Project Management is the application of knowledge, skills, tools and techniques to project activities in order to meet stakeholders' needs and expectations. Project management involves balancing competing demands such as
- Scope, time, cost , quality
- Stakeholders with differing needs and expectations
- Identified requirements (needs) and unidentified requirements (expectations).
The key factor in a successful project management is coordination in various aspects of management such as HR, MIS, Finance, Production etc.
HR: (Human Resources):
- From the view point of organization HR represent the people at work. They are the sum total of inherent abilities, acquired knowledge and skills, talents and aptitudes of its employees.
- HR is the most important element of organization. Efficient utilization of all other resources depends on the quality of HR.
- HR includes all dynamic components of all people at all level in organization and they have greatest potential to develop and grow provided the right climate is provided to them. Generation of new projects and managing and evaluating existing projects need decision making abilities of employees.
- HR thus plays an important role in Project management.
MIS (Management Information System):
- Management comprises the processes that describe what managers do in the operation of their organization like Planning, organization, control and making decisions. Decision making is a fundamental pre requisite to each of the fore going process including Project management.
- Information is data that have been retrieved and used for informative purpose and decision making. For e.g. Sales forecast, Profit and Loss a/c are information required for financial analysis; market survey helps in market analysis in a Feasibility study of a project.
- Systems are a set of elements joined together for a common objective. An organization is a system and the various divisions, departments and units are the subsystem. To evaluate and for efficient management of projects an effective system is required.
- The objective of an MIS is to provide information for decision making on planning, organizing and controlling the operations of subsystems of the firm and to provide a synergistic organization in the process.
- MIS support decision making at all levels of organization. MIS are made of people, computers, procedures, databases and so on. Thus the impact of MIS becomes important in facilitating decisions necessary for project management.
- Finance function deals with the problem of raising funds and their effective utilization in business.
- Various decisions regarding acquisition of assets, specific norms where money is to be invested is the scope of finance.
- It is the ways and means of managing money and involves activity concerned with planning and controlling of firms financial resources.
- Finance plays an important role while evaluating a new project and to generate finance for the project.
- It helps to decide on which type of finance is to be chosen and what kind of working capital levels are to be maintained in the project.
- Thus finance has an impact on decision making in evaluating a project.
- Production is a process of converting raw materials to finished goods. Production plays an important role in project management.
- The choice of technology required for the project is to be decided depending on the plant capacity and the appropriateness of technology.
- It involves ensuring the availability of raw materials and other utilities.
- The important charts and lay outs drawings like Material flow diagram, production line diagram etc facilitates in Project management.
- Production helps in evaluating a project such that it meets the expectations of the stakeholders.
Generation and screening of project ideas
The business has to identify the investment opportunity which is feasible and promising. Identification of promising investment opportunities requires imagination, sensitivity to environmental changes and a realistic assessment of what the firm can do. The broad considerations and guidelines helpful in the generation and screening of project ideas are given below:
- Generation of ideas
- Monitoring the environment
- Corporate appraisal
- Profit potential of industries: Porter Model
- Scouting for project ideas
- Preliminary screening
- Project rating index
Generation of project ideas:
Stimulating the flow of ideas: to stimulate the flow of investment ideas, the following are helpful:
- SWOT analysis: (Strength, Weakness, Opportunities and threats): It represents a conscious, deliberate and systematic effort by an organization to identify opportunities that can be profitably exploited by it. Periodic SWOT analysis facilitates the generation of ideas.
- Clear articulation of objectives: The operational objectives of a firm may be one or more of the following:
- Cost reduction
- Productivity improvement
- Increase in capacity utilization
- Improvement in contribution margin
- Expansion into promising fields.
Monitoring the environment:
The firm must systematically monitor the environment and assess its competitive abilities. For purposes of monitoring, the business environment may be divided into six broad sectors.
- Economic Sector (State of the economy, Overall rate of growth, Growth rate of primary, secondary, and tertiary sectors, Cyclical fluctuations etc.)
- Governmental Sector (Industrial policy, Government programmes and projects, Tax framework,. Subsidies, incentives, Import and export policies etc.)
- Technological Sector (Emergence of new technologies, Access to technical know-how, foreign as well as indigenous etc.)
- Socio-demographic Sector(Population trends, Age shifts in population, Income distribution, Educational profile, Attitudes toward consumption and investment)
- Competition Sector (. Number of firms in the industry and the market share of the top few (four or five), Entry barrier, Marketing policies and practices etc.)
- Supplier Sector (Availability and cost of raw materials, Availability and cost of energy, Availability and cost of money etc.)
A realistic appraisal of corporate strengths and weaknesses is essential for identifying investment opportunities which can be profitably exploited. The broad areas of corporate appraisal and the important aspects to be considered under them are as follows:
- Marketing and Distribution (Market image, market share, customer loyalty etc.)
- Production and operations ( Condition and capacity of plant, cost structure)
- Research and development (Research capability, co ordination between research and operations, etc)
- Corporate resources and personnel (corporate image, state of industrial relation etc.)
- Finance and accounting ( Cost of capital, relation with shareholders, accounting and control system)
Profit potential of industries:
There are several useful tools or frameworks that are helpful in identifying promising investment opportunities. The more popular ones are the Porter model, life cycle approach, and experience curve.
Porter Model: Profit Potential of Industries: Michael Porter has argued that the profit potential of an industry depends on the combined strength of the following five basic competitive forces:
- Threat of new entrants
- Rivalry among existing firms
- Pressure from substitute products
- Bargaining power of buyers
- Bargaining power of sellers
Life Cycle Approach: Many industrial economists believe that most products evolve through a life cycle which has four stages:
- pioneering stage,
- rapid growth stage,
- maturity and stabilization stage,
- and decline stage.
