Calculating real values of activities - an introduction to the risk-based project value

“A Guide to the Project Management Body of Knowledge” (PMBOK Guide)(R) by Project Management Institute (PMI) has been introduced to Japan and widely accepted by the IT industry in recent 10 years. As it became well known, technique of Earned Value Management System (EVMS) has also been widely tried put in practice. EVMS is a very useful tool that can monitor and control cost and progress of a project at the same time. In Japan, the concept of “Earned Value” (EV) has corresponding word “Dekidata” (出来高). This word and concept can be tracked back even to 18c Edo-era in Japanese construction industry. However, we could not develop any management system using EV, which is a bit pity for us.

By the way, introduction of the EVMS seems to have made many practitioners to hold a misperception that it is applicable and powerful to control any types or situations of project. No, it is not. The EVMS should be used carefully with appropriate premises and methods. It is not an omnipotent tool.

The weak point of the EVMS may be clearly understood when we try putting it to the research and development (R&D) type of projects for new products. Let us consider very simple example: suppose there are two people starting a garage company. One is an engineer and the other is a salesman. The engineer has made a brilliant new idea. With this idea, he thinks he can make a very unique product having new features from parts and materials costing only $2,000 amount. The salesman says to the engineer that he can easily find a customer to buy the product at a price of $10,000 if it is really manufactured and be functional.

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However, the engineer thinks success probability of making the product would be fifty-fifty, as it is the first attempt for his new invention. On the other hand, the salesman is 90% confident that he could find a customer. It is a very simple new product development project with only two activities: development activity and sale activity. Initial cost of the development activity requires $2,000. Sales activity would cost only some phone calls and transportation, therefore negligible small.
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Now, here is a question. Suppose their project have just successfully completed the first activity, development. The engineer has fabricated the new product and it’s functional. Then, what is the current project progress in percentages? How do you think?

Conventional EVMS tells us that the project progress percentage should be measured by current EV divided by total EV (which equals to the total budget of the project). In this case, current EV is $2,000, and the total budget is also $2,000. Therefore, progress becomes 100% even though they have completed the first activity! Do you concur to this calculation?

Clearly, this calculation does not match perceptions by practitioners. You cannot manage projects properly, with measurements which is not acceptable to people. Some may argue that a cause of this problem is in the assumption of zero cost in the second activity for sales. Then, let’s assume sales may cost $10. Progress calculation now becomes 2,000 / 2,010 = 99.5%. When we round up after the decimal point, it is still 100%. It does not resolve this issue. You can see challenges when we apply the EVMS progress calculation automatically to new product development projects.

What is the root cause of this issue? It comes from the assumption widely used in EVMS that “budgeted cost of an activity is regarded as its value”. It means that low cost activities are low value activities, in other words. In general, costs of intellectual activities such as design or concept development are relatively small because it just human salaries. To the contrary, manufacturing or implementation activities normally cost higher as they require material and outsourcing expenses. Physical labors are high value than intellectual world. EVMS has evolved in procurement projects in the US DoD. Cost-based progress measurement seems to have been base of their way of thinking.

If the cost-based progress calculation is not acceptable, then how about this? “This is a collaborative project with two persons, so, we say 50% progress at the completion of the first half.” However, this is not a theoretical resolution, rather a political compromise. What do we say if development needs 2 persons or sales takes 5 guys? Progress measurement system depending on political voice power may not be useful in the fair management. Then, what should we do?

I give the answer first. We can calculate progress with "risk-based value” of the project activity. In this case, it tells us the current progress = 81.8%. New product development projects are collaborative endeavors undertaken to attain unique outcome, which are always associated with risks of failure. In fact, any project is associate with risks. In such cases, theory of the risk-based value analysis of projects are applicable and useful. Let me describe it in the below sections.

The above contradiction with the EVMS comes from assumption that value of an activity is its budgeted cost. It gives us 100% completion in the middle of a project. In order to avoid this, we have to weigh the real value of an activity in the project. Then, what is the “real value”?

