Integral Logistics Management — Operations Management and Supply Chain Management Within and Across Companies

19.2.5 Project Cost, Project Benefits, Project Profitability, and Project Risk

Intended learning outcomes: Produce an overview on the total cost of ownership of a project. Explain the Matrix for estimating the project benefit of an investment in a software system as well as the graphic representation in overlay of nine profitability calculations, for cumulative benefits with degrees of realization 1 to 9. Identify NPV, the net present value technique. Present the issue of project risk management.

For the decision to be made to conduct a project, generally the benefits have to be greater than the costs. A profitability calculation is also a basis for prioritizing several possible projects. As the projects of interest here are mostly the realization of systems, the decision techniques are illustrated, taking the example of the introduction of an ERP software system.

Project costs, also called total cost of ownership of a project, encompasses both for the initial investment and for running costs incurred in accomplishing work during a given time period.

The difficulty of estimating the different project costs varies. Relatively good estimates can be made of the initial investment. In the ERP example, the initial costs generally include:

  • the required hardware, system software, and application software
  • premises and installations for machines and people
  • internal startup costs for the persons assigned to the project
  • decommissioning of the existing, old system
  • first training of users in mastering the selected business processes; that is, the organizational solution
  • first training of users in mastering computer support of the business processes
  • external startup costs; for example, for consultants

Running costs of maintaining the operation of the IT system should not be underestimated. In the case of introducing software, these include

  • service and maintenance of hardware and software
  • ongoing training of users

Estimation of expenses to avoid opportunity costs is not simple. These expenses arise through evaluation of customer requirements for the new system in the target areas of quality and delivery. They therefore concern system risks and are sometimes difficult to estimate. In the case of investment in information technology, the costs are also called “total cost of computing.”System risks include the costs of nonaccessibility for one, and faultiness of hardware and software, for another. The opportunity costs include lost profit contributions from customer business. Depending on the application, opportunity costs are very high as compared to other costs, or they are inconsequential. Examples:

  • A bank that deals in online stock trading has to equip the system for extreme loads that can unexpectedly and rapidly occur if there are new issues or the stock market crashes. System overload or even system failure at this time inevitably leads to a loss of a large part of the customers. To reduce system risks, and thus avoid opportunity costs, the information technology system can at best be duplicated; that is, mirrored, as a backup, which leads to increased investment costs.
  • Tax collection agencies do not have to deal with the problem of losing “customers.” A system failure of short duration is unproblematic and does not result in opportunity costs. In other words, no additional costs arise in order to avoid opportunity costs.

Project benefit is the financial return that arises through the realization of theproject.

As with project costs, the difficulty of determining project benefit can vary. A fundamental difficulty here is the following problem: many aspects of benefit — particularly in the target areas of quality and delivery — are not expressed primarily in monetary terms and therefore have to be converted in the end to financial quantities, that is, returns.

This is also the case with introduction of a new software system. The following description is taken from [IBM75a]. It can be applied easily to other types of projects. Here, three types of benefit are distinguished:

  1. Direct benefit through savings: Example: Reduction of administra­tive personnel by one job, reduction of the expensive maintenance costs of previous machines requiring higher maintenance.
  2. Direct benefit through additionally achieved profit contributions: For example, higher business volume through the processing of additional contracts with customers via EDI (Electronic Data Exchange) or via the World Wide Web, improved payment practices by customers through the charging of 0.5% interest on the invoiced amount for late payment.
  3. Indirect benefit: For example: Reduction of physical inventory by 3% through more exact, complete, and detailed information, 2% increase in utilization achieved in the same way, faster lead times in the flow of goods.

Figure shows these three types of benefits in a matrix, in comparison with high, medium, or low probability of realization.

Fig.       Matrix for estimating the benefit of an investment in a software system.

The idea is to enter all expected benefits into the cells of the matrix, together with the year in which the respective benefit will occur (that is, the year of its realization), calculated from the time of introducing the software system. Sometimes, two or more cells must be used.

  • For example, it is estimated that a 1% reduction in physical inventory will occur starting in year 2 with high probability, 1% starting in year 3 with medium probability, and 1% starting in year 4 with low probability. In this case, the value and the year are entered into cells 6, 8, and 9.

This technique takes the observation into account that benefits — in greater variation than costs — can be estimated pessimistically, realistically, or optimistically. The numbers from 1 to 9 indicate the sequence in which the expected benefits will be included in the calculation of the cumulative benefit.

Cumulative benefit with degree of realization d, 1 <=  d <= 9, is defined as the addition of the benefits in cells 1 to d.

The different degrees of realization allow estimation of risk in the form of a sensitivity analysis.

Project profitability is comparison of the costs and benefits of a project.

This calculation is also called capital budgeting.