Each stage presents investment opportunities that exhibit different characteristics. Investment in the pioneering stage, per se, may have a low return and negative NPV. However, it may possibly create options for participating in the growth stage. Investment in the growth stage is likely to earn a high return and generate positive NPV. Investment in the maturity stage may earn average return and be NPV-neutral. Finally, investment in the decline stage may earn meager returns and produce negative NPV.
The Experience Curve
Investments aimed at reducing costs are essential to the long-term survival and profitability of the firm. The experience curve is a useful tool for planning such investments.
The experience curve shows how the cost per unit behaves with respect to the accumulated volume of production. The accumulated volume of production is the total number of units produced cumulatively from the very beginning-it should not be confused with the annual rate of production.
Scouting for project ideas
A wide variety of sources should be tapped to identify good project ideas. They are:
- Analyze the Performance of Existing Industries.
- Examine the Inputs and Outputs of Various Industries
- Review Imports and Exports
- Study new technological developments
- Explore the possibility of reviving sick units.
Screening of project ideas: Some kind of preliminary screening is required to eliminate ideas which prima facie are not promising. For this purpose the following aspects may be looked into:
- Compatibility with the promoter.
- Consistency with governmental priorities
- Availability of inputs
- Adequacy of market
- Reasonableness of cost
- Acceptability of risk level
Compatibility with the promoter: The idea must be compatible with the interest personality and resources of the entrepreneur. It must offer him rapid growth and high return on the invested capital.
Consistency with governmental priorities: The project idea must be feasible given the national goals and governmental framework.
Availability of inputs: The resources and inputs required for the project must be reasonably assured. Capital requirements, technical know how, raw materials, power supply etc is within the manageable limits.
Adequacy of market: The size of the present market must offer the prospect of adequate sales volume. There should be potential for growth and a reasonable return on investment.
Reasonableness of cost: the cost structure of the project must enable it to realize an acceptable profit with a price.
Acceptability of risk level: The desirability of a project is critically dependent on the risk characterizing it. The risk factors can be technological changes, competition from substitutes, competition from imports, governmental control over price and distribution.
Project rating index:
When a firm evaluates a large number of project ideas regularly, it may be helpful to streamline the process if preliminary screening. For this purpose a preliminary evaluation may be translated into a project rating index. The steps involved in determining the project rating index are as follows:
- Identify factors relevant for project rating.
- Assign weights to these factors (the weights are supposed to reflect their relative importance).
- Rate the project proposal on various factors, using a suitable rating scale. (Typically a 5-point scale or a 7-point scale is used for this purpose.)
- For each factor, multiply the factor rating with the factor weight to get the factor score.
- Add all the factor scores to get the overall project rating index.
Feasibility study of Project
A Feasibility study of project is done with a goal to identify the existing strengths and weakness of the project. A Feasibility study of project includes market analysis, technical analysis financial analysis, economic and ecological analysis
Market Analysis: The first step is to estimate the potential size of the market for the product proposed in the project and get an idea of market share that is likely to be captured. Market and demand analysis are concerned with 2 broad issues:
- What is the likely aggregate demand for the product/service?
- What share of the market can be captured?
Step (1) Situational analysis and specification of objectives:
Process stands with informal discussion with customers, competitors, middlemen and others in the industry.
Analysis of situation generates sufficient idea to measure the market and gives reliable information.
The objectives should be defined clearly and comprehensively.
Questions not relevant to the market and demand analysis should not be asked.
Step (2): Collection of secondary information:
Secondary information is the information that has been gathered in some other context and is already available provides a base point for market and demand analysis.
Sources of secondary information are:
National sample survey reports
Peoples of planning commission
Economic survey of industries
Industry potential surveys
Annual survey of industries
Reports of CBO
Reports of Muscat securities exchange.
Reports from chamber of commerce and industries.
Evaluation of secondary information:
While this information is available readily , its reliability, accuracy and relevance for the purpose under consideration must be carefully examined.
Who gathered the information?
What was the objective?
When the information was collected?
How representative was period for which the information was gathered?
Are the terms was selected?
What was the sample size?
How representative was the sample?
How satisfactory was the process of information gathering?
What was the degree of misrepresentation by respondents?
How accurate the information analyzed?
Step (3): Conduct of market survey:
The secondary information must be supplemented with primary information gathered through market survey specified to the project surveyed. Primary information represents information that is collected for the first time to meet the specified purpose on hand.
The objectives of the market survey should be to sought the information of any one or all of the following:
Demand and rate of growth of demand
Demand in different segments of market
Income and price elasticity of demands
Motives for buying
Satisfaction with existing products
Attitudes towards various products
Socio-economic characteristics of buyers.
Steps in a sample survey are:
Define the target population
Select the sampling scheme and sample size.
Develop the questionnaire
Recruit and train field workers.
Collection information from the sample of respondents.
Scrutinizing the information
Analysis the information and
Interpreting the results.
Heterogeneity of the country
Multiplicity of language
Design of questionnaire.
Step (4): Characterization of the market:
Based on the secondary sources and market survey the market for the product may be described in terms of:
Breakdown of demand:
Nature of product: One generic name often subsumes many different products:
(e.g Commercial vehicles cover trucks, and buses of various capacities.)
Consumers may be divided into ® industrial
These may be further subdivided into : income groups, age groups etc.
A geographical breakdown of consumers is helpful for products which have small value to weight relation and for products which require regular after sale service.
Price: It may be helpful to distinguish different types of prices like
- manufacturers price as FOB price or CIF price
- Landed price for imported goods
- Average wholesale price
- Average retail price
Methods of distribution and sales promotion:
- Different distribution channels depending on nature of products
- Sales promotion (advertising, discounts etc.)
Consumers: Consumers may be characterized based on
- Demographic® age, sex, income, profession, social backgrounds.