Let us simplify this project. How about making it into a single activity project of “make-and-sales”? It requires initial cost of $2,000. Risk probability of failure of this project equals to 55%, because 100% - 50%×90% = 100% - 45%=55%. If this project successfully completes, then it will bring out monetary value of $8,000 as a profit.

However, at the beginning of the project, revenue of $10,000 is not assured. Its expected value is calculated as just $4,500, because 10,000 x 45% = 4,500. On the other hand, it is sure they have to expend $2,000 as an initial cost for parts and materials. Therefore, the expected monetary value of the project is just $4,500 - $2,000 = $2,500 at the starting point. Success of “make-and-sales” activity will increase and realizes their project value from $2,500 to $8,000. It will contribute value to the project by $5,500 (= $8,000 - $2,500).

Let me put this in other way. Value contribution of an activity can be expressed as an increase of the expected monetary value of the project; the difference of values before the activity’s starting point and after its successful completion. Expected monetary value of a project is determined by costs and incomes (cash flows) of its consisting activities, and risk probability of failure associated with the activities.

Then, what would be with the project with two activities: development and sales as in the original example. Let us calculate. Expected monetary value of the project (we call it “risk-based project value", or RPV in short, hereinafter) is as follows:

After completion of “sales” activity: $10,000 - $2,000 = $8,000.
After completion of “development” activity: $10,000 x 90% - $2,000 = $7,000.
Before starting of “development” activity: $10,000 x 90% x 50% - $2,000 = $4,500 - $2,000 = $4,500.

Therefore,

Value contribution of “sales” activity = $8,000 - $7,000 = $1,000.
Value contribution of “development” activity = $7,000 - $2,500 = $4,500.
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Total contributions of the two activities are $5,500 in total, which corresponds to the value contribution of the “make-and-sales” activity in the simplified case.

Now, we are ready to measure the progress. They have just completed the development and are about to start the sales. Progress can be obtained as attained (“earned") contributed value divided by total value contributions, like the EVMS tells us. It is,
$4,500 / $5,500 = 81.8%.

OK? Real value of an activity is represented by an increase of the project’s expected value before and after of the activity execution. The value depends on risk probabilities of failure with project activities. Please see the above example. Value contribution of development is greater than that of sales. This difference comes from the fact that the development has higher risks, or in other words, more difficult. The more the work difficult, the more it brings value when successfully completed. The theory of risk-based project value proves why our common-sense insights are true.

What if the risk probability of sale in the above case is zero? You can immediately see the value contribution by the sales equals to zero. Activities with no risks are zero values to contribute to the project, even if they are necessary to complete.

Practical projects have activities far more than two, and there are parallels projects. Even with these cases, calculation of the RPV and value contribution of activities are possible. Please see my academic papers in the references.

And, please see the above case once more. Conventional management theory has usually treated as development as the “cost center” activity and regarded the sale as “profit center” one. This is one background of the phenomenon that sales sections have more influential power in companies. However, if we compare real value contributions of the two activities in the above case, development has greater value. It is clear which is more important in the viewpoint of management.

The theory of risk-based project value enables evaluation of components in value-chain in a enterprise or calculation of added-values in a supply chain. This was made possible because we included concept of “risk probability” into cash flow analysis. I hope the readers understand how this theory can be a powerful tool for us.

References:

(1) Sato, T. (2014): “Risk-based project value – the definition and applications to decision making”, Procedia - Social and Behavioral Sciences. Vol. 119, pp.152-161.
(2) Sato, T. (2009): “Risk-based Project Value Analysis: General Definition and Application to Progress Control”, Journal of Japan Industrial Management Association Vol. 60, No. 3E.

Please also listen to my podcast from PMI (Project Management Institute) series, which is available from below URL.
https://www.pmiwdc.org/pm-pov/2016/04/advances-in-pm-part-2
by Tomoichi_Sato | 2016-06-10 06:53 | English articles | Comments(0)
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