Decision Making Process in an Organization
The main focus of this report is on decision making process in an organization and various tools and techniques that assist the managers in taking logical and rational decisions.
Project Management is one of the important tools and techniques available to the organization through which it can ensure that the set target is achieved in required or allocated budget and timeframe. It also helps managers to track and monitor the progress of a project and identify and rectify deviations, if any. Hence, the report will discuss the phases and importance of project management from the perspective of managers and decision making process. It will also shed light on various tools that can assist in project management.
An organization is typically involved in more than one project and sometimes it may be represented with multiple opportunities but limited funds and resources that can be allocated. In such cases, the organization needs to carry out feasibility analysis and select the project that optimises the output and targets. Hence, the report will focus on project optimisation and what techniques can be sued to assess the most suited projects that should be selected. The major discussion will be around Net Present Value method and Internal Rate of Return method.
An organization conducts various planning and forecast exercises that are based on certain assumptions and estimates. This holds true for feasibility analysis as well where multiple assumptions are made, including expected cash flows. However, sometimes the forecasted estimates may prove to be inaccurate and in such situation, the selected project opportunity may actually prove to be worse than the rejected opportunity. In order to avoid such scenario, an organization conducts sensitivity analysis for various inputs so as to observe the variations basis changing inputs and take an appropriate decision accordingly. Hence, the report will also discuss sensitivity analysis through an example taken forward from project optimization stage.
With the new advancements and technologies, any organization uses a plethora of these available tools in order to attain success sin the work environment and achieve the organizational objectives. One of such techniques is called project management which helps to attain desired objective in a given time frame. It involves management of various types of conflicts related to resources, skill set, work environment, managers, etc. and ensuring that the project is divided into sub tasks which get completed within allocated time and budget (Kalogerou & White, 2014). All these details are listed out clearly in a document known as ’Project Charter’. Then, the project manager and corresponding team is responsible to ensure timely completion of tasks and ensure that there are no or minimal deviations from the set project charter.
Typical project management phases are presented below:
Each of these phases is associated with certain activities that need to be completed during the given phase. In order to ensure efficiency and appropriate decision making, it is necessary for an organization to create an application system where the needs can be listed out and technique to be used etc. can be entered as a record (Ge & Ho, 2014).
Various project management methodologies that can be used to manage the entire project include critical path method, critical chain project management, waterfall model, agile method, and Adaptive Project Framework (Tsolas, 2013). Further, there are other techniques that can be used for sub tasks within a project. These include - planning the project, work breakdown structure and work authorization success (Ren, Cao, & Han, 2015). Additionally, there are other approaches that help to complete sub tasks basis the planned schedule, such as, Gantt charts, Line of balance method, and Critical Path Method.
Besides the planning of tasks and monitoring them, other typical challenges faced during a project management process include scope of the project that should be clearly defined, cost estimates should be reliable, change management process should be well defined and followed, communication should be open and follow the hierarchy as mentioned in the charter to avoid confusion, limited budget allocated, availability of resources and managing the same.
An organization is typically involved in multiple projects at a given point of time. Similarly, it is presented with multiple project opportunities at a point of time. However, due to the constraints of limited budget availability and limited resources availability, an organization needs to select the project opportunities it intends to pursue at a point of time.
Hence, here an organization will undertake project optimisation or feasibility analysis in order to determine what project opportunities are most appropriate for the organization. A project needs to be assessed from different angles such as, expected success rate, financial numbers, reactions from employees etc. (Arnold & Nixon, 2006).
For this purpose, two project alternatives were taken and assessed in the previous report for the purpose of undertaking feasibility analysis from the financial perspective. The feasibility analysis includes determining estimated cash flows of either projects and determining which project provides higher cash flows. The objective is to select only the project with higher cash flows, assuming limited resource availability in the organization. However, it must be noted that an organization can take up multiple projects at the same time if it has availability of resources such as, budget, manpower, infrastructure etc., as long as the projects selected are profitable with positive cash flows.
