenregardingBCRasameasureofbothprojectacceptabilityandprojectselection.(Whilemanyprojectmanagersmayfindthisausefulshortcutforprojectrobustness,thefinancialliteraturesuggeststhatextremecareshouldbeexercisedwherethisisusedasabasisforprojectselection.)BCRisderivedfromthemathematicsofNetPresentValue(NPV)andissubjecttotheassumptionsofthediscountingmodel.Theseassumptionsarenotalwaysvalidfortechnologyprojects.Likewise,forprojectselection,technologyisoftenanenablerratherthanameasureofdirectrevenuegainorattributablecostsavings.Forsuchprojects,degreeofalignmentwithbusinessstrategyisthemoreimportantcriterion. Tailoringaconceptfromfinancetotherealitiesofprojectscanbehazardousfortheunwary. BCRandProjectAcceptability TheBCR,orprofitabilityindex,dividestheNPVofthecashinflowsbytheNPVofthecashoutflows,suchthat: andkistherequiredrateofreturn. ProjectswithaBCRof1ormorearepotentiallyacceptable. ProjectswithaBCRoflessthan1shouldberejected.1 StephenSmithlecturesininformationsystemsattheUniversityofMelbourne.Priortojoiningtheuniversity,hewasthefinancialaccountantfortheAustraliansubsidiaryofSquareDCompany.Hecanbecontactedat[email protected]. JohBarkerhasover20yearsexperienceininformationtechnologyandfinance.Shehasworkedasaseniorprojectmanagementandindirectorroles,andischieffinancialofficerwithSMSConsultingGroup.Shecanbecontactedat[email protected]. Thediscountingofcashflowsisusedtoaccountforthetimevalueofmoney.2Thisprovidesabuilt-inestimatefortheopportunitycostofthoseinflowsthatrequireborrowingorinvestingthroughoutthelifeoftheproject.Asindicatedabove,theusualacceptancecriterionfortheBCRmethodisthatanyprojectreturningaratioof1ormoreispotentiallyacceptable,althoughatleastonetextrecommendssettingahurdleratioof1.33.Regardlessofwhetherthehurdleratioissetat1orsomethinghigher,BCRsthatexceedthehurdleratioareofnetbenefittothesponsor.Anythinglessthanthehurdleratioshouldberejected. ProblemsWithBCR PowerfulastheBCRis,financialanalystsgenerallydon'tuseitinisolation.Whynot? Problem1:BCRisaRelativeMeasure.First,theBCRindicatesonlytherelativeprofitabilityofaproject,butwhencomparingdifferentprojects,theabsolutecontributiontoshareholderwealthmustalsobeconsidered.AnyprojectwithaBCRof1ormoreisprofitableattheminimumacceptablerateofreturn,butthecalculationdoesn'tshowthesizeofreturns.A$10projectcouldshowaBCRof10,whilea$10-millionprojectmightonlyshowaBCRof1.Clearly,theabsolutesizeoftheprojectmatters. Giventhatabsolutesizematters,andprojectswithaBCRof1ormoremeettheminimumrequiredrateofreturn,profitableprojectsshouldberankedbyabsolutesize.Todootherwisecouldmeanrejectingtheprojectsprovidingthegreatestincreaseinwealthinfavorofthosethatseemtohavethegreatestrateofreturn.Mostbusinessmanagersandshareholderswouldnotregardsuchapracticeasgoodbusinessdecision-making. Interestingly,however,someoftheliteraturesupportingBCRseemstorecommendexactlythat.AtleastonetextsuggeststhatprojectswithaBCRoflessthan1.33shouldberejected.Itisnotentirelycleartouswhythehurdleratiohasbeensetat1.33.Yet,torejectanyprojectwithaBCRof1ormoreistorejectprofitablebusinessopportunities.Commonsenseindicatesthatprojectswiththehighestratesofreturnareoftentheriskiest.Rejectingallbutthemostprofitableprojectsthereforeexposesthebusinesstomoreriskthanisnecessary,aswellaslimitinggrowth.Inordertoforceaworthwhileprojecttocrosstheextrahurdle,projectmanagersmightalsoneedtosacrificequalityforshort-termgains(forexample,byusingcheaper,lower-qualityequipment)andpossiblyeveninadvertentlyengineerasituationwheretheprojectbecomesafinancialburdeninthelongrun. Problem2:BCRisSubjecttotheAssumptionsoftheNetPresentValueFormula.ThesecondproblemwithBCRisthatitisderivedfromtheNPVformula.TheNPVwasdesignedtomodelanenvironmentwherethereisasubstantialup-frontinvestmentfollowedbyanongoingrevenuestream;costandrevenuesareeasilytracedtotheinvestmentdecision;andthesizeoftheinvestmentandthesizeoftherevenuestreamareknownwithsomedegreeofcertainty. Commonsenseindicatesthatprojectswiththehighestratesofreturnareoftentheriskiest.Rejectingallbutthemostprofitableprojectsthereforeexposesthebusinesstomoreriskthanisnecessary,aswellaslimitinggrowth. TypicallythisisnotthesituationconfrontingITprojectmanagers.UsuallyITprojectsareofshortdurationandhavecomplexinterdependenciesandhighuncertainties.MarketforcescontinuetopressureITprojectsintodeliverytimetablesoflessthan12months.Frequently,stagegatesareintroducedasabasisforriskcontainmentandprojectevaluation.Thesestagegatesidentifymilestonesthroughoutaproject'slifewherethedecisionistocontinue,changedirectionorceasetheassignment.Stagegatesarealsousefulincontainmentoratleastexplicitidentificationofscopechanges.ScopechangesareoftenmorekeenlyexperiencedinITwheremarketandtechnologypressuresmeanthefinalprojectdeliverymayvarysignificantlyfromtheinitialcharter.Allthesepressuresadduncertaintytothemeasurementofcoststreams,theidentificationofrevenuestreams,andtherelevanceoftimevalueforinvestment. TheshorttimetablesforITprojectsalsocausetheprojectmanagertobecomeanegotiatorforresources—ratherthananowner,asinafunctionalorganization.Thisresultsinshort-termteams,whicharebuilttoachieveataskandthenreturnedtotheirfunctionalhomebase—beittheITdepartment,thecustomer,ortheprocessenvironments.Costallocationforshort-term,oftenpart-time,sharedresourcesisahighlycomplexandinexactareaofmanagementaccounting.Thefixed-costnatureofmuchoftheresourcecostmeansthattheprojectchargesoftenreflectanorganization'sallocationpoliciesratherthanatruemeasureofresourceconsumptionoropportunitycost. Uncertaintyintheprojectmanagementworldismanagedthroughriskidentification,riskquantification,andriskresponsedevelopment.Thelatterisconcernedwithavoidance,mitigationand/oracceptanceoftheriskconsequences.Withallresponses,acontingencyvalueshouldbeestimatedandincludedintheplannedcashoutflows.Giventhattheriskresponsesareidentified,andvaluedinthecashflows,caremustbeexercisedtoensurethatthediscountfactorreflectsinterestforgoneratherthanthebusinessriskalreadyincludedinthecashflowestimates. Amoretechnicalexplanationofriskiscoveredbytheterm,costofcapital.Companiesoftenestablishapreferreddiscountfactorbasedontheircorporatecostofcapital.Thiscostofcapitalisequivalenttothereturnthatfinanciersrequireforinvestmentinthebusiness.Itincludesthreefactors:areturnfordeferredconsumption,anallowanceforinflation,andareturnforthesystematicriskorvariabilityinherentwiththeproposal.3WhereBCRusesthecompanycostofcapitalastherelevantdiscountfactor,andhasincludedcontingenciesinthecashoutflows,thenthefinancialpenaltiesofriskareoverstated. TheBCRandProjectRiskManagement