Metrics = incentives

The metrics that an organization uses for evaluating projects have a big impact not only on the projects that get chosen but also on the projects that get proposed. Tell me how you will measure me, and I will tell you how I will behave [1]. Even if the metrics aren’t used to create incentives, managers interpret them as indicating what the organization regards as important. Lack of the right metrics is the third reason organizations choose the wrong projects.

Defining Project Value

The metrics for evaluating projects must support the goal of project portfolio management (PPM). which is to maximize the value derived from the project portfolio. Thus, we need metrics for measuring project value. How do you measure project value? More fundamentally, how do you define value? These questions are more perplexing than you may think.

A Definition of Value

People have been arguing about the definition of value for centuries. The relevant concept of value for our purposes is termed the utilitarian concept of value: The value of a project is a measure of degree to which that project enables the organization to achieve its objectives. This view of value was first articulated in the fourth century BC by Aristotle the value of something is not an intrinsic property of that thing, but rather is determined by its usefulness to those that want it.

Organizations conduct projects because they believe that the outcomes or consequences of the projects will be useful. The more useful the project outcomes, the more valuable the project will be. The project consequences that are desired depend, of course, on the organization’s fundamental objectives. Suppose, for example, that an organization’s fundamental objective is to create value for its shareholders (more discussion of shareholder value is provided below). Suppose further that the organization is considering a hypothetical project that provides only one consequence: an immediate, one-time cash flow to the company of one million dollars (to be more precise, suppose that the magnitude of the cash flow from the project is such that, after all tax and accounting considerations are addressed, increases the net worth of the company by $1 million). Under these specified assumptions, it would seem reasonable to conclude that the value of that project is $1 million.

An extension to this line of reasoning, which applies regardless of what the organization’s objectives might be, is to argue that the value of a project is the worth, to the organization, of obtaining the consequences of the project. Thus, project value might be defined as an amount of money that is equally as desirable as the project, including consideration of risk. (In other words, if project consequences are uncertain, project value could be defined as the amount of cash deemed equally desirable as the gamble over those uncertain project consequences.) In the portfolio context, this may be interpreted as an amount of cash that would make executives indifferent between (a) the portfolio with the project and (b) the portfolio without the project but with that amount of incremental cash.

In the literature on valuation. the above definition of project value is termed the project’s selling indifference price (also called the breakeven selling price ). A close relative is the buying indifference price (or breakeven buying price ), which argues that the value of a project is the amount of cash that would make executives indifferent between (a) the portfolio without the project and (b) the portfolio with the project plus a debt equal to that amount of cash.

Estimating Value is Essential to Making Any Purchase Decision

Suppose you are a skier. Your uncle wins a pair of skis in a raffle. Not being a skier, he offers to sell them to you. Should you buy the skis?

You should buy them if the asking price is less than what they are worth to you, provided that you don’t need the money for something else that is more important. If the price is higher than the worth, you shouldn’t buy them. So, before deciding whether to make the purchase, it would be wise to estimate what the skis are worth to you.

The ski’s worth to you will depend on many things. For example, if you like skiing the park, the skis will be worth more to you if they are park skis than if they are race skis. But, even if they are race skis, they may still be worth something to you because you could turn them into cash by selling them on eBay. Regardless, the skis worth to you will have to be less than the market price, since otherwise you would have already purchased them from a store. Thus, though the worth to you is subjective, it is not arbitrary and can be bracketed through reasoning.

Projects differ from skis in that, unlike skis you can’t buy and sell them on eBay. There are no market prices from transactions to bound project value. However, there are considerations that similarly bound the worth of projects. If a project will generate revenue, then the worth of that revenue (e.g. its NPV ) is one component of the total worth of the project. If the project will produce additional benefits beyond revenue (e.g. learning), the project’s worth will include the worth of those additional benefits. Sometimes, those additional types of benefits can be purchased in the marketplace (e.g. staff training), and those market prices similarly anchor the worth of those benefits.

Estimating worth is key to making wise project decisions just as it is for personal purchase decisions. In both cases, determining worth requires carefully considering what the purchase will do for you as well as what other options exist for obtaining the desired benefits. Estimating worth may seem like hard work, but how else could you decide what to purchase?

As explained in the next two sections, it is possible to create models for estimating project value. Value models eliminate the need to subjectively estimate project worth for the consequences of each candidate project. Value models capture decision-maker preferences while accounting for market prices and other factors that should logically determine project worth.

In my experience, most people find it intuitive that the value of something is what you are (just) willing to give up for it. For this reason, my working definition for project value is the maximum amount of organization wealth executives would be willing to trade away to obtain the (uncertain) project outcomes. This is a variation of the buying indifference priceit is a buying price because it is an amount the organization would pay to buy the project consequences, and it is an indifference price because it is the price point such the organization is indifferent between declining the project versus paying the price and obtaining the project consequences.