- Attitudes ® preferences, habits, attitudes, responses.
Supply and competition:
- It is necessary to know existing source of supply whether foreign or domestic.
- Competition from substitutes and near substitutes should be specified.
Government policy: The government plans, policies have a bearing on the market for a product.
Step (5) : Demand Forecasting:
After gathering information about various aspects of the market from primary and secondary sources an attempt may be made to estimate future demand. Demand Forecasting means estimating or predicting the future demand 0r future sales for the product of a firm.
The various methods of demand forecasting are:
- Qualitative method: Relies on judgement of experts to translate qualitative information to quantitative estimates. The important methods are:
- Jury of executive method
- Delphi method
- Trend projection method
- Exponential smoothing method
- Moving average method:
- Chain ratio method
- Consumption level method
- End use method:
- Econometric method
Uncertainties in demand forecasting:
- Data about past and present markets: (Lack of standardization, Few observations, Influence of abnormal factors.)
- Methods of forecasting (Inability to handle unquantifiable factors, Unrealistic assumptions, Excessive data requirements.)
- Environmental changes: ( Technological, Governmental, International scenario)
How to cope with uncertainties:
Conduct analysis with data based on uniform and standard definitions.
Ignore the abnormal observations
Choose method appropriate to the situation.
Monitor changes in environmental factors.
Consider alternative scenarios and their impact on market.
Conduct sensitivity analysis to assess the impact on the demand for unfavorable and favorable variations of the determining factor from their most likely levels
Step 6: Market planning:
A market planning usually has the following components:
Current market situation
- Market situation - Site, growth, consumer aspirations, buying behavior.
- Competitive situation - major competitions their objectives, strategies, strengths etc.
- Distribution situation
- Macro environment - effect of social, political, economic, technological etc. factors.
Opportunity and Issue analysis:
In this section a SWOT analysis is conducted. ( Strength, weakness, opportunity and threat)
Objectives: Clear cut, specific and achievable.
Market Strategy cover the following:
- Target segment
- Product line
- Sales force
- Sales promotion
- To enable the product to reach a desired level of market penetration, a suitable marketing plan, covering pricing, distribution, promotion and service needs to be developed.
Analysis of technical and engineering aspects is done continuously when a project is being examined and formulated. The purpose of the technical analysis is
- To ensure that the project is technically feasible, that all inputs required for the project are available.
- To facilitate the most optimal formulation of the project in terms of technology, size, location and so on.
Technical analysis would cover the following issues:
- Manufacturing Process / Technology: This would include the Choice of Technology
- Plant capacity
- Principle inputs
- Investment out and production cost
- Use by other units
- Product mix
- Latest developments
- Ease of absorption
Appropriateness of technology: These would refer to those methods of production which are suitable to local, economics, social and cultural conditions.
Whether the technology protects ecological balance?
- Nature of support from collaborators during each stage of the project.
- Process and performance guarantees in terms of plant capacity, product quality and consumption of raw materials and utilities.
- License and royalty fee
- Benefit of collection agreement and manner of sharing management control.
- Raw materials classified into:( Agricultural products, Mineral products, Livestock forest products, and Marine products)
- Processed industrial materials and components. (Represent important inputs and Analysis should cover the total requirement, sources, prices etc.)
- Auxiliary materials and factory supplies chemicals, packing materials, oils, grease etc.
- Utilities power, water, fuel, steam etc.
Plant capacity is the production capacity or volume of units that can be produced during a given period of time. It may be
Feasible normal Capacity - (FNC) Capacity attainable under normal working conditions ® calculated on the basis of installed capacity, technical conditions of plant, shift pattern, down time for maintenance and holidays.
Nominal maximum capacity (NMC) - Capacity that is technically attainable, corresponds to the installed capacity guaranteed by the supplier of the plant.
Factors affecting plant capacity decisions are: Technology requirement, input constraints, investment cost, market conditions, resources of the firm, and government policy.
Location and site:
Location refers to Broad area like city, industrial zone and Site refers to Specific area or piece of land where the project would be set up. The choice of location would depend on:
- Proximity to raw materials.
- Proximity to market
- Availability of infrastructure ® power, transportation, water, communication
- Labour availability
- Governmental policies
- Other factors (Climate, Living conditions, Pollution, Ancillary units)
The site selection would depend on the cost of site. Two or three alternative sites ,must be considered and evaluated with respect to cost of land and cost of site preparation and development.
Machineries and equipment
The requirement of machinery and equipment depends on production technology and plant capacity and also the type of project. To determine the kinds of machinery required the following procedure may be followed:
- Estimate the likely levels of production overtime
- Define various machining and other operations
- Calculate machine house for each type of operation
- Select machineries and equipment for each function.
The equipment required may be classified into the following types:
Process, Mechanical, Instruments, Control, Internal transportation, Others
Constraints in selecting machineries and equipments may be:
- Limited availability of power
- Difficulty in transport
- Workers not able to operate
A project may cause environmental pollution in various ways hence these aspects must be properly examined.
Once the data is available on the principle dimensions of the project, charts and lay out must be prepared. The important charts and lay outs drawings are:
- General functional layouts
- Material flow diagram
- Production line diagram
- Transport layout
- Communication layout
- Plant layout
As part of the technical analysis a project implementation is also prepared. Following information is required for this:
- List of all possible activities from project planning to commencement of production
- Sequence in which various activities have to be performed.
- Time required for each activity
- Resources required
- Implication of putting more resources or less resource than normally required.
The work schedule reflects the plan of work concerning installation as well as initial operation.