Theabovediscussionontheselectionofanappropriatediscountfactorindicatesthatapprovingandfundingprojectsisaveryinexactscience.Therefore,ifthoseprovidingthefundsseemoverlycautious,itisprobablybecausetheyhavegoodreasontobeprudent:fundsprovidersrelyheavilyontheperformanceoftheprojectandso,byprovidingfinance,theyexposethemselvestosomerisk.Asaresult,projectfinancingismoreexpensivethanconventionalfinancingbecauseofthetimemanagersandtechnicalexpertsspendevaluatingandmonitoringtheproject,thechargesmadebylendersforassumingadditionalrisks,andinsurancecoverage. Acommonmethodfinanciersusetomanagetheirexposuretoprojectriskistofundaprojectportfolio.Ideally,theprojectsintheportfolioshouldbeindependent.Iftheyaredependentoneachother,riskincreases,becausewhenonefails,theothersareatmoreriskoffailure.Iftheyareindependent,riskisreduced,becausenotonlydofailuresnothaveflow-oneffects,itislikelythatsome—hopefullymost—projectswillsucceedandcompensateforthefailures.Ofcourse,projectsoftenincorporatedependencies(forexample,ERPsystemimplementations),soitmightbepossibletodiversifyawayonlyasmallamountoftherisk. TheBCRandPortfolioSelection Sohowshouldweselectprojectsforaportfolio?Resourceconstraintsmeanthatonlysometechnicallyfeasibleandeconomicallyattractiveprojectscanbeselected.Atthesametime,managerswanttoensurethatasmuchaspossibleoftheavailableresourcesareusedprofitably.Inaquantitativesense,therealprojectselectiondecision,therefore,isnotwhethertoacceptorrejectagivenproject,buthowtomaximizereturnandresourcesused,whileminimizingrisk.ThesubjectivenatureoftheseconstraintshasledoneauthortolikentheprojectselectionprocesstochoosingaMissWorld—highlysubjectiveand,atbest,abletoprovideareasonable(probablynotexactlycorrect)result. Untilthelate1960s,someinfluentialfinanceauthorsarguedthattheBCRisidealforidentifyingthemostefficientprojects(thosewiththehighestratios).However,morerecentfinancetextsstatethatunlessacomplexmodificationismadetotheformula,theBCRisinaccuratewhenusedwithinterdependentormutuallyexclusiveprojects.Furthermore,itcannotaggregateseveralsmallprojectstodisplaceonelargeprojectsoastoachieveabetterrisk,return,andresourceusageprofile.4Tomakemattersworse,thereisnofoolproofsubstituteprocedureforrankinginvestmentseither.Theproblemisthatrankingimpliestheuseofacutoffrateabovethecostofmoneyandarejectionofinvestmentsthatwouldbeacceptableexceptfortherationingsituation.Also,theopportunitycostoffuturetimeperiodsmaywellbedifferentfromthatofthepresent,ascapitalbecomeseitherscarcerormorefreelyavailable. ReaderServiceNumber012 ALeapofFaith:BritishAirways In1994,BritishAirways(BA)discoveredthatapproximatelyone-thirdofitscustomerswereinsomewaydissatisfiedwiththeirflights,butlessthan10percentoftheseunhappycustomersmadecontactwithcustomerrelations.Thebenefitsofkeepingcustomershappyhadbeenestablished:Researchindicatedthatadelayinrespondingtocomplaintsledtoa30-45percentdeclineinthepossibleintenttoreuseBA.1However,theeffectofthisdeclineinpossibleintentonactualbehaviorwasnotclear. Nevertheless,BA'sstrategicfocusatthetime,underthedirectionofCEOColinMarshall,wasto“putthecustomerfirst”(which,ofcourse,meantmorethansimplytakingoffandlandingontime).Asaresult,BAinvested£4.5million(approximatelyUS$9million)inasystemthatenablescustomerstoregistercomplaintsfaster.1,2Itmustbestressedthatthefinancialbenefitswerenotknown,soacost-benefitratioanalysiswouldnothaveproducedmeaningfulresults.However,theintangibleaspectsoftheproject—fitwithbusinessstrategyandimprovedcustomerinformation—meantthateveniftheprojectgeneratednoadditionalincomeitself,itprovidedthefoundationforfurtherprojectstowinbacktheestimated£400millionofpotentiallylostrevenuedissatisfiedcustomersrepresented.3Thatis,inthisinstance,strategicconsiderationoftheprojectwasfarmoreimportantthanshort-termemphasisonrevenuesandcosts. References 1.Weiser,CharlesR.July1994.“BestPracticeinCustomerRelations.”ConsumerPolicyReview,130-137. 