Finding the Right Metrics
What kinds of metrics reflect impacts on value? Many organizations have trouble answering this question. Organizations tend to measure what is easy to measure, not necessarily what is important. Most organizations use a bottom-up approach. They define interesting metrics, but then can't come up with the algorithms for computing value based on those metrics. Unless there is a way to combine the metrics to determine the value added by projects, the metrics will not be of much help in identifying value-maximizing project portfolios. How can you determine the value added by projects?
Create a Value Model
The answer is -- you need to reverse the process, use a top-down approach and create a value model. The value model describes the various ways that projects create value, e.g., shareholder value, stakeholder value, or mission value. Identifying the ways that a project creates value requires judgment. In the case of shareholder value, judgments are similar to those made by careful investors and Wall Street analysts. Since the model is based on judgment, the model's assumptions must be clear so that they can be discussed, debated, and set to reflect best-organizational understanding of what the organization does how it does it, and how it's choices determine the value it creates.
Building a value model is not as difficult as it may sound. Even a fairly sophisticated value model can be constructed in a 2-3 day framing workshop (using techniques based on multi-attribute utility analysis, influence diagramming, and causal modeling). The model captures the understanding of the organization's experts in relevant areas such as R&D, engineering, manufacturing, marketing, sales, customer relations, legal counsel, regulatory affairs, etc. The value model establishes an explicit connection between the characteristics of the business that may be impacted by proposed projects and the value ultimately derived. Figure 4 provides an example.
Figure 4: Portion of value model linking characteristics and impacts of
proposed projects to value creation (electric power delivery company)
Having a value model is critical to making intelligent project decisions. Project value determines whether the project should be done at all, and whether, after it has been started, it should be continued. But, the value model has other uses as well. For example, a value model provides a way to estimate the value of a day of schedule, the value of a project feature, or the value of a dollar of project cost. The project team or portfolio manager can use the value model to illustrate how a marginal change in resources, say plus or minus 10%, might affect the overall value to be generated. A value model is a means for explaining and justifying the resources required for doing projects.
Once you have a value model, it is relatively easy to define the right project metrics. The desired metrics are "observables" (discussed next) that influence the model's value drivers; that is, those project characteristics and impacts, i.e. model parameters that have the greatest influence on value. These typically include forward-looking financial metrics, like NPV, but also factors and considerations on value paths that don't directly impact cash flows. The latter can include indicators of the contribution of the project to the organization's capability and knowledge, customer satisfaction, and even political and regulatory impacts.
Metrics for these other sources of project value must be included along with the financial metrics. Otherwise the value of projects will be underestimated and there will be a bias against doing projects whose benefits cannot readily be expressed as cost savings or revenue increases. Note that metrics need to represent timing, that is, when the project benefits are likely to occur, and the risks, e.g. the likelihood that the project will actually produce its anticipated benefits. When all such metrics are specified, the model defines the aggregation equation that allows the value of a project to be expressed in dollar terms. In the case of a privately owned company, for example, this represents the estimated impact of the project on shareholder value.
2. The recommendation to develop a value model and, more generally, the views and ideas expressed in this and the next part of this paper are shared by many decision analysts. See especially "Choosing the Right Metrics for Measuring, Monitoring, and Maximizing Shareholder Value," C. Spetzler and R. Arnold, www.sdg.com, May 2003. The book "Value Focused Thinking" by Ralph Keeney describes many of the concepts and techniques for building value models.
3. The figure is derived from an application described in E. Martin and M. W. Merkhofer, "Lessons Learned - Resource Allocation based on Multi-Objective Decision Analysis", Proceedings of the First Annual Power Delivery Asset Management Workshop, New York, June 3-5, 2003.