Project financial analysis is what happens before a project is approved, and is a way of making sure that the company is spending its investments wisely by making smart choices about what projects to take forward. Thorough analysis is important to ensure that you don’t end up doing projects that lose money.
According to The Harvard Business Review Project Management Handbook: How to Launch, Lead, and Sponsor Successful Projects by past PMI Chair Antonio Nieto-Rodriguez, there are 5 common financial metrics: opportunity costs, payback period, IRR, NPV and ROI. Let’s take a look at those.
Opportunity costs are a way of looking at what you aren’t going to do because the business’ resources will be tied up on this project. If the other projects are worth more to the business (however that is decided), then this project should be put on hold and instead the other projects should be taken forward.
You’ll need a relatively mature portfolio management approach to do this because you’ll have to identify the other projects that will be put on hold, and have budget/resource assessments for them to calculate what it would cost to do those – and have information about their benefits. If you’re in the kind of business that only does full business cases when the idea is pretty much ready to go, then this could be hard.
Even so, you should be able to include a paragraph in the financial evaluation that talks about the fact other projects will not be going ahead if the company decides to invest in this work.
This measure relates to how long it takes before the project starts to generate a return. On a programme, that could be before the end (and I’d hope it would be) because individual projects should be generating benefits as they complete.
Nieto-Rodriguez talks about the duration of the payback period being set by the organisation. Then if the project earns back the investment before that time is up, it’s a worthwhile investment. If it’s going to take longer than that, it’s time to think again. Typically, shorter payback periods are better, as it means the project starts to earn back more than it cost to do in a shorter time.
Internal Rate of Return (IRR)
I used to find IRR a difficult concept to understand, because rate of return is quite clear, but what’s the ‘internal’ all about? IRR refers to the amount the project ‘earns’ for the business. IRR is expressed as a percentage, and relates to the efficiency of the investment.
Let’s say you put your project budget in the bank and didn’t do the project. Instead, you just claimed the interest that the bank paid on the money. Your investment is safe, and you make some money back. But bank interest rates are pretty rubbish for the most part.
What if you did the project instead? The IRR calculation tells you what the ‘interest’ rate would be – it’s a different way of looking at the way project’s generate return. If the IRR is better than what you’d get in a bank, then the project is worth doing. If the IRR is less than what the bank could offer, you may as well save your time and effort and put the cash in the bank – assuming that financial returns are what you want to get.
Net Present Value (NPV)
NPV is really useful, because it helps you work out project financials as they relate to what money is worth today. A positive NPV is what you are looking for: that translates as the project forecasts being worth an amount that generates future cash at an acceptable rate.
NPV targets, minimum rates and discount rates may be set as industry standards or by your finance team, so check how if there are any specific variables or values you are expected to consider in the calculations (or better still, get a finance person to give you a template where you just plug the project forecasts in and get the NPV out). NPV is expressed as a financial value.
Return on Investment (ROI)
This measure relates to the project’s financial return given the investment made to deliver the project. In the business case or financial documents, it is expressed as a percentage of the total anticipated project cost, often including the Year 1 to 5 opex or running costs too, but the exact calculation will depend on the criteria set by your finance team.
ROI is a way to clarify what the business gets back from its investment. Typically, the higher the ROI, the better, as it means that the company is going to receive more income from the investment and it will pay off in a better way.
What is ROI?
Return on Investment.
That’s a term you’ll have come across before, I’m sure. Let’s dig into what it means and how we can use it on projects.
What’s the best ROI?
Big. Big is best! The bigger the ROI, the better, so in terms of project selection, prioritise projects with the biggest return.
Return on investment is a calculation used to work out the rate of return for a particular investment over a specific period of time. In the business cases I am most familiar with, we worked out ROI over a 5 year period.
I say “worked out” but often it is a case of plugging a few numbers into a spreadsheet that Finance provided and typing the output into the business case. Or the Finance team simply provided the numbers, based on what I gave them from the project financial projections.
ROI is often expressed as a percent. For example, if you are building a new hospital, the ROI on the new facility might be 6%. That’s 6% of the initial investment, so in order to deduce anything useful from ROI it helps to know the initial investment cost too! If it costs us £10,000 to build a new hospital (ha ha) then that’s a very different ROI to if it cost £10 million.
There are multiple different ways to calculate return on investment, and for 99.9% of what you do as a project manager, you aren’t going to need to know how it’s worked out, so I’m not going to cover that today.
What do you use ROI for?
The major point of ROI in a project environment is to compare projects. Because you are creating a percent figure, you can compare across projects, even projects that are substantively different, with different lifecycles, delivery methods, or for different clients. ROI is a great leveller in the stakes for project selection.
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