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This presentation will examine portfolio selection through the popular lens of project prioritization or ranking. In it, I will look at project ranking on the basis of strategic and financial decision criteria and calculate the financial value created by such a methodology. By way of comparison, I will then rank projects on the basis of a single financial criterion and run the corresponding calculation. What I hope to demonstrate is that while strategic considerations are doubtless important to the sustainability of business excellence, there can often be a cost associated with portfolio selection on the basis of non-financial decision criteria. The challenge, in my view, is to quantify the financial impact of all relevant aspects of your decision-making before you commit to a decision. And no, this presentation does not imply that strategic considerations are unimportant to portfolio selection. So, let’s begin by taking a look at some of the common pitfalls of project selection when decisions are made on non-financial criteria.
I’m sure that the vast majority of you have encountered one or other of these statements during a project selection review. One of my all time favorites is this one this one “I know the NPV doesn’t add up, but this project is filled with strategy”. By the way, this one is not far behind “We must be able to afford this project; let’s just cut every other project investment by 10%”.
So, here’s a case study of Value Creators ‘R’ Us that wants to select its portfolio by rank ordering projects on the basis of both strategic and financial criteria. Further, the company has decided that it will measure strategic value on the basis of Leadership Differentiation & Competitive Advantage and it will measure financial value on the basis of Net Present Value or NPV. Naturally, the company wants to maximize both strategic and financial value and it has decided that both components are equally important to decision-making. Consequently, both goals are equally weighted at 50%.
This table of data shows – for each of the 10 projects in the portfolio (HERE) - the categorical descriptors (in this column) for Leadership Differentiation & Competitive Advantage as well as the numerical values (in this column) for NPV. In the final column, we see the 2016 cost associated with each project. Note (ANIMATION) that while the entire portfolio requires $200M, the budgetary constraint for 2016 is $125M. Now, how do we convert these categorical descriptors (HERE) and numerical values (HERE) to a common currency that facilitates an apples-to-apples comparison between all projects?
Well, we need to create a utility function that measures the level of ‘usefulness’ or ‘attractiveness’ or ‘value’ for each of the decision criteria, while taking into account the organization’s risk preference. So, this organization has chosen to measure the attractiveness of Leadership Differentiation & Competitive Advantage along 5 categorical thresholds i.e. Low Comparative, High Comparative, Low Competitive, High Competitive, and Absolute. Once each threshold is well defined, a utility score from 0-10 is assigned to each threshold. Note: this organization has decided that, based on its risk preference, there is a disproportionate jump in value between a Low Competitive score (HERE) and a High Competitive score (HERE).
(ANIMATION) Likewise, a utility function is created for NPV. This one is easier to construct because the numerical values are readily quantifiable.
The common currency therefore, for both utility functions is a util.
Based on the utility functions described in the previous slide, each categorical descriptor and numerical value is converted to a raw utility score. For example, a categorical descriptor of ‘Low Competitive’ is worth 5 utils (HERE) while a numerical value between $3,000 B and $3.499 is worth 8 utils (HERE). Parenthetically, the term ‘raw’ is used to describe a score that has not yet been weighted.
So, let’s go ahead and weight these raw utility scores based on their absolute levels of importance to decision-making i.e. to project prioritization. This is rather easy because, since we have only 1 criterion for each goal and both goals are equally weighted, the absolute weight of each criterion is 50% or 0.5. In this case, the raw scores from the previous slide are weighted at 50% to create the weighted scores shown in this table (HERE).
A simple rank order or prioritization of the 10 projects in the portfolio is shown here where projects with the highest weighted utility scores (HERE) rise to the top and those with the lowest weighted utility scores (HERE) flow to the bottom. Now, we simply add up the cost of each project from top to bottom until we hit our budget constraint and that occurs (ANIMATION) here. The results is (ANIMATION) that the company can afford to pursue the top 5 projects (HERE) D through I but cannot afford to pursue projects below the red line i.e. projects A through B. The economic results is that this portfolio is worth roughly $9.5 B. This is certainly a good portfolio that best meets the goal of maximizing both strategic and financial value.
But, how does this compare with a portfolio that is selected on the basis of financial value alone?
Well, what this means is that the weight of the single decision criterion – NPV – is now 100%.
Again, a simple rank order or prioritization of the 10 projects in the portfolio is shown here where projects with the highest weighted utility scores (HERE) rise to the top and those with the lowest weighted utility scores (HERE) flow to the bottom. Now, we repeat the process by simply adding up the cost of each project from top to bottom until we hit our budget constraint and that occurs (ANIMATION) here. The results is (ANIMATION) that the company can afford to pursue the top 5 projects (HERE) D through C but cannot afford to pursue projects below the red line i.e. projects J through A. The economic results is that this portfolio is worth roughly $13 B. This is certainly a good portfolio that best meets the goal of maximizing financial value alone and is a more financially rewarding portfolio than that shown before at $9.5 B.
So, which portfolio do you prefer? The one that seeks to attain the highest strategic and financial value OR the one that seeks to attain the highest financial value?
Clearly, both portfolios are good (i.e. they create a lot of value) and actionable (i.e. they do not violate the year’s budget constraint). So, let’s examine a few considerations more closely.
A recommended approach to resolving the dilemma surrounding the question as to which is the better portfolio is to use ‘strategic value’ as a pre-filter to project selection. Let me be more explicit. Before prioritizing your projects on one or multiple decision criteria, determine, a priori, if each project fulfills a desired strategic intent i.e. is it ‘on strategy’ or ‘off strategy’. If it is ‘on strategy’, proceed to the prioritization step and stop debating its strategic importance. On the other hand, if it’s ‘off strategy’, there are really 3 major choices – (a) stop investing in it and do not proceed to the prioritization step OR (b) if it is a project that is deemed to be a quasi-policy decision (i.e. irrespective of its strategic value, it must be a part of the prioritization discussion), move to the prioritization step OR (c) if it is a true policy decision, exclude it from the prioritization exercise but account for its funding so you are now working with a budget that is less than $125 M for the reminder of projects because this project must be funded.
But, what should be the goal of the prioritization step? To attain the highest strategic and financial value? No, it should be to attain the highest financial value only because you have already filtered away projects that are ‘off strategy’ and accounted for projects that are deemed to be true policy decisions.
If you are successful is doing that, there is a high likelihood that your portfolio selection process will be much less bogged down in politics and become more objective, rational, and defensible. Lastly, if I go back to my 2 least favorite reasons for project inclusion, I hope we can agree that (HERE) ‘strategic value’ doesn’t necessarily add financial value to a project and, even though I did not touch on the subject of project funding that (HERE) simply cutting every other project by 10% to make way for a particular project is simply poor Portfolio Management practice.
So, I hope I’ve given you some food for thought in preparation for the next time you help engage your decision-makers in a project prioritization exercise for portfolio selection.