Every entrepreneur, project manager or decision-maker in an organization needs to asses and compare different investment options.
This may include small decisions, such as the purchase of office equipment or other expenses. However, evaluating options and alternatives is crucial when it comes to considerable investments or strategic projects.
What Is an Investment?
There are probably a million definitions out there. From a cash flow perspective, an it can be characterized as an outflow of funds based on the expectation of gaining positive returns. However, those returns can also be qualitative and they are not necessarily monetary values.
It can refer to financial assets (such as investments in bonds), tangible assets (such as real estate, machines, hardware) or intangible assets (e.g. licenses and software).
Is a Project an Investment?
A project is defined as an endeavor with a defined scope that needs to be conducted under certain time and budget constraints, according to Wikipedia. It often aims to create a new internal or external (type of) product or service for an organization and often involves cross-functional teams.
This definition applies particularly well to large organizations and companies that follow traditional project management approaches. Agile project teams, smaller entities and entrepreneurs often prioritize a focus on the output or outcome rather than the organizational structure and planning.
A project requires some resource to be conducted. This involves normally people and technology, certain project types may also require other resources such as materials, vendors, land etc. Projects are initiated aiming to either generate economic benefits for a company, eliminate threats or follow legal requirements.
Therefore, projects have indeed the characteristics of investments. A project usually involves an outflow or consumption of resources. Upon its completion (sometimes even before), the output of a project is supposed to yield positive returns.
How to Determine a Worthwhile Investment?
If you need to decide about one investment option or select from different alternatives, you probably wonder how to systematically evaluate such options. There are actually several approaches to assess the value of an investment.
Qualitative and Strategic Assessment
Firstly, it is about the pros and cons of such a decision which can focus on the qualitative side. You might want to ask yourself whether an investment option improves your life or the efficiency of your organization and company. You will also take a look at the potential downside, which may include implementation risks, environmental effects and other considerations.
Depending on the decision criteria, this step can already eliminate options that are not suitable for qualitative considerations. The remaining options can proceed to the next steps.
Nobody can exactly predict the future. However, to assess an investment, it is necessary to project the expected benefits and costs that occur after the initial investment has been made. You should estimate the costs and benefits and seek input from experts, benchmarks and market data to come up with the numbers.
If monetary values are not available, e.g. in the case of qualitative benefits or internal resources that are used, try to allocate a monetary value to ensure comparability across the different options.
Quantitative Cost-Benefit Analysis
Once you have produced a financial projection, you need to perform a quantitative cost-benefit analysis (learn more at project-management.info).
The purpose of this step is to create a set of key performance indicators (KPIs) that are used to compare different options. These cost-benefit measures are used to assess and rank the different investment alternatives and eventually prepare a final decision.
Common KPIs are the Net Present Value, the Benefit-Cost Ratio and the Internal Rate of Return methods. All these approaches involve a series of cash flows representing cost and benefits that are discounted.
The net present value describes the value an investment adds compared to a predefined return rate. The benefit-cost ratio describes the ratio between present values of benefits and costs. The internal rate of return transforms the profitability of an investment into a quasi-interest rate that can be used for comparisons with the expected return rate of other investments.
The result of this step is a list with a ranking of the analyzed project or investment alternatives.
Selection and Decision
After the number-crunching, a decision on the selection of an investment or project is to be made. You should thereby consider both the ranking created during the quantitative cost-benefit analysis and the previously identified qualitative and strategic aspects.
However, do not limit your assessment to these numbers only. There is no investment without risks and you should be considerate of their probability and their potential impact. These may include strategic, environmental, political, legal or financial risks (to name just a few common ones) which could eventually turn an investment that appears attractive at the beginning into the loss-bearing endeavor.
Understanding and transparency of risks is key, and all risks incurred should be covered by an organization’s risk appetite.
Make sure you follow the requirements of your organization for decision-making. This may include involving internal project or program management offices, steering committees, c-suites and, in some cases, even applying for board approvals. In smaller companies and for entrepreneurs, this step is usually much simpler and less formal.
Making an informed decision is undoubtedly required to generate profitable returns. However, the monitoring of such endeavors is also important! If it is a project that follows a standardized methodology (such as PMI), it makes sense applying the monitoring and controlling techniques suggested by the respective standard. This may include earned value management, regular progress reporting, sprint burn-down charts etc.
Thus, you ensure transparency on the progress and the financial development of an initiative. In case things turn out different from original expectations and forecasts, you are able to identify underlying reasons and perform root-cause analyses to track down the source of the issues. With proper action taken, you are likely to bring your investment back on track.
As you have seen, it is not a rocket science identifying investments. With a strategic, qualitative and quantitative cost-benefit analysis, you will be able to find the right option for your requirements. Proper monitoring and control increases the likelihood that your investment will meet your expectations.
However, the devil usually lies in the details. Even if the pros and cons and all your numbers look good, make sure that you also understand the risks involved!
If you have done a proper holistic assessment, you are all set to kick off a promising new project.