2.Cash,JamesI.Jr.1May1995.“BritishAirGetsonCourse.”Informationweek,p.140. 3.Gooding,C.24Feb.1994.“Technology:ACaressfortheCustomer.”FinancialTimes,p.19. AFinalWordonProjectSelection Themainissueforprojectselectionis,“Shouldwedothis?”OverrelianceonBCRor,indeed,anyfinancialmeasureemphasizesthetangibleovertheintangible.Thiscaninhibitaleapoffaiththatisoftencriticalforinformationtechnologyprojects. Therateofchangeanduncertaintyinthesystemsdevelopmentprocessmeansthatmanytechnologyprojectsareleading-edge.Leading-edgeprojectsfailtoprovidetherepeatabilitythatreducesriskandguidescostandrevenuepredictions.Moreover,theseprojectsrequireanappreciationofasyetunseenandonlydimlyperceivedchangestofundamentalprocesses.Thisrequiresaleapoffaith.TheBritishAirwayscase,inthesidebar,illustratestheneedforaleapoffaithratherthananemphasisonBCR. AnindiscriminatefocusonBCRwillignoreglobal,lesseasilyquantifiable,issuessuchasbusinessstrategy,businessstructure,andtechnicalinfrastructure.ForprojectselectionthisrequiresamovefromhighestBCRtoalonger-termcustomerfocusandamorebroadlybasedevaluationofcurrentandstrategicinfrastructureissues.Thelaterrequiresanalysisofhowthebusinessprocessissupportedbytechnologytodayandtomorrow. BCR:OneMeasureAmongstMany TheforegoingargumentsaremeanttoinducecautionandtoguidethereaderagainstanoveremphasisonBCR.Whilefinancialconsiderationsplayasignificantrolethroughoutthelifeofprojects,informationtechnologyisusuallytoouncertaintobecapturedbyasinglemeasure.Probabilisticfinancialmetrics,withreferenceandconstantrealignmenttospecifiedobjectives,arepreferable. BYRECOGNIZINGTHEINHERENTmeasurementdifficultieswithBCR,theprojectmanagercanbedirectedtowardamoreformalacceptanceoftherangeofoutcomesandpredictedimpact.Suchmeasurementneedstobealignedwiththebusinessobjectives.Constantfocusonthebusinessobjectiveswithadequateappreciationfortherangeofoutcomeswillenabletheprojectmanagertofocusonwhatthebusinessvalues.AndwhatthebusinessvaluesisnotalwaysthehighestBCR. SomeDefinitions 1.BCRasdefinedinstandardFinancetexts: wherekistherequiredrateofreturn. 2.Inadditiontotheeffectofpotentialinterestforgoneonthevalueofmoney,inflationexpectationshaveasubstantialinfluenceonvalueviatheirinfluenceoninterestratesoverall.Itisgenerallyagreedthatthenominal,orobserved,interestrateonanysecurityincludesapremiumforinflation.Thehighertheanticipatedinflation,thehigherthispremiumneedstobeset.Knownasthe“Fisher”effect,thenominalinterestrate(i)requiredtogenerateareal(inflationadjusted)increaseinwealthatagivenrate(r)regardlessofexpectedinflation(π)canbecalculatedasI=r+π+rπ. Inmostapplications,analystsignorethetermrπandwritei=r+π. 3.Therearetwomethodsforestimatingthecostofcapital.Thefirst,CapitalAssetPricingModel,calculatesabetathroughtimeseriesanalysisofpriorresults.Thesecond,WeightedAverageapproach,calculatesthemarketvaluesfrombothdebtandequitysources. 4.ThisisactuallyaweaknessoftheNetPresentValueformulafromwhichtheBCRisderived.TheNVPdoesnottellushowmuchcapitalhadtobecommittedtotheinvestment.Becauseoftherisk,return,andresourceusageconsiderationsoutlinedabove,twoormoresmallinvestmentsmaywellbebetterthanonelargeinvestment,eventhoughthelargeinvestmenthasalargerNPV(orBCR)thananyoneofthesmallinvestments. Thismaterialhasbeenreproducedwiththepermissionofthecopyrightowner.Unauthorizedreproductionofthismaterialisstrictlyprohibited.Forpermissiontoreproducethismaterial,pleasecontactPMI. 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