There are several methods for measuring the benefits of a project. These methods aim to define criteria for comparing the values of one project to another. As expected, projects with higher positive values generally receive approval over projects with lower values. Here are some common methods of measuring project benefits that you may encounter:
Murder Boards
Murder Boards are committees of individuals who speculate on all imaginable negative issues about the proposed project. Their goal is to expose the strengths and weaknesses of the project and prematurely terminate it if it is deemed worthless to the organization. Not an agreeable decision-making process.
Scoring Models
Scoring models (sometimes called weighted scoring models) are models that use a common set of values across all projects in place for selection. For example, values may include profitability, complexity, customer demand, and so on. Each of these values is assigned a weight—those of greater importance have a higher weight, while values of lesser importance have a lower weight. Projects are evaluated based on these values, and scores are assigned based on how well they match the predefined values. Projects with higher scores take precedence over projects with lower scores. Demonstrates the scoring model.
Benefit/Cost Ratios
As the name suggests, the benefit/cost ratio (BCR) is a model that examines the relationship between the cost and expected benefits. For example, a typical measure is the cost of completing a project, the cost of ongoing operations of the project’s product, compared to the expected benefits of the project. For example, consider a project that will cost $575,000 to create a new product, market the product, and provide ongoing support for the product for one year. However, the expected gross return on the product is $980,000 in the first year. The benefit of completing the project exceeds the cost of creating the product.
Payback Period
How long does it take for the project to “pay back” the project costs? For example, Project AXZ will cost $500,000 to the organization for a creation period greater than five years. The expected cash flows (revenue) on the project’s deliverable, however, is $40,000 per quarter. From there, it’s just simple math: $500,000 divided by $40,000 equals 12.5 quarters, or a little over three years to recoup the costs. This selection method is one of the simplest and also the weakest. Why? Cash flow entries are not discounted over time to start making money. This is the time value of money. The $40,000 per quarter in five years is worth less than $40,000 in your pocket today.
Discounted Cash Flow
Discounted cash flows account for the time value of money. If you were to borrow $100,000 for five years from your uncle, you’d pay interest on the money, right? (If not, you have a great uncle.) If the $100,000 were invested for five years and managed to earn a whopping six percent interest annually, compounded annually, it would be worth $133,822.60 at the end of five years. This is the future value of money in today’s terms.
The magic formula for future value is FV = PV(1 + i)n, where:
- FV is the future value
- PV is the present value
- i is the interest rate
- n is the number of periods (years, quarters, and so on)
Here’s the formula with the $100,000 in action:
FV = 100,000(1 + .06)^5 FV = 100,000(1.338226) FV = $133,822.60
The future value of $100,000 in five years is worth $133,822.60 today. So how does that help? Now we have to calculate the present value of cash flows across all projects up to selection. Discounted cash flows are really just the inverse of the previous formula. We’re looking for the present value of future cash flows:
PV = FV ÷ (1 + i)^n
In other words, if a project says it will earn the organization $160,000 per year in five years, that’s great, but what is $160,000 in five years really worth today? This puts the amount of cash flows into perspective with what the projections are in today’s money. Let’s plug it into the formula and find out (assuming the interest rate is still six percent):
PV = FV ÷ (1 + i)^n PV = 160,000 ÷ (1.338226) PV = $119,561
So… $160,000 over five years is really only worth $119,561 today. If we had four different projects with different times to completion, costs, and project cash inflows to the end, we’d calculate the present value and choose the project with the best PV as it will likely be the best investment for the organization.
Internal Rate of Return
The final benefit measurement method is the internal rate of return (IRR). The IRR is a complex