Although conceptually intuitive, determining the buying indifference price for a project gets more complicated when you consider that paying a buying price means not investing in something else. Buying A means that you cannot buy B, so the true cost of buying A is not getting the most valuable B that you could have bought. Thus, the most an organization would be willing to pay to obtain the consequences of a project should be less if doing the project means foregoing other, very good investments than when it would mean foregoing only marginal investments.

Also, if the organization were to pay a buying price, the budget available for investing would change, so the opportunity cost of incremental investments may change. In the portfolio context, as indicated above, a project indifference price is an incremental value, determined relative to other projects in the portfolio. If the projects are interdependent, the indifference price will depend on those other projects, Thus, if the indifference price for a project is determined based on it being the first project in the portfolio (or if its value is determined in isolation to other projects), we’d likely get a different value than if it is being added to other portfolio projects. In general, therefore, project indifference prices depend on the order in which the projects are added to the portfolio.

Fortunately, these complexities need not be of much concern for our context. Organizations obtain capital from a variety of sources and spend that capital on numerous different investments. As a practical matter, it is impossible to know when candidate projects are being considered which other investments would be foregone if there are incremental reductions to available investment capital and what the opportunity costs would be. More importantly, our concern is identifying the set of projects that can be conducted within a specified budget that will produce the greatest value. Project prioritization, with projects ranked based on the ratio of value to cost (as explained in the paper on Mathematical Theory ) will identify the value-maximizing portfolio, provided projects are defined to be independent of one another. If the projects are independent, they can be considered one-by-one, in isolation to one another, and with value being relative to the case where the project is not done. So long as we assume the same opportunity cost when establishing the worth of the possible consequences of the different projects, the project ranking will be correct. Thus, the subtleties for setting indifference prices are unlikely to pose significant problems for project prioritization, and defining project value as the worth of project consequences is reasonable for our purposes.

Note that the value of a project, defined in this way and under these assumptions, does not depend on its cost. (The decision of whether to conduct a project, does, of course, depend on cost. In particular, you would never want to conduct a project whose cost was greater than its value.) An exception to the rule that project value does not depend on project cost would be a case where paying for a project impacts the organization’s ability to benefit from the project or from other projects. An extreme example would be a project anticipated to produce great project outcomes, but whose cost would bankrupt the company. In such cases, the value of projects would logically be the value of the project consequences taking into account any effects of having to pay for the project. Since we are concerned with organizations that conduct numerous projects, each of which consumes only a portion of the budget, we can typically safely ignore such effects.

Project value is the worth to the organization of the (possibly uncertain) consequences of doing the projectin other words, it is the maximum price the organization would pay to obtain the project’s consequences

Our preferred definition of project value has a critically important propertynamely, it maps to organizational preferences. Suppose there are two projects requiring the same cost and resources, and only one can be added to the project portfolio. The organization will prefer Project A to Project B if and only if our measure of project value is higher for Project A than it is for Project B (because any organization would be willing to pay more for the consequences of Project A than for Project B if and only if it prefers Project A’s consequences). Many common approaches to project prioritization don’t use a project evaluation measure with this essential property (e.g. strategic alignment ). Unless project value is defined in a way that maps to the true preferences of the organization, that measure cannot correctly prioritize projects. Our definition of project value is a true measure of the relative attractiveness to the organization of its project alternatives, and that measure can be compared with project costs to determine the projects that are worth doing and their priorities.

OK, assuming we accept that the worth to the organization of the project consequences is a reasonable definition of project value, how do we determine how much an organization should be willing to pay to obtain those consequences? Before addressing that question we need to consider more carefully why organizations conduct projects

Projects Determine the Evolution of the Business

The business of an organization is always evolving, and the projects that the organization chooses affect that evolution. For example, a new technology might become available that would allow the organization to reduce its costs. If a project is conducted to install the technology, the organization would incur lower operating costs than it would have if it had chosen not to do the project.

It is also true that the projects that an organization chooses not to do affect the evolution of the business. For most organizations, standing still means falling behind. There are many reasons for this, including increasing competition, changing customer preferences, and the aging of organizational assets. Thus, to take one example, if the organization chooses not to do projects that maintain or replace aging assets, the service provided by those assets will decline.

Figure 18 illustrates a useful way to think about project value. At the point in time when an organization is considering a new project, it is really facing a choice between two alternative future states. If the project is conducted, that project will, presumably, transform the business to some more desirable state. If the project is not conducted, some other, presumably less-desirable, state will result.

Figure 18: Project choices determine the future state of the business.