Further, the project optimisation also focuses on minimising the overall cost and there are multiple ways in which efficient cost structure can be created, such as utilising cost accounting concepts, standard cost converts, etc. The main components of cost include raw material, wages, and overheads. Each of these four costs is further sub-divided into other categories (Rose & Delaney, 2005). But for the purpose of this report, the focus is on optimising cash flows, assuming certain costs that remain same in a project.
This section will provide a summarised view of two projects that are assumed to be presented to an organization as well as the techniques of feasibility analysis that will be utilised. Multiple analysis tools are available for the manager to make decisions (Balyeat & Cagle, 2015). The tools and techniques should be selected keeping in mind the nature of the project as well as the unique characteristics of that project. Two major methods used include (Potter & Sanders, 2012):
- Net Present Value (NPV): The NPV method uses a discount rate to discount cash flows of each year in order to calculate the present value of the cash flows as of today. The cash flows include both the cash outflows and inflows. The summation of all the present values provides the Net Present Value of the project. The higher the NPV (positive values) the better it is.
- Internal Rate of Return (IRR): The IRR method extrapolates the rate of discount at which the present value of cash outflows of a project are equal to the present value of the cash inflows of that project. The higher the IRR the better it is. Additionally, the IRR should be higher than the weighted average cost of capital for the firm (Balyeat & Cagle, 2015).
The following section will present an overview of two projects selected and calculate NPV and IRR in order to compare the projects in terms of feasibility:
- Project A: The upfront cost for this project comes to USD 7 million payable in beginning itself. The project will start generating cash inflows three years from initial year and the inflows are expected to be around USD 3 million each year for continuous five years.
- Project B: The upfront cost for this project comes to USD 2.5 million payable in the beginning itself. Further, the project is expected to entail outflow of USD 2 million each year for three years continuously. Further, the cash inflows will be received as a lumpsum of USD 16 million once the project completes six years.
Given the two project opportunities, the managers now need to conduct a feasibility analysis by determining NPV and IRR of either project. For this purpose, the discount rate has been assumed to be 8%. The following table presents the estimated cash flows in a tabular form:
|Year||Cash Flows ($mn)|
|A||B||Discount Factor (8%)|
The table above clearly shows the cash flows for each year, outflows as well as inflows. Further, the last column indicates discount factor that needs to be multiplied with corresponding year’s cash flows in order to arrive at NPV.
Project A NPV:
PV Annuity Factor for r= 0.08, N=5, it will be = (1 - (1/(1 + r) N)/r = (1 - (1/(1.08) 5)/0.08 = (1 - (1/(1.469328)/0.08 = (1 - (1/(1.469328)/0.08 = (0.319417)/0.08 = 3.99271.
Now, this factor needs to be multiplied with the cash flows of US $3 million to determine the present value of the cash inflows for a given project, which will be = ($3 million) X (3.99271) = $11.978 million.
Now, this amount needs to be discounted for two periods, and hence,
PV inflows = ($11.978) / (1.08) 2 = $10.269 million.
The NPV of the project can thereby be calculated as = ($10.269 million) - ($7 million) = US $3.269 million.
Project B NPV:
Considering the annuity factor for r = 0.08 and N=5,
PV factor = 1 - (1/ (1.08)3) / 0.08 = (1 - (1/ (1.259712) / 0.08 = (0.206168) / 0.08 = 2.577097.
Thus, Present Value of the annuity = ($2 million) X (2.577097) = $5.154 million.
Thus, total outflows for the project will be = ($2.5 million) + ($5.154 million) = $7.654 million.
Further, the sales price of the project is provided after six years. Hence, there is a need to calculate the present value of the project considering r = 0.08 and N=6.
Thus, total inflows of the project will be = $16 million/ (1.08) 6 = $10.083 million.
Now, NPV for Project B = ($10.083 million) - ($7.654 million) = $2.429 million.
Thus, on comparing the NPV of both the projects, Project A can be chosen over B as it will bring inflows of $3.269 million versus $2.429 million.
The IRR is that rate of discount factor such that the NPV of cash outflows is equal to Cash inflows. It can be calculated through interpolation or by using Microsoft Excel. The results of NPV and IRR are presented below:
|Project A||Project B|
It can be seen that the project A yields higher NPV as well as higher IRR and hence, should be preferred over project B.
