Project Benefit Analysis Concepts for the PMP Exam

During project initiation, the project manager is often tasked with the responsibility to assess whether a project proposal is beneficial to the performing organization and whether the project is aligned to organization business goals. In fact, the new PMP Exam has added a new task to the PMP Exam Content Outline:

Conduct benefit analysis with stakeholders (including sponsor, customer, subject matter experts), in order to validate project alignment with organizational strategy and expected business value.

There are some metrics / accounting terms that would help the Project Manager to better assess and compare project proposals, namely:

• Payback Period
• Return on Investment (ROI)
• Opportunity cost
• Net Present Value
• Benefit-Cost Ratio (BCR)
• Internal Rate of Return (IRR)
• Depreciation
• Sunk Cost

We will discuss the first three terms in this article and leave the rest in the sequel.

Payback Period

Payback Period is the time it takes for the organization to earn back the initial investment (in terms of monetary cost) to the project and begin making profits.

If the income generated from the project is constant, the payback period can be calculated using the simplified formula:

Payback Period = Initial Investment / Periodic Cash-flow

For example, if the organization need to invest US$10,000 into a project that is expected to generate US$1,000 per month, the payback period would be:

Payback Period = US$10,000 / US$1,000/month = 10 months

In the actual exam, candidates are seldom required to calculate the payback period for projects (after all, the exam is not an accounting exam). The exam inclines more on testing Aspirants’ conceptual knowledge, i.e. whether the candidate understands the meaning behind payback period or other terms.

The following would be a sample PMP Exam question on payback period:

1. You are the project manager of the organization and you are tasked with the responsibility of selecting a project from two proposals A and B based on the business values with the information on hand: Project A has a payback period of 20 months while Project B has a payback period of 30 months. Which one should you recommend?
   A. Project A
   B. Project B
   C. Neither one is beneficial to the organization.
   D. Ask the project sponsor to choose.

Generally speaking,

The shorter the Payback Period, the more favourable the project financially to the organization.

However, Project Managers should note that Payback Period is rarely used solely as a project selection criterion. The organization would need to consider an array of different metrics in order to selection the projec with the best value realization to the organization. common project selection criteria include:

• Return on Investment
• Cost-benefit Ratio
• Net Present Value , etc.

Return on Investment (ROI)

Return on investment (ROI) is the benefit an investment bring about, by comparing profits in relation to capital invested.

The formula for calculating Return on Investment for a project is (note that the PMP Exam does not require candidates to calculate ROI):

Return on Investment = Net profit / Capital Invested

Net profit (usually expressed as net present value [NPV]) is the total capital invested minus all expenditure. If ROI is larger than 1, the project is deemed to be profitable. If ROI is smaller than 1, the project loses money.

A sample PMP Exam question on return on investment:

1. The organization is considering several projects with the following return on investment:
   ROI of Project A = 1.1
   ROI of Project B = 0.4
   ROI of Project C = 1.8
   ROI of Project D = 1.0
   By judging on ROI alone, which project is the most favourable choice?
   A. Project A
   B. Project B
   C. Project C
   D. Project D

Aspirants would only need to remember that:

The higher the Return on Investment, the more favourable the project financially to the organization.

However, in reality, ROI is not only project selection criteria. Let’s look at the mock question above again, if we further know that Project C is such a small project that the net gain from the project is US$8 while that for Project A is US$800,000. If you are the senior management, how will you choose again? It is really difficult to tell. Other factors must be considered.

But one thing is clear is that in the exam, the questions are usually simplified enough to ask you to make the choice based on a single metric which is never the case in real life situations.

Opportunity Cost

Opportunity Cost is the value of the best alternative given up when a choice is made, in which the choices must be mutually exclusive owing to limited resources.

In simpler terms, opportunity cost is the highest value a person needs to give up for the chosen choice. For example, if you have US$10, you can either buy a coffee or 2 muffins. When you purchased the coffee, your opportunity cost is 2 muffins as you don’t have the money to purchase the muffins.

For the PMP Exam, Aspirants should only need to know that owing to limited resources (money, human, space, etc.), the organization will often need to select one project over the others. The Opportunity Cost is the single best alternative NOT chosen (NOTE: Opportunity Cost is not the sum of the values of all project given up). For most cases, the chosen project is believed to deliver the best values among all the project choices.

There is no calculation required for getting the opportunity cost.

A mock exam question on opportunity cost:

1. You are the working in the PMO of your organization and there are three project proposals submitted. However, owing to the limitation of capital, only one project can be chosen. Project A would have a NPV of US$100,000, Project B would have a NPV of US$120,000 while Project C would have a NPV of US$50,000. What is the opportunity cost of choosing the project with the highest NPV?
   A. US$120,000
   B. US$50,000
   C. US$100,000
   D. US$150,000