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

19.2.5c Discounting Using the Net Present Value Technique (NPV), and Project Risk

Intended learning outcomes: Identify NPV, the net present value technique. Present the issue of project risk management.

Continuation from previous subsection (19.2.5b)

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, Project Task, Work Package, Statement of Work

    Intended learning outcomes: Produce an overview on the project phases in a generic project life cycle. Identify project task, work package, and statement of work.

  • 19.2.2b The Work Breakdown Structure

    Intended learning outcomes: 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

    Intended learning outcomes: Produce an overview on the total cost of ownership of a project.

  • 19.2.5b Project Benefits and Project Profitability

    Intended learning outcomes: 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.