In the above section, it was seen that the Project A is superior to Project B in terms of NPV as well as IRR. Hence, this provides an indication to the respective managers in the organization to select Project A. The managers need to conduct similar feasibility analysis for various projects to come up with rational and logical decision regarding selection of particular project (s) (Cairns, 2013). Further, it is necessary for the project managers to check for the assumptions and other values that are provided in the form of inputs. Only then true and accurate results will be generated in a given scenario.
Additionally, this provides a basis for communication with the senior management regarding project selection and rationale behind the same. It is easy to understand and provides streamlined analysis of all projects in same format such that it is easy to assess and discuss further. Once satisfied, the seniors will give approval to go ahead with a particular project.
In an ideal scenario, the above will hold true and go smooth. However, in the real world, the situation is different. The above analysis is based on assumptions such as, costs in various years, cash inflows in various years, discount rate. Additionally, requirement of funding and other resources including manpower is also assumed. This assumptions or any one of them has to deviate a little to give a different scenario where selected project may turn out to be loss making proposition.
This can happen due to improper calculations of such costs; these managers are not able to select the best project alternative. Additionally, even if estimates remain same the management of the project itself may go awry, for example, delays in achieving various milestones, changes or amendments, shortages of material and plant, inflation, funding problems, and lack of proper training, etc. This can also be aggravated by skill mismatch, for example, untrained or incorrect skilled manpower, inexperienced project manager, biases etc. Any of these factors will hamper attainment of target (Balyeat & Cagle, 2015).
In order to concur this, it is recommended to undertake financial model analysis and also perform sensitivity analysis to be aware about worst and best case scenarios.
The following section will perform sensitivity analysis for the two projects to see the changes in variables and corresponding impact on NPV and IRR. For this, (Iloiu & Csiminga, 2009):
- The first step is to identify key variables that may be impacted. When base case scenario is created, multiple variables are there that can change. However, for sensitivity analysis, only major variables need to be considered. Those that are not significant or are not expected to change much can be left out of sensitivity analysis. Additionally, the sensitivity analysis can only analyse quantitative factors. The qualitative factors such as changes in policies etc. need to be considered separately. For our purpose, the variables to be analysed include the discount factor as well as cash inflows. The cash outflows are assumed to be same.
- The next step is to calculate the effect of changes in the selected variables. The IRR and NPV will be calculated for each of the changed scenarios. For our purpose, we are creating two scenarios, minimum and maximum, apart from the base case. In the minimum case, both the discount factor and cash inflows will be lower than the base case. Similarly, in the maximum case, both the discount factor and cash inflows will be higher than the base case. This will help to cover worst case and best case scenarios that might occur due to changes in estimates.
- The next step is to analyse the impact of changes in the variables in returns of percentage changes. The full analysis is presented in tables below:
|Year||Discount Rate Factors||Project A Cash Flows ($mn)||Project B Cash Flows ($mn)|
It can be seen from above analysis that the worst case discount factor is higher at 10% and best case discount factor is lower at 6.5%. Further, the cash inflows in worst case scenario (Min) are lower than the base case whereas cash inflows in bets case scenario (Max) are higher than the base case. This leads to change in NPV and IRR of both the projects. The next table will analyse these change sin percentage terms:
|%age change||Project A||Project B|
It can be seen that as soon as the discount rate increases by 25%, the NPV of the projects reacts by more than 170% as higher discount rate directly hits the present value of cash inflows, leading to lower NPV. Similarly, NPV in the best case scenario increases by more than 240% for project A and 143% for Project B. Hence, in both cases, the change in discount rate is getting reflected multiple times in the NPV.
Now, discussing the changes in IRR, the changes in discount rates are still getting magnified, however, not as much as in case of NPV.
Further, it can be seen that the changes in NPV and IRR in case of project B are less sensitive as compared to Project A. Hence, if the management chooses project A, they should be well aware about the risk and returns of the project with respect to change in variables.
We saw how an organization and managers can take rational decisions and monitor the deviations using project management tools. Further, in order to select the most appropriate project opportunities, we understood project optimisation techniques and sensitivity analysis to cover for changes in cost estimates and how management can use this analysis to determine appropriate choice in-line with the organization’s policies and strategies.