There are alternative ways of transforming an idea into a concrete project. These alternates may differ in one or more of the following aspects:
- Nature of project
- Production process
- Product quality
- Scale of operation and time phasing
Financial analysis of a project is carried out to ensure that a satisfactory return is earned on the investment made in the project. Financial analysis would cover the following aspects:
- Cost of project
- Means of Financing
- Estimates of sales and production
- Cost of production
- Working capital requirement and its financing,
- estimates of working results (profitability projections)
- projected cash flow statement
- projected balance sheets.
Cost of project represents the sum of all items of outlay associated with a project which are supported by long term funds. It is the sum of outlays on the following: i. Land and site development, ii. Building and civil works, iii. Plant and machinery, iv. Technical know how and engineering fees, v. miscellaneous fixed assets, vi. Preliminary and capital issue expenses, vii. Provision for contingencies, etc.
Means of Financing: To meet the cost of project the following sources of finance or means of finance may be available: share capital (Equity and Preference capital),
Term loans, debenture capital (Non convertible and convertible debentures) , deferred credit, incentive sources ( Capital subsidy, tax deferment and exemption) and miscellaneous sources ( unsecured loans, public deposits and lease and hire purchase finance).To determine the specific means of finance for a given project the following should be taken care: i. Norms of regulatory body and financial institutions, and ii. Key business considerations namely cost, risk, control and flexibility.
Estimating sales and production: the starting point of profitability projections is the forecast for sales revenues. In estimating sales it is reasonable to assume that capacity utilization would be somewhat low in the first year and rise thereafter gradually to reach the maximum level in the third or fourth year of operation.
Cost of production: The major components of cost of production are: Material cost, utilities cost, labour cost and factory overhead cost. The material cost comprises the cost of raw materials, chemicals, components and consumable stores required for production. The cost of utilities is the sum of the cost of power, water and fuel. The labour cost includes the cost of all manpower employed in the factory. Factory overheads refer to the expenses on repair and maintenance, rent, taxes and insurance on factory assets.
Working capital requirement and its financing: In estimating the working capital requirement and planning for its financing the following must be borne in mind: the build up of current assets till the rated level of capacity is reached, the maximum permissible bank finance and the margin requirements against various current assets.
Estimates of working results (profitability projections):
The profitability projections or estimates of working results are prepared based on
- Cost of production
- Total administrative expenses
- Total sales expenses
- Expected sales
- Gross profit before interest
- Total financial expenses
- Operating profit
- Other income
- Profit and loss before taxation
- Provision for tax
- Profit after tax
- Retained profit and
- Net cash accrual
Projected cash flow statement: The cash flow statement shows the movement of cash into and out of the firm and its net impact of the cash balance with the firm.
Projected Balance sheet: The balance sheet showing the balance in various asset and liability accounts reflects the financial condition of the firm at a given point of time.
PROJECT CASH FLOWS
Estimating cash flows - the investment outlays and the cash inflows after the project is commissioned - is the most important, but also the most difficult step in capital budgeting.
A project which involves cash outflows followed by cash inflows comprises of three basic components. They are,
- Initial investment: Initial investment is the after-tax cash outlay on capital expenditure and net working capital when the project is set up.
- Operating cash inflows: The operating cash inflows are the after-tax cash inflows resulting from the operations of the project during its economic life.
- Terminal cash inflow: The terminal cash inflow is the after-tax cash flow resulting from the liquidation of the project at the end of its economic life.
Basic Principles of Cash Flow Estimation:
The following principles should be followed while estimating the cash flows of a project:
- Separation principle
- Incremental principle
- Post-tax principle and
- Consistency principle.
The cash flow of a project must be measured in incremental terms. To ascertain a project's incremental cash flow one has to look at what happens to the cash flows of the firm with the project and without the project. The difference between the two reflects the incremental cash flows attributable to the project. That is,
(Project cash flow for the year t) = (Cash flow for the firm with the project for the year t) - (Cash flow for the firm without the project for the year t)
In estimating the incremental cash flows of a project, the following guidelines must be borne in mind:
- Consider all incidental effects: In addition to the direct cash flows of the project, all its incidental effects on the rest of the firm must be considered. The project may enhance the profitability of some of the existing activities of the firm because it has a complimentary relationship with the; or it may detract from the profitability of some of the existing activities of the firm because it has a competitive relationship with them-all these effects must be taken into account.
- Ignore sunk costs: A sunk cost refers to an outlay already incurred in the past or already committed irrevocably. So it is not affected by the acceptance or rejection of the project under consideration. Suppose, for example, a company is debating whether it should invest in a project. The company has already spent R.O. 10,000 for preliminary work meant to generate information useful for this decision. This R.O. 10,000 represents a sunk cost as it cannot be recovered irrespective of whether the project is accepted or not.
- Include opportunity costs: If a project uses resources already available with the firm, there is a potential for an opportunity cost. The opportunity cost of a resource is the benefit that can be derived from it by putting it to its best alternative use. For example, if a project uses a vacant factory building owned by the firm, the revenue that can be derived from renting out this building represents the opportunity cost.
- Question the allocation of overhead costs: Costs which are only indirectly related to a product (or service) are referred to as overhead costs. They include items like general administrative expenses, managerial salaries, legal expenses, rent and so on. When a new project is proposed, a portion of the overhead costs of the firm is usually allocated to it.
- Estimate working capital properly: Outlays on working capital have to be properly considered while forecasting the project cash flows. In this context the following points must be noted:
- Working capital is defined as "Current Assets - Current Liabilities.
- The requirement of working capital is likely to change over time as the output of the project changes.
- Working capital is renewed periodically and hence is not subject to depreciation. Therefore, the working capital at the end of the project life is assumed to have a salvage value equal to its book value.
There are two sides of a project, viz., the investment (or asset) side and the financing side and the cash flows associated with these sides should be separated.
