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)
- Sunk Cost
We will discuss the first three terms in this article and leave the rest in the sequel.
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:
- 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.
Based on the fact that only the payback period is provided, we should rely solely on this information to make the selection. Since Project A has a shorter payback period, it is considered financially more beneficial for the organization. NOTE: since you are tasked with the responsibility, it is not appropriate for you to escalate the decision making back to the project sponsor. Project Managers are expected to should responsibilities according to PMI, though in reality it is always the senior management / project sponsor to make the project selection.
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:
- 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
Project C has the largest ROI. If ROI is the only metric to compare, Project C would be the best project to undertake.
Aspirants would only need to remember that:
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 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:
- 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?
Project B has the highest NPV and hence it is chosen. Based on the definition of opportunity cost, the second best NPV would be the best value given up. So the NPV of Project A would be the opportunity cost, i.e. US$100,000.