Following [IBM75a], the cumulative benefits with degree of realization 1 to 9 are entered on the time axis, as shown in Figure This results in nine different benefit curves. The cost curve is entered into the same graph. At time point 0, this is the initial investment; in the following years, this is initial investment plus running costs. The result obtained is the payback period, or, in other words, the breakeven point of the investment: (and this is what makes the technique intuitively simple) de facto for nine profitability calculations shown in overlay.

Fig.       Graphic representation in overlay of nine profitability calculations, for cumulative benefits with degrees of realization 1 to 9.

According to the example graph in Figure, for degree of realization 6, the payback period is approximately two years. For cumulative benefits with degree of realization 7, the payback period is approximately one and a half years.

Up to now, costs and benefits were included in the comparison without adjustment. However, tallying up the costs and benefits can also be done with discounting, which means con­verting all costs and benefits to their present value (at the time of introducing the system). For this, standard methods for analyzing the profitability of investments can be used. The net present value (NPV) formula, shown in Figure is one. See here also [Kerz17, Ch. 14].

Fig.       NPV, net present value technique.

The net present value formula takes into account the fact that one Euro is worth more today than one Euro a year from now. This is because of interest payments on capital. At an interest rate of 10%, one Euro today is equal in value to 1 Euro * (1+0.1) = 1.1 Euro a year from now. Vice versa, one Euro one year from now is only worth 1 Euro / (1+0.1) = 0.909 Euro today. Projects with a net present value greater than zero are profitable. As most projects have many of the investment costs up-front or in year one, the NPV formula favors de facto projects with a short payback period.

Project risk refers to events that impact the profitability of a project.

In accordance with Figure, the project risk can be that the cost objectives of the project or the expected benefits are not achieved. As the costs of the projects are generally far better known than the project benefits, the risk analysis is usually restricted to the amount of the benefit and the year in which it occurs (realization). One way to estimate the risks is sensitivity analysis, which becomes possible by performing several profitability calculations with inclusion of cumulative benefits with different degrees of realization, as is the case in Figure

In practice, for most investments with strategic importance, the big benefits are often seen only with cumulative benefits with degree of realization 6 and higher — that is, they include indirect benefits. In these cases, project management must take caution. The realization of an indirect benefit depends, namely, not only on realization of the actual investment, but also and primarily on whether the selected organizational solution as such is appropriate for handling the business task and whether staff know how to use it. When an IT system to support business processes is introduced, for example,

  • the physical inventory level also depends on the general situation concerning orders and the competitiveness of the company. The inventory that results from these influencing factors can surpass by far any possible reduction of inventory due to the software investment.
  • the lead time for goods also depends on whether information made available by a software application can also be implemented on time. Rapid information flow — information concerning a late order, for example — is no use, if there is no one at the workplace to process the information.

If the choice is to be made among a number of possible projects, varying risk behavior is seen in the degree of realization of the cumulative benefits that one wants to include.

The reasons for project risk are many and diverse. The fundamental difficulty of estimating costs and benefits is made even more difficult, among other things, by inadequately defined project objectives, poor project organization, inadequate human and other resources, inadequate project management, and insufficient motivation on the part of the people. Appropriate project risk management includes the use of methods such as assessments or audits, which are discussed in Section 18.3.3.

Course section 19.2: Subsections and their intended learning outcomes

  • 19.2 Project Management

    Intended learning outcomes: Present goals and constraints of a project. Describe project phase, project life cycle, and work breakdown structure. Explain scheduling and effort planning as well as organization of a project. Differentiate between cost, benefits, profitability, and risk of a project.

  • 19.2.1 Goals and Constraints of a Project

    Intended learning outcomes: Produce an overview on project performance and project deliverables. Differentiate between external constraints and internal constraints in project management.

  • 19.2.2 Project Phase, Project Life Cycle, and Work Breakdown Structure

    Intended learning outcomes: Produce an overview on the project phases in a generic project life cycle. Describe the increasing degree of detail of tasks and work packages in a work breakdown structure. Present an excerpt from a work breakdown structure for the preliminary study for a building conversion.

  • 19.2.3 Project Scheduling and Project Effort Planning

    Intended learning outcomes: Present in detail the schematic display of project effort per organizational unit. Explain an excerpt of the Gantt chart for the project “preliminary study for building conversion”.

  • 19.2.4 Project Organization

    Intended learning outcomes: Differentiate between project coordination in a functional, or line, organization and project management in a project-based organization. Describe project management in a strong matrix organization.

  • 19.2.5 Project Cost, Project Benefits, Project Profitability, and Project Risk

    Intended learning outcomes: Produce an overview on the total cost of ownership of a project. Explain the Matrix for estimating the project benefit of an investment in a software system as well as the graphic representation in overlay of nine profitability calculations, for cumulative benefits with degrees of realization 1 to 9. Identify NPV, the net present value technique. Present the issue of project risk management.