Ali Can Ramazanoğlu-PROFILE MODELS in PROJECT MANAGEMENT

Profile Models in Project Management

Profile models allow managers to plot risk/return options for various alternatives and then select the project that maximizes return while staying within a certain range of minimum acceptable risk. “Risk,” of course, is a subjective assessment: That is to say, it may be difficult to reach overall agreement on the level of risk associated with a given project. Nevertheless, the profile model offers another way of evaluating, screening, and comparing projects. Let us return to our example of project screening at SAP Corporation. Suppose that instead of the four project alternatives for the new software project we discussed earlier, they had identified six candidates for development. For simplicity’s sake, they chose to focus on the two criteria of risk and reward.

In Figure, the six project alternatives are plotted on a graph showing perceived Risk on the y-axis and potential Return on the x-axis. Because of the cost of capital to the firm, we will specify some minimum desired rate of return. All projects will be assigned some risk factor value and be plotted relative to the maximum risk that the firm is willing to assume.

Therefore, graphically represents each of our six alternatives on a profile model. (Risk values have been created here simply for illustrative purposes.) Consider Project X4 for example. In our example, SAP can employ a variety of measures to assess the likely return offered by this project, including discounted cash flow analysis and internal rate of return expectations. Likewise, it is increasingly common for firms to quantify their risk assessment of various projects, enabling us to plot them along the y-axis. The key lies in employing identical evaluation criteria and quantification approaches across all projects to be profiled on the graph. Clearly, when project risks are unique or we have no way of comparing the relative risks from project to project, it is impossible to accurately plot project alternatives.

We see that Project X2 and Project X3 have similar expected rates of return. Project X3, however, represents a better selection choice.Why? Because SAP can achieve the same rate of return with Project X3 as it can with Project X2 but with less risk. Likewise, Project X5 is a superior choice to X4: Although they have similar risk levels, X5 offers greater return as an investment. Finally, while Project X6 offers the most potential return, it does so at the highest level of risk. The profile model makes use of a concept most widely associated with financial management and investment analysis—the efficient frontier. In project management, the efficient frontier is the set of project portfolio options that offers either a maximum return for every given level of risk or the minimum risk for every level of return.15 When we look at the profile model in Figure , we note that certain options (X1, X3, X5, X6) lie along an imaginary line balancing optimal risk and return combinations. Others (X2 and X4), however, are less desirable alternatives and would therefore be considered inferior choices. The efficient frontier serves as a decision-making guide by establishing the threshold level of risk/return options that all future project choices must be evaluated against. One advantage of the profile model is that it offers another alternative to compare project alternatives, this time in terms of the risk/return trade-off. It is sometimes difficult to evaluate and compare projects on the basis of scoring models or other qualitative approaches. The profile model, however, gives managers a chance to map out potential returns while considering the risk that accompanies each choice. Thus profile models give us another method for eliminating alternatives, either because they threaten too much risk or promise too little return. On the other hand, profile models also have disadvantages:

1.      They limit decision criteria to just two—risk and return. Although an array of issues, including safety, quality, and reliability, can come under the heading of “risk,” the approach still necessarily limits the decision maker to a small set of criteria.

2.       In order to be evaluated in terms of an efficient frontier, some value must be attached to risk. Expected return is a measure that is naturally given to numerical estimate. But because risk may not be readily quantified, it may be misleading to designate “risk” artificially as a value for comparison among project choices.

EXAMPLE

Let’s consider a simple example. Suppose that our company has identified two new project alternatives and we wish to use risk/return analysis to determine which of the two projects would fit best with our current project portfolio. We assess return in terms of the profit margin we expect to achieve on the projects. Risk is evaluated at our company in terms of four elements:

1. technical risk—the technical challenge of the project

2. capital risk—the amount invested in the project
3. safety risk—the risk of project failure

4. goodwill risk—the risk of losing customers or diminishment of our company’s image.

The magnitude of each of these types of risk is determined by applying a “low, medium, high” risk scale where 1 = low, 2 = medium, and 3 = high. After conducting a review of likely profitability for both the projects and evaluating their riskiness, we conclude the following: 

   

                                                   Risk                  Return Potential

Project Saturn                              10                             23%

                                                 
Project Mercury                           6                              16%

Figure shows our firm’s efficient frontier for the current portfolio of projects. s. How would we evaluate the attractiveness of either Project Saturn or Project Mercury?

SOLUTION

When we consider the two choices, Projects Saturn and Mercury, in terms of their projected risk and return, we can chart them on our profile model relative to other projects that we are undertaking. Figure illustrates the placement of the two new project options. Note that Project Saturn, although within our maximum risk limit, does not perform as well as the other projects in our current portfolio (it has a higher risk rating for its projected return than other comparable projects). On the other hand, Project Mercury offers us a 16% rate of return for a lower level of risk than the current efficient frontier, suggesting that this project is an attractive option and a better alternative than Project Saturn.