Don't Forget Financial Metrics
The traditional financial metrics should be used to determine the direct financial (or "hard") components of project value. Project investment cost is, of course, an important financial metric for any project. Projects that impact operations (e.g., projects that create new products or cut costs) produce additional financial impacts that should also be evaluated. Thus, any significant, incremental, period-by-period cash flows that are anticipated to result from such projects should be estimated, either directly as an average or in the form of alternative scenarios. The organization's standard accounting model may then be used to determine the after tax, or unencumbered "free" cash flows, which may be used to compute a project's financial NPV.
Some important principles for estimating financial value in support of project prioritization include:
- Ignore previously paid, sunk costs.
- Include opportunity costs (the opportunity cost of a resource is the value of the net cash flow that could be derived from it if it were put to its best alternative use).
- Include overhead expenses (e.g., administrative expenses, managerial salaries, legal expenses, rent) that are directly related to a project. Indirect overhead can, if necessary, be prorated across proposed projects.
- Include "spill over" effects. For example, if a project introduces a new product or service that draws sales from existing products, include such lost revenue in cash flow estimates.
- Interpret expected project cash flows submitted in support of a project proposal as commitments to be achieved by the project manager. If there are cash flow components that are more speculative or for which the project manager cannot be held accountable (e.g., because they are contingent on events beyond the control of the project manager), specify such cash flows separately and assign probabilities.
- Identify and include any terminal cash flows, for example, cash flows expected from the disposal of assets when the project is terminated.
- Be consistent in accounting for inflation. For example, using an inflation-adjusted discount rate while ignoring inflation in estimating cash flows would result in a bias against accepting projects.
- For the purposes of prioritizing projects, remember that the project's financial benefit is its NPV exclusive of its current-period costs.
Be suspicious of long-term, positive NPVs. Keep in mind the economic axiom that excess profits (the source of positive NPV) are zero in a competitive market. For a project to have a positive NPV, it must have some competitive edge -- be first, be best, be the only.