Tuesday, September 24, 2019

What Are the Real Opportunity Costs of Your Project?

Opportunity cost should be one of the biggest factors in your project portfolio valuation
There are two ways to lose money on any given project

1) Create business value less than your actual cost.

2) Create business value less than your opportunity cost.

The first is clear to most people, and is used by most organizations to determine which projects to do and which not to do.

The second is not so clear, and unfortunately, it's ignored or misunderstood by many organizations … which is a missed opportunity by itself.

One of the biggest factors in the valuation of a project portfolio should be opportunity cost.

When you hear the term "opportunity cost" you are really hearing a fancy word for "tradeoff." Every time you make a choice, there is a tradeoff to consider. You must analyze what you are gaining as well as what you may be giving up.

Unless you have sufficient management bandwidth, technical capability, time, and money to execute every idea in your project portfolio, you will only be able to fully pursue some of the projects.

The remaining projects will either be set aside completely or, worse, be underfunded and understaffed, never getting the resources necessary to reach either success or failure.

It’s usually straightforward to understand the cost of the projects you pursue, but it is not always easy to understand the opportunity cost of the portfolio choices you make.

Value Ranges

One view of your project portfolio should be on the estimated value ranges of the included projects. To do this it is necessary that you estimate these values based on ranges and not on points (single value). One of the most straightforward and most used methods is the so-called three-point estimation.

The three-point estimation technique is used in management and information systems applications for the construction of an approximate probability distribution representing the outcome of future events, based on very limited information.

While the distribution used for the approximation might be a normal distribution, this is not always so and, for example, a triangular distribution might be used, depending on the application.

In three-point estimation, three figures are produced initially for every distribution that is required, based on prior experience or best guesses:

a = the best-case estimate
m = the most likely estimate
b = the worst-case estimate

These are then combined to yield either a full probability distribution, for later combination with distributions obtained similarly for other variables, or summary descriptors of the distribution, such as the mean, standard deviation or percentage points of the distribution.

The accuracy attributed to the results derived can be no better than the accuracy inherent in the three initial points, and there are clear dangers in using an assumed form for an underlying distribution that itself has little basis.

Based on the assumption that a double-triangular distribution governs the value of your projects, several estimates are possible. These values are used to calculate an E value for the estimate and a standard deviation (SD) as L-estimators, where:

E = (a + 4m + b) / 6
SD = (ba) / 6

E is a weighted average which takes into account both the most optimistic and most pessimistic estimates provided. SD measures the variability or uncertainty in the estimate. In project evaluation and review techniques (PERT) the three values are used to fit a PERT distribution for Monte Carlo simulations.

When you put these in a chart it can look like below.
Portfolio View - Range of uncertainty
Each bar in the chart represents the range of value of a single project, where the range is determined by the uncertainty in the success factors of that project.

The thin white line in each bar is the most likely value. In this example, the most likely value of Project A is the largest of the portfolio projects, but more significantly, the potential upside of Project A stretches far to the right. With a well-crafted and executed plan, the actual value of Project A could be more than the combined value of projects E, F, G and H.

Each project, regardless of its significance, requires a certain amount of management attention to pursue. Managing projects E, F, G and H takes away from the attention available to manage Project A for maximum upside.

The champions for small projects may not see the opportunity cost from not redeploying their efforts to higher-growth projects. However, you can see that Project F also has a big upside; finding a way to pivot this project toward that upside can make it more valuable than Projects C or D. Set aside less significant projects — or pivot them to more growth — to reduce your portfolio’s opportunity cost and increase its overall value.

Difficulty to Realize Value

Another view on your portfolio should be on the difficulty to realize value. Difficulty is as different as costs. It is an estimation based on scarcity of skills and knowhow.
Portfolio View - Difficulty to realize
Scarcity of technical resources, such as engineering and marketing hours, affects each project’s chances of technical success, its potential value, or both.

At the top of this view by difficulty are easy projects that require less effort: Bread and Butters offer small returns and Pearls offer large returns. At the bottom are difficult projects requiring a great deal of effort that may not pay off: White Elephants offer small returns for the extra risk and Oysters offer potentially high returns.

Pursuing White Elephant projects creates opportunity cost in the form of resources that could be used to drive growth through creating and cultivating Oysters. Examine each White Elephant project to determine if it can pivot to be a high-potential Oyster; if it can’t, cancel it and redirect those resources to other projects to increase the overall upside potential of the portfolio.

Time to Realize Value

The third view you should have on your project value is time vs. estimated value. Time is another driver of opportunity cost. Cash velocity — the rate at which cash invested in business operations generates revenues and billings that replenish that cash — is relevant for your project portfolio.
Portfolio View - Time vs Value
Some projects require a few months to turn R&D investment back into cash-generating products or services; others may take years. A small-return project that completes quickly frees up development resources for the next project: the quick turnaround boosts cumulative returns.

Conversely, a small-return project that ties up resources for years creates the opportunity cost of preventing you from conducting several small projects in the same span of time.

Slow projects are Snails (small returns) or Tortoises (large returns); fast projects are Rabbits (small returns) or Racehorses (large returns).

Costs to Realize Value

Opportunity cost also stems from scarce financial resources. Fully funding one project over another means incurring the opportunity cost of forgoing the second project. However, fear of incurring the opportunity cost and/or sunk costs of killing some projects outright often leads to too many underfunded projects.

Because underfunding can lead to failure of projects that would otherwise succeed, this strategy often has a greater opportunity cost than committing to some projects and cancelling the rest.
Portfolio View - Cost vs Value
The cost vs. value chart helps in allocating the budget efficiently by ranking projects by their ROI, or return-to-cost ratio. In the example, the budget is sufficient to fund projects E, O, D and C, and no other combination would yield greater total value. The vertical lines indicate that management can choose to cut the budget to just fund those four projects without losing potential value, or choose to increase the budget to capture the value from funding Project G.

Understanding the costs of your available opportunities — in difficulty, time and money — is the key to assessing the opportunity costs of your portfolio choices. You'll have a better chance of creating business value that's higher than your opportunity costs, which means higher returns and fewer losses.

When your organization needs the tools and training to understand the drivers of value in each of your projects, to find and unlock upside potential, and to make the most of your opportunities while minimizing opportunity costs, just give me a call.

In a nutshell: One of the biggest factors in the valuation of your project portfolio should be opportunity cost.

You can buy my eBook The Project Valuation Model ™ by clicking here or on the image.

Posted on Tuesday, September 24, 2019 by Henrico Dolfing