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Tenet #4 - Ten Tenets of Portfolio Management

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by Larry Pendergrass, Principal

Tenet #4: Apply uncertainty.

In last week’s blog, the critical need to agree on one unit of measure, money, was addressed. Even the toughest qualitative concerns about a project can be reduced to an estimate of the financial impact on that project. And any estimate is better than none, since it will force the discussions the team needs to have. Without this discipline, advocacy for a given project can degenerate into debates where the winners are not necessarily the best projects. Insist on one common unit of measure, and that measure should be money.

In Tenet #2, I admonished you to insist on being presented with alternatives when offered an opportunity. An effective PPM process must have options from which to choose. In some cases, these options may be modifications of the scale of the project being considered. But Tenet #2 should not be confused with this tenet, Tenet #4, “Apply uncertainty”. In this new tenet, we have picked a project baseline from the alternatives presented. We plan an “expected outcome” in all of the project measures. Uncertainty analysis is then applied by looking at each major variable (project scope, project schedule, project cost, market acceptance and market share taken, etc.) in the project and stating a range of probable inputs. In the end, it is possible to show how the primary financial measures (like NPV of cash flows) change over the range from worst case, to expected value to best case. Note that this uncertainty analysis is not just done once during the proposal phase and then forgotten. It must be carried with the project throughout the execution phase, updated as necessary and used at any time to compare to other potential projects.

There are at least 3 reasons to apply uncertainty:

 

  1. To provide a more realistic view of a given project for better PPM choices. Providing uncertainty analysis will spark discussions of the upside and downside risk of a given project, as compared to other projects under consideration. Often the expected values shown in a single set of financials do not provide enough information on which to make a good decision for a given project proposed for the portfolio. Providing uncertainty analysis for each project allows the PPM team to fully understand what could happen in the best and the worst case, and to take this into account in their decisions.
  2. To create a common understanding of risk of chosen project. If only the “expected values” are shown and discussed during project acceptance, it is likely that this exchange will be taken as a contract with the advocating manager and failure to achieve any one of the variables in the project will be taken as a failure. On the other hand, early discussion of the uncertainties in the key variables and the resulting impact on financials will serve as a useful as a reminder to sponsors during the execution of the project.
  3. To highlight key variables on which to focus during project execution to maximize return. Once we have a clear understanding of the impact of each key variable on the project outcome, the project manager and the project team can focus extra effort on this key variable in order to maximize the results in accordance with the company goals. For instance, if it is seen that the NPV of cash flows is most impacted by the schedule of the project, more so than the project cost, it may be prudent to hire several contract engineers to assure the schedule is met.

Without uncertainty analysis, a firm is likely to suffer from many issues including:

  • Poor decisions on PPM including not enough understanding and balancing of the risk undertaken.
  • A culture of constant beatings of project advocates during project execution, since it is nearly impossible for all of the variables in a project to be guessed correctly.
  • A contract-like culture where changes to the plan are less likely, and managers stick to the original agreement despite a better variable combination, since the range of possibilities and the impact on the overall value to the firm is not well understood.
  • A less than optimum output from a project, since the project manager does not understand which variable will cause the greatest impact on the project success.

I worked for a company that was embarking on a very large investment to replace an aging, expensive, high-tech product sold to a few powerful customers. This project was on the edge of profitability even without uncertainty analysis added. Since this was the first in a planned three project series, in an unusual step the team even added value to the financials through option analysis, accounting for the added value of “buying an option” to do the follow on projects. Still, the project was on the edge of profitability. This was a company that did not practice the use of uncertainty analysis. Nor did it convert the “strategic need to retain a key customer” into added financial valuation. So it only created trouble when later the project was in distress, and the project manager revealed his knowledge of the down-side possibilities and the impact on the financials. The possibility of events that resulted in angry accusations and finger-pointing would have been revealed at the start of the project if the use of uncertainty analysis had been practiced. The financials would have revealed a much higher risk from the start. We may still have gone through with the project, especially if we estimated and added in the monetary value of the “strategic need to retain a key customer”. Even so, everyone in the organization would have known and understood the risk, walking into the project with their eyes completely open. As it was, perhaps the wrong heads rolled as blame was placed squarely on the execution team.

As a final note, it should be stated that for most of these tenets of PPM, but especially for this one, it is essential to develop a culture of trust, of truth in data and objective examination of the options for maximizing the value to the firm. Little of the benefit of a good PPM process will be achieved if the data presented is false or colored with the agendas of the participants, and the team is not able to examine all of the data together and come to unbiased conclusions.

Develop this trust, openness and honesty. Insist on uncertainty analysis as a natural expectation for the PPM process.

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