Risk-based project value analysis – contributed value and procurement cost

1. Risk-based project value analysis – contributed value and procurement cost 3rd International Conference on Project Management 28 September 2006 Sydney, Hilton Tomoichi Sato JGC Corporation (c) Tomoichi Sato, JGC Corporation, 2006

2. Introduction • Conventional approach: different methodologies for different aspects of evaluation. • New approach: single theoretical framework “RPV” Project evaluation DCF method Progress measurement EVMS Procurement cost evaluation Bid tabulation Project evaluation Risk-based project Value (RPV) Progress measurement Procurement cost evaluation (c) Tomoichi Sato, JGC Corporation, 2006

3. Task B (sales) Risk factor 10% Task A (development) Risk factor 50% $ -20 $100 RPV $80 $100 Task B Contributed value = $10 RPV $25 $ -20 Task A Contributed value = $45 RPV $70 Basic concept of the RPV (risk-based project value) • Simple “project Z” with two tasks. • Initial cost = –20, sales revenue = 100. Risk factor = 50% and 10%. • If 2 tasks complete successfully, obtained value = 100 – 20 = 80. • Expected revenue = 90 before task B, and 45 before task A due to risk factors. Risk-based project value (RPV) = 70 and 25 respectively. • Obtained (earned) value by task A = 70 – 25 = 45, for B = 80 – 70 = 10. (c) Tomoichi Sato, JGC Corporation, 2006

4. RPV calculation method • Initial RPV for single task project: where, S=revenue, C=cost, r=risk factor (probability of failure). Risk factor r is subjective probability in Bayesian inference. • Initial RPV for project with two tasks: • RPV before task i for a project with multiple serial tasks: where, Si, Ci, ri are revenue, cost, and risk factor of task i (1) (2) 1 2 i-1 i i+1 n (3) (c) Tomoichi Sato, JGC Corporation, 2006

5. Projects with parallel tasks • Calculation of parallel tasks’ risk factors • If parallel tasks exists in a project (normally they do), combine them to make a single task. • Risk factor for the combined task (j*k) : • Value contribution of parallel tasks • First, obtain value contribution of the combined task (j*k) : • Then, divide it in proportion to the risk factors of task j and task k : , and rj ri rj*k rm ri rm rk (4) (5) (c) Tomoichi Sato, JGC Corporation, 2006

6. RPV and NPV in DCF method • Net present value (NPV) of DCF method is based on “time value of money” concept; future cash flow should be discounted by cut-off rate (COR) to the present value. COR (R) is like interest rate and determined by capital costs. • For a simple project with cost C and revenue S, NPV is calculated as: • Risk-based approach: future revenue is reduced due to risk factor • Investor to this project may require risk premium R . • R should be determined so that the expected return is not less than loss in failure. • Hence, as minimum, • Therefore, two approaches gives the same result • DCF method assumes flat risk factors throughout the project life cycle. (6) (7) (8) (9) (c) Tomoichi Sato, JGC Corporation, 2006

7. Value contributed by the task • After successful completion of each task, RPV increases. This increment can be regarded as the value contributed, or “earned”, by the task. • From equation (3), contributed value of task i can be obtained as: • If we denote then, • These equations show that the value contributed by a task is proportional to its risk factor. • If the task has no risk, there is no value contribution. The higher the risk is, the greater the contributed value to project. (10) (11) (12) (c) Tomoichi Sato, JGC Corporation, 2006

8. Progress measured by contributed task values • Conventional Earned Value Analysis (EVA) has regarded the budgeted cost of each task as its value (BCWS). • Progress measurement of EVA is defined as: • In product development project, costs for early “soft tasks” are normally smaller. Successful development of product concept earns only small value. • RPV approach gives greater values to early soft tasks with higher risks. Progress measurement should base on contributed value, enabling more meaningful progress control. • Progress (%) • If Task A successfully completes in “Project Z” in slide 3, project progress = 45 / (80 – 25) = 81.8 %. (13) (14) RPV $80 Task B Contributed value = $10 RPV $25 Task A Contributed value = $45 RPV $70 (c) Tomoichi Sato, JGC Corporation, 2006

9. Procurement cost evaluation process • Typical process in the project procurement management • Basic principles: • Inquire from multiple sources • Ensure “apple to apple comparison”. Create requisition to define vendor’s scope of work and technical specification precisely. • Procedure for the fair competition • bidders should submit technical proposal and commercial proposal separately. • Technical professionals make technical clarification and evaluation without looking commercial prices. • Select the vendor with the most commercially competent among acceptable vendors. Procure-ment Plan Vendor survey Spec. & Requisition Inquiry Bid Tabulation Order placement (c) Tomoichi Sato, JGC Corporation, 2006

10. Risk-based cost evaluation • Purchasing and outsourcing has always risks associated: fail to deliver products or services, fatal schedule delay, quality anomaly, bankruptcy, etc. • How can we compare vendors: reliable but costly one vs. risky cheap one? • From equation (10) and (11), we can deliver following formula: • Note that Hi+1 is not dependent on Ci. Therefore, condition to select vendor A should be; • Conventional vendor selection is based on price comparison (Ca < Cb). Equation (14) shows risk factors should also be taken into consideration. (15) (16) (c) Tomoichi Sato, JGC Corporation, 2006

11. Concept of the critical cost • It is not always easy for each buyer to calculate Hi+1 on procurement stage. Much simpler approach is needed. • Consider C* as the maximum cost payable to the procurement task. Its condition is; • Comparing two vendors, the following relation can be delivered: • we can define a new criteria Cr, “Critical Cost”, as follows: • In comparison of more than one vendors, evaluate each Critical Cost Cr and select the smallest one. (17) (18) (19) (c) Tomoichi Sato, JGC Corporation, 2006

12. Critical cost vs. risk factor (c) Tomoichi Sato, JGC Corporation, 2006

13. Project portfolio value and “extended DIPP” • Project portfolio value • Remaining value of an ongoing project : where, n = final task, i = current task • RPV can be calculated at any timing, unlike DCF method which is limited in the planning phase. Enterprise project portfolio value is summation of all projects’ remaining values. • Extended DIPP index • S. Devaux proposed “Simple DIPP” as an index to evaluate project profitability; expected revenue divided by cost ETC. • DIPP can be extended using RPV as follows: • Extended DIPP normally reaches peak just before the production start. (c) Tomoichi Sato, JGC Corporation, 2006

14. Conclusion • Theoretical framework of risk-based project value (RPV) analysis is proposed. • RPV equals to NPV of DCF method if all tasks are supposed to have the same risk factors per time. • RPV calculation method is presented for projects having complex task networks. • RPV analysis can provide three application fields. • (1) Contributed value of tasks. • (2) Procurement cost analysis. • (3) Portfolio management. • Further development with real project case studies is essential, and the author is glad to have any collaboration opportunities. (c) Tomoichi Sato, JGC Corporation, 2006