Project Selection Criteria Using ROI, NPV, IRR and Risk

Developing project selection criteria that rely on a defensible business case and solid Return on Investment (ROI) is fundamental to effective IT governance and project portfolio management (PPM). That means a business case and ROI for every project under consideration developed using a standard ROI calculator using Net Present Value (NPV) and Internal Rate of Return (IRR).

An earlier post provided a range of methods for evaluating IT investments using objective project ranking criteria. That post was followed up with an ROI calculator template that uses NPV, IRR and Payback Period to build the financial justification of the business case. So now let’s pull it all together and outline how to use these elements along with project risk as criteria for ranking projects in any project portfolio management system and supporting the project selection process.

Project Selection Criteria

Net Present Value (NPV): NPV should be calculated for every project so that all proposed projects in the project portfolio management system can be compared. When using NPV as one of the project selection criteria, generally only projects with positive NPV are considered for funding with the higher NPV being favored over the lower. When a project has a zero NPV other factors such as intangibles within the business case might warrant the project being funded. Projects with negative NPV are usually not funded.

Decision matrix for positive and negative NPV with Hi and Lo IRRInternal Rate of Return (IRR): IRR should also be calculated for every project and used in a project ranking of the entire project portfolio management system. Projects with higher IRR should be favored over projects with lower IRR. However, every organization should have a minimum IRR required as part of their project