When you have a number of interesting and challenging projects to choose from, finding a project that is the right fit for your team’s skill set, level of competence, and has the best chance of success is the first step in effective project management. Project Selection Methods offer a set of time-tested techniques based on sound logical reasoning to choose a project and filter out undesirable projects with a very low likelihood of success. Project selection methods are an important concept for practicing project managers and aspirants preparing for the PMP® exam alike. And in this article, we will discuss the following project selection methods in detail:
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- Benefit measurement methods
- Benefit/cost ratio
- Economic model
- Scoring model
- Payback period
- Net present value
- Discounted cash flow
- Internal rate of return
- Opportunity cost
- Constrained optimization methods
- Non-financial considerations
What are Project Selection Methods?
Consider this scenario: the organization you are working for has been handed a number of project contracts. Due to resource constraints, the organization can’t handle all the projects at once, so they need to decide which project(s) will maximize profitability.
This is where project selection methods come into play. There are two categories of project selection methods:
- Benefit Measurement Methods
- Constrained Optimization Methods
Although time-consuming, employing these methods is essential for an effective business plan. There are a variety of documented methods for selecting a project, but the basic thumb rule is: for small projects that aren’t very complex, the Benefit Measurement Model is useful, whereas if it’s a large, complex project, the Constrained Optimization Method is a better fit. Let’s take a look at both these methods in further detail.
Various Project Selection Methods
1. Benefit Measurement Methods
Benefit Measurement is a project selection technique based on the present value of estimated cash outflow and inflow. Cost benefits are calculated and then compared to other projects to make a decision. The techniques that are used in Benefit Measurement are as follows:
2. Benefit/Cost Ratio
Cost/Benefit Ratio, as the name suggests, is the ratio between the Present Value of Inflow or the cost invested in a project to the Present Value of Outflow, which is the value of return from the project. Projects that have a higher Benefit-Cost Ratio or lower Cost-Benefit Ratio are generally chosen over others.
3. Economic Model
EVA, or Economic Value Added, is the performance metric that calculates the worth-creation of the organization while defining the return on capital. It is also defined as the net profit after the deduction of taxes and capital expenditure.
If there are several projects assigned to a project manager, the project that has the highest Economic Value Added is picked. The EVA is always expressed in numerical terms and not as a percentage.
4. Scoring Model in Project Management
The scoring model in project management is an objective technique: the project selection committee lists relevant criteria, weighs them according to their importance and their priorities, then adds the weighted values. Once the scoring of these projects is completed, the project with the highest score is chosen.
5. Payback Period
Payback Period is the ratio of the total cash to the average per period cash. It is the time necessary to recover the cost invested in the project. The Payback Period is a basic project selection method. As the name suggests, the payback period takes into consideration the payback period of an investment. It is the time frame that is required for the return on an investment to repay the original cost that was invested. The calculation for payback is fairly simple:
When the Payback period is used as the Project Selection Method, the project that has the shortest Payback period is preferred since the organization can regain the original investment faster. There are, however, a few limitations to this method:
- It does not consider the time value of money.
- Benefits accrued after the payback period are not considered; it focuses more on the liquidity while profitability is neglected.
- Risks involved in individual projects are neglected.
6. Net Present Value
Net Present Value is the difference between the project’s current value of cash inflow and the current value of cash outflow. The NPV must always be positive. When picking a project, one with a higher NPV is preferred. The advantage of considering the NPV over the Payback Period is that it takes into consideration the future value of money. However, there are limitations of the NPV, too:
- There isn’t any generally accepted method of deriving the discount value used for the present value calculation.
- The NPV does not provide any picture of profit or loss that the organization can make by embarking on a certain project.
- For more details on the NPV and how to use the NPV as a tool to filter projects out, here’s an insightful article on calculating the opportunity costs for projects.
7. Discounted Cash Flow
It’s well-known that the future value of money will not be the same as it is today. For example, $20,000 won’t have the same worth ten years from now. Therefore, during calculations of cost investment and ROI, be sure to consider the concept of discounted cash flow.
8. Internal Rate Of Return
The Internal Rate of Return is the interest rate at which the Net Present Value is zero—attained when the present value of outflow is equal to the present value of inflow. Internal Rate of Return is defined as the “annualized effective compounded return rate” or the “discount rate that makes the net present value of all cash flows (both positive and negative) from a particular investment equal to zero.” The IRR is used to select the project with the best profitability; when picking a project, the one with the higher IRR is chosen.
When using the IRR as the project selection criteria, organizations should remember not to use this exclusively to judge the worth of a project; a project with a lower IRR might have a higher NPV and, assuming there is no capital constraint, the project with the higher NPV should be chosen as this increases the shareholders’ profits.
9. Opportunity Cost
Opportunity Cost is the cost that is given up when selecting another project. During project selection, the project that has the lower opportunity cost is chosen.
10. Constrained Optimization Methods
Constrained Optimization Methods, also known as the Mathematical Model of Project Selection, are used for larger projects that require complex and comprehensive mathematical calculations. The techniques that are used in Constrained Optimization Methods are as follows:
These topics, however, are not discussed in detail in the PMP® certification. For the exam, all that is necessary to know is that this is the list of Mathematical Model techniques that are used in Project Selection.
11. Non-Financial Considerations
There are non-financial gains that an organization must consider; these factors are related to the overall organizational goals. The organizational strategy is a major factor in project selection methods that will affect the organization’s choice in the choice of project. Customer service relationships are chief among these organizational goals. An important necessity in today’s business world is to build effective, cordial customer relationships.
Other organizational factors may include political issues, change of management, speculative purposes, shareholders’ requests, etc.
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As you now know, Project Selection may be carried out in a number of ways. It is best for an organization to try different project selection methods and consider a wide range of factors before choosing a project to be as certain as possible that the best decision is made for the company.
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