Suppose a firm is considering a one-year project that requires an investment of R.O. 1000 in fixed assets and working capital at time 0. The project is expected to generate a cash inflow of R.O. 1200 at the end of year 1 (this is the only cash flow expected from the project). The project will be financed entirely by debt carrying an interest rate of 15 percent and maturing after 1 year. Assume there are no taxes. The following chart explains the financing side and the investment side of the project.
The cash flows on the investment side of the project includes the rate of return of 20% and do not reflect the financing costs of 15% (interest in our example). The cash flows on the financing side of the project includes the financing cost of 15% (interest in our example) and do not reflect on the rate of return of 20%.
The important point is that while estimating the cash flows on the investment side do not consider financing costs like interest or dividend.
Operationally, if interest is deducted in the process of arriving at profit after tax, an amount equal to 'Interest (1-tax rate)' should be added to 'Profit after tax'.
Long Term Funds Principle:
A project can be viewed from four distinct points of view. They are (1) Equity point of view, (2) Long term funds point of view, (3) Explicit cost funds point of view, and (4) Total funds point of view. We will discuss the long term funds point of view.
Magnum Technologies Limited is evaluating an electronics project for which the following information has been assembled. Prepare a net cash flow statement relating to long-term funds:
- The total outlay on the project is expected to be R.O. 50 million. This consists of R.O. 30 million of fixed assets and R.O. 20 million of current assets.
- The total outlay of R.O. 50 million is proposed to be financed as follows: R.O. 15 million of equity, R.O. 20 million of term loans, R.O. 10 million of bank finance for working capital and R.O. 5 million of trade credit.
- The term loan is repayable in five equal instalments of R.O. 4 million each. The first instalment will be due at the end of the first year and the last instalment at the end of the fifth year. The levels of bank finance for working capital and trade credit will remain at R.O. 10 million and R.O. 5 million till they are paid back or retired at the end of five years.
- The interest rates on the term loan and bank finance for working capital will be 15 percent and 18 percent respectively.
- The expected revenues from the project will be R.O. 60 million per year. The operating costs, excluding depreciation, will be R.O. 42 million. The depreciation rate on the fixed assets will be 33 and 1/3 percent as per the written down value method.
- The net salvage value of fixed assets and current assets at the end of year 5 will be R.O. 5 million and R.O. 20 million respectively.
- The tax rate applicable to the firm is 50 percent.
Project Appraisal Criteria
(NPV -Net Present value, IRR -Internal Rate of Return, and Pay Back Period-PBP)
Pay Back Period:
The payback period is the length of time required to recover the initial cost of the project. The payback period is stated in terms of number of years.
The Decision Rule: the actual payback is compared with a predetermined pay back, that is, the pay back set by the management in terms of the maximum period during which the investment must recovered. If the pay back period is less than the predetermined payback, then the project would be Accepted; if not, it would be rejected.
- It is very simple. It is easy to understand and apply.
- It is cost effective.
- The payback period measures the direct relationship between annual cash inflows from Proposal and the net investment required.
- It gives an indication of liquidity.
- The pay back period also deals with risk. The project with a shorter payback period will be.
- The pay back period entirely ignores the cash inflows that occur after the pay back period.
- It ignores the concept of required rate of return.
- The pay back period also ignores salvage value and total economic life of the project.
- It ignores the time value of money.
Net Present Value (NPV) Method:
The Net present value of a proposal is the sum of present values of all cash inflows related to a proposal, less the sum of present values of all cash outflows associated with a proposal.Thus, NPV is the sum of the discounted valves of all cash flows pertaining to a proposal.
The present value factors are multiplied to their respective net cash flows to arrive at the present value of each net cash flow. When all such present values are added the resultant figure is the Net Present Value.
The Decision Rule:
The NPV is positive accept the project and reject the project if the NPV is negative. The positive NPV of a proposal signifies the present worth of its inflows is more than the present worth of its out flows.Thus; the NPV represents the excess of benefits over the costs in real term.
- It recognizes the time value of money.
- It is capable of evaluating proposals that is profit seeking.
- The discount rate is most appropriate to ensure the minimum expectations of share Holders are adequately met.
- The NPV allows for both the recovery of the initial investment and the earnings at a Pre-stipulated rate.
- It is based on accounting information which is readily available and familiar to businessman
- It involves lengthy and difficult calculation.
- Determination of requires rate of return is a difficult job.
- It is difficult to estimate economic life of a project with full accuracy
Internal Rare of Return:
The IRR of a proposal is defined as the discount rate at which the NPV of the proposal works out to zero. In otherswords, IRR is the discount rate that equates present value of cash inflows with present value of cash outflows.
First find out the PV of cash outflows at chosen original discount rate. Depending upon wheather the NPV so arrived at positive or negative, another PV of cash inflows is calculated by taking a discount rate that is higher or lower than the original rate. Now two rate and two corresponding PVs. The IRR is calculated by interpolating the two rates with the help of the following formula:
The original discount rate can be chosen in a manner that can help us in reducing the number of iterations. This can be done by following the steps.
- Calculate the pay back period. Incase the project generate the uneven streams of cash flows, then the weighted average of cash inflows should be calculated. The original investment must be divided by the weighted average cash flow to arrive at the artificial payback period.
- Then, search for the PVAF factor as near as possible to the figure obtained as payback period in the row that stands for the life of the project. The interest rates that correspond to the PVAF value should be taken as the range with in which the IRR lies.
The Decision Rule:
The IRR is compared with the required rate of return. This rate is also known as the cut off rate or the hurdle rate. A proposal may be accepted if its IRR is more than the required rate. If the IRR is less than Required rate, the proposal is rejected. If the required rate of return is equal, the firm is indifferent as to whether accept or reject the proposal.
- It takes into account the time value of money.
- It is profit oriented concept.
- The IRR of the proposal is expressed as a percentage and is compared with the cut of rate, This is also expressed as a percentage.
- It is based on the cash flows rather than the accounting profit.
- It involves a complicated calculation hence it is difficult to use.
- It is difficult to use in decision making
- The estimate of cash inflows are based on the estimates of sales and cost which are uncertain.
- A critical shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment.
Network techniques for Project Management
(Development of project work, PERT and CPM Model and Network Cost System)
Project Planning Techniques
The three basic project planning techniques are Gantt chart, CPM and PERT. All monitor progress and costs against resource budgets.
Rules for Network Construction
The rules to be observed in constructing the network diagram
- Each activity must have a preceding and a succeeding event. An activity is numerically denoted by the pair of preceding and succeeding events.
- Each event should have a distinct number Events are so numbered that the the number at the head of the arrow is greater than that at its tail
- There should be no loops in the project network.
- Not more than one activity can have the same preceding and succeeding events.
Once the logic and detail of the network have been established, time estimate must be assigned to each activity:
- Optimistic time (to): It is time required if no hurdles or complications arise.
- Most likely time (™): It is the time in which the activity is most likely to be completed.
- Pessimistic time (tp):It is the time required if unusual complications/or unforeseen difficulties arise.
Obtaining time estimate:
Time estimate should be obtained by the PERT planner from persons who are responsible for estimation.
- Time estimates should be obtained by skipping around the network rather than by following a specific path.If estimate are obtained by the following one path, there is a tendency for the person providing the estimates to ad them mentally and compare them with a previously conceived notion of the time of the total path.
- The estimates of to, tm, tp should be defined independtly of each other.
- The time available for completing the project should not influence the estimates of to, tm, tp
Once the three time estimates for each activity are obtained, the expected value of activity durations is calculated. The expected value tc is usually obtained by the formula
Tc = (to + tm + tp)/6
Determination of the critical path
- Calculate the Earliest Occurrence Time (EOT) for each event
- Calculate the Latest Occurrence Time (LOT) for each event
- Calculate the slack for each event
- Obtain critical and slack paths
- Compute the activity floats
NB (For Detailed study kindly refer book: Projects planning , analysis, Financing , Implementation and review Author :Prasanna Chandra page no:633-638)
The Program Evaluation and Review Technique (PERT) is a network model that allows for randomness in activity completion times. PERT was developed in the late 1950's for the U.S. Navy's Polaris project having thousands of contractors. It has the potential to reduce both the time and cost required to complete a project.
The Network Diagram
In a project, an activity is a task that must be performed and an event is a milestone marking the completion of one or more activities. Before an activity can begin, all of its predecessor activities must be completed. Project network models represent activities and milestones by arcs and nodes.
PERT is typically represented as an activity on arc network, in which the activities are represented on the lines and milestones on the nodes.
The milestones generally are numbered so that the ending node of an activity has a higher number than the beginning node. Incrementing the numbers by 10 allows for new ones to be inserted without modifying the numbering of the entire diagram. The activities in the above diagram are labelled with letters along with the expected time required to complete the activity.
Steps in the PERT Planning Process
PERT planning involves the following steps:
- Identify the specific activities and milestones.
- Determine the proper sequence of the activities.
- Construct a network diagram.
- Estimate the time required for each activity.
- Determine the critical path.
- Update the PERT chart as the project progresses.
- Identify activities and milestones
- Determine activity sequence
- Construct the Network Diagram
- Estimate activity times
The activities are the tasks required to complete the project. The milestones are the events marking the beginning and end of one or more activities.
This step may be combined with the activity identification step since the activity sequence is known for some tasks. Other tasks may require more analysis to determine the exact order in which they must be performed.
Using the activity sequence information, a network diagram can be drawn showing the sequence of the serial and parallel activities.
Weeks are a commonly used unit of time for activity completion, but any consistent unit of time can be used.
A distinguishing feature of PERT is its ability to deal with uncertainty in activity completion times. For each activity, the model usually includes three time estimates:
- Optimistic time (OT) - generally the shortest time in which the activity can be completed. (This is what an inexperienced manager believes!)
- Most likely time (MT) - the completion time having the highest probability. This is different from expected time. Seasoned managers have an amazing way of estimating very close to actual data from prior estimation errors.
- Pessimistic time (PT) - the longest time that an activity might require.
The expected time for each activity can be approximated using the following weighted average:
Expected time = (OT + 4 x MT+ PT) / 6
This expected time might be displayed on the network diagram.
Variance for each activity is given by:
[(PT - OT) / 6]2
Determine the Critical Path
The critical path is determined by adding the times for the activities in each sequence and determining the longest path in the project. The critical path determines the total time required for the project.
If activities outside the critical path speed up or slow down (within limits), the total project time does not change. The amount of time that a non-critical path activity can be delayed without delaying the project is referred to as slack time.
If the critical path is not immediately obvious, it may be helpful to determine the following four quantities for each activity:
- ES - Earliest Start time
- EF - Earliest Finish time
- LS - Latest Start time
- LF - Latest Finish time
- Expected project completion time.
- Probability of completion before a specified date.
- The critical path activities that directly impact the completion time.
- The activities that have slack time and that can lend resources to critical path activities.
- Activities start and end dates.
- The activity time estimates are somewhat subjective and depend on judgment. In cases where there is little experience in performing an activity, the numbers may be only a guess. In other cases, if the person or group performing the activity estimates the time there may be bias in the estimate.
- The underestimation of the project completion time due to alternate paths becoming critical is perhaps the most serious.
These times are calculated using the expected time for the relevant activities. The ES and EF of each activity are determined by working forward through the network and determining the earliest time at which an activity can start and finish considering its predecessor activities.
The latest start and finish times are the latest times that an activity can start and finish without delaying the project. LS and LF are found by working backward through the network. The difference in the latest and earliest finish of each activity is that activity's slack. The critical path then is the path through the network in which none of the activities have slack.
The variance in the project completion time can be calculated by summing the variances in the completion times of the activities in the critical path. Given this variance, one can calculate the probability that the project will be completed by a certain date.
Since the critical path determines the completion date of the project, the project can be accelerated by adding the resources required to decrease the time for the activities in the critical path. Such a shortening of the project sometimes is referred to as project crashing.
Update as project progressesMake adjustments in the PERT chart as the project progresses. As the project unfolds, the estimated times can be replaced with actual times. In cases where there are delays, additional resources may be needed to stay on schedule and the PERT chart may be modified to reflect the new situation.
Benefits of PERT
PERT is useful because it provides the following information:
Limitations of PERT
The following are some of PERT's limitations:
CPM - Critical Path Method
DuPont developed a Critical Path Method (CPM) designed to address the challenge of shutting down chemical plants for maintenance and then restarting the plants once the maintenance had been completed.
Complex project, like the above example, require a series of activities, some of which must be performed sequentially and others that can be performed in parallel with other activities. This collection of series and parallel tasks can be modelled as a network.
CPM models the activities and events of a project as a network. Activities are shown as nodes on the network and events that signify the beginning or ending of activities are shown as arcs or lines between the nodes.
Steps in CPM Project Planning
- Specify the individual activities.
- Determine the sequence of those activities.
- Draw a network diagram.
- Estimate the completion time for each activity.
- Identify the critical path (longest path through the network)
- Update the CPM diagram as the project progresses.
Specify the individual activities
All the activities in the project are listed. This list can be used as the basis for adding sequence and duration information in later steps.
Determine the sequence of the activities
Some activities are dependent on the completion of other activities. A list of the immediate predecessors of each activity is useful for constructing the CPM network diagram.
Draw the Network Diagram
Once the activities and their sequences have been defined, the CPM diagram can be drawn. CPM originally was developed as an activity on node network.
Estimate activity completion time
The time required to complete each activity can be estimated using past experience. CPM does not take into account variation in the completion time.
Identify the Critical Path
The critical path is the longest-duration path through the network. The significance of the critical path is that the activities that lie on it cannot be delayed without delaying the project. Because of its impact on the entire project, critical path analysis is an important aspect of project planning.
The critical path can be identified by determining the following four parameters for each activity:
- ES - earliest start time: the earliest time at which the activity can start given that its precedent activities must be completed first.
- EF - earliest finish time, equal to the earliest start time for the activity plus the time required completing the activity.
- LF - latest finish time: the latest time at which the activity can be completed without delaying the project.
- LS - latest start time, equal to the latest finish time minus the time required to complete the activity.
The slack time for an activity is the time between its earliest and latest start time, or between its earliest and latest finish time. Slack is the amount of time that an activity can be delayed past its earliest start or earliest finish without delaying the project.
The critical path is the path through the project network in which none of the activities have slack, that is, the path for which ES=LS and EF=LF for all activities in the path. A delay in the critical path delays the project. Similarly, to accelerate the project it is necessary to reduce the total time required for the activities in the critical path.
Update CPM diagram
As the project progresses, the actual task completion times will be known and the network diagram can be updated to include this information. A new critical path may emerge, and structural changes may be made in the network if project requirements change.
- Provides a graphical view of the project.
- Predicts the time required to complete the project.
- Shows which activities are critical to maintaining the schedule and which are not.
While CPM is easy to understand and use, it does not consider the time variations that can have a great impact on the completion time of a complex project. CPM was developed for complex but fairly routine projects with minimum uncertainty in the project completion times. For less routine projects there is more uncertainty in the completion times, and this uncertainty limits its usefulness.
Construct a network diagram for a project consisting of the following activities:
Network cost System
The techniques of PERT and CPM discussed above are essentially time oriented. They seek to answer questions like:
- What is the most desirable time schedule of activities?
- How much time would it take, on an average, to complete the project?
- What is the probability of completing the project in a specified time?
Such analysis largely overlooks the cost aspect which is usually as important as the time aspect and sometimes even more. To provide a vehicle for cost planning and control of projects, the network cost system was developed.
The principle of the network cost system is fairly simple: costs are planned, measured, analysed and controlled in terms of project activities. Though simple, this principle represents a departure from the conventional cost accounting system where costs are generally planned, measured analysed and controlled in terms of functions or organisational divisions.
Once costs are estimated in terms of activities, cost projections can be made for any chosen schedule. For cost projection it is usually assumed that the expenditure for any activity is incurred evenly over the duration of activity. Where this assumption does not appear valid, the activity should be divided into two or more sequential components, such that for each of the components the expenditure occurs uniformly over its duration. The projected cost curve for a given schedule and activity-wise cost estimates can be readily obtained.
Analysis and control of costs
As the project progresses the following may be measured/estimated periodically for purpose of monitoring and control.
Costs incurred to date: In a network cost system costs are recorded activity wise. Costs incurred to date can be obtained by summing up costs for various activities wise.
Budgeted costs to date: budgeted costs to date can be easily obtained from the costs projections made at the beginning.
Value of work done date: When costs are measured, an estimate should also be made of the extent of work accomplished. The value of work done can then be obtained as follows: Budgeted costs x percentage work accomplished. This may be illustrated by an example. A certain activity has budgeted costs of RO 800 and at the time of the periodic progress review it is estimated that 60 percent of the work has been accomplished. So the value of work done is put at RO 800 x 60 percent = RO 480.
Cost over run (under run) to date: There is cost over-run when the cost incurred is more than the value of work done. Similarly, there is cost under run when the cost incurred is less than the value of work done. Cover over-run (under-run) is usually expressed in percentage terms. It is defined as follows: Actual cost - Value of work completed x 100
Value of work completed
Time over-run (under-run) to date: There is time over-run if the project is behind schedule. Likewise, there is under-run if the project is ahead of schedule. Time over-run (under run) is usually defined in terms of months behind or months ahead.
Project review and administrative aspects
The last phase of capital budgeting is concerned with the review of the projects undertaken. A project is monitored during the implementation phase so that time and cost over-runs are minimized. The followings are the techniques or topics discussed under project review and administrative aspects.
Control of in-progress projects
It is necessary to exercise strict control on in-progress capital projects. There are two aspects of controlling in-progress capital projects.
Establishment of internal Control procedures: For every in-progress capital project, proper control accounts are setup. These are charged with all relevant expenditures, which are further classified into capital and revenue items. These accounts reflect out-of-pocket payments as well as allocated expenses. The project-by-project segregation of costs ensures that proper attention cab be directed to projects as they approach various milestones.
Use of regular progress reports: Periodic progress report compares actual expenditures against estimates. They offer several benefits:
- They provide timely information so that corrective action can be initiated to tackle potential problems
- they generate inputs for cash budgeting and fund raising
- They serve as the basis for calculating variances and explaining variances.
An audit of a project after it has been commissioned is referred as a post-audit or a post-completion audit. Regular post-audits of capital projects:
- Control of in-progress projects
- Provide a documented log of e
- Experience that may be valuable in improving future decision making,
- Enable the firm in identifying individuals with superior abilities in planning and forecasting,
- Help in discovering systematic biases in decision,
- Induce healthy caution among project sponsors,
- Serves as a useful training ground for executives who need experience and exposures.
A capital investment cannot be regarded as a commitment till the end of the project life. As time passes, changes occur which can alter the attractiveness of projects. Hence, capital investments must be reappraised periodically to determine whether they should be continued or terminated or divested, known as abandonment analysis.
To decide whether the project should be continued or terminated or divested, the following information is required;
- Present value of expected cash flows(PVCF)
- Salvage value (SV) - value to be realized from terminating the project and selling its assets.
- Divestiture value (DV) - price at which the project is sold.
Administrative aspects of capital budgeting
Administrative aspects of capital budgeting has been organized as follows:
- Identification of promising investment opportunities.
- Classification of investment or capital expenditure proposals.
- Submission of investment proposals to sponsors of projects.
- A mix of centralized and decentralized decision making.
- Preparation of capital budget and appropriation.
- Implementation of decision taken by the project members.
- Evaluating actual performance with projected performance.
Identification of promising investment opportunities: For identifying promising investment opportunities, the relationship between the firm and its environment should be regularly analyzed, corporate plans and perspectives must be widely shared, and the creativity and imagination of the employees must be tapped.
Classification of investment or capital expenditure proposals: Investment proposal may be classified in many ways. The following scheme of classification can with minor modification be adopted for most manufacturing enterprise:
- Replacement investments
- Modernization and rationalization investments
- Expansion investments
- New product investment
- Research and development investment
- Obligatory and welfare investments.
Submission of investment proposals to sponsors of projects: to ensure that all relevant information for proposal is gathered systematically, a standardized proposal form may be used by all the sponsors of investment projects.
A mix of centralized and decentralized decision making: some decentralization of capital budgeting is required to facilitate quick decisions, develop executives, and converse top management time for important matters. That is why most companies empower executives at different levels to take investment decisions involving outlays up to certain limits.
Preparation of capital budget and appropriation: While capital expenditure budget is usually drawn up for one to two years, it is desirable to have a perspective plan ranging from three to five years. In some cases it may even be of a longer duration .The coordination of the capital expenditure budget should preferably be done by a financial officer of the firm.
Implementation of decision taken by the project members: For timely implementation of the projects within reasonable costs, the following are helpful; adequate formulation of projects ; use of the principle of responsibility accounting ; use of network techniques; and exercise of proper control
Evaluating actual performance with projected performance: Despite its importance, performance review tends to be one of the most neglected aspects of capital budgeting. The soundness of the capital budgeting system of an organization may be evaluated in terms of the following criteria: result, techniques, communication, decentralization, intelligibility, flexibility, control and review.
Performance review is meant for evaluating actual performance vis-à-vis projected performance. It is concerned with the verification of assumptions regarding both revenues and costs. In scope, it is broader than the popularly used accounting review which is concerned only with costs.
Despite its importance, performace review is one of the most neglected aspects of capital budgeting. The reason could be:
It is difficult to isolate the cash flows attributable to individual investments from financial accounts which are compiled for the firm as a whole and which re based on the accrual principle.
There is an apprehension that a performance review may be used for punitive purposes.
The first problem can be overcome largely by using estimates and approximations whwerevr it is not possible to obtain accurate data. For examplre, if cosy=ts relating to a project have not been recorded separately , a reasonable estimate can usually be made on the basis of information relating to total costs and the activities of the firm.Likewise , cash flows from sales arising from a project can be roughly estimated by looking into the collection pattern of receivables as a whole.
The second problem can be overcome by making it clear to all project sponso that the purpose of post-audit is to promote learning and not to penalize the persons involved. It provides feedback that is necessary for furure improvements.
Evaluating the capital budgeting system of an organization
Capital budgeting system of an organization may be evaluated in terms of following criteria:
- Results - results of capital budgeting system should be consistent with the goal of the organization.
- Techniques - efficient techniques of capital budgeting system should be employed.
- Communication - premises of capital budgeting system should be communicated to all participants in the process.
- Decentralization - there should be meaningful delegation and decentralization in decision making.
- Intelligibility - all departments of the organization involved in capital budgeting system should understand policies and methods.
- Flexibility - system should be flexible to respond the dynamic changes in the environment.
- Control - adequate controls should be exercised in the implementation of capital budgeting system.
- Review - there should be a systematic review, monitoring and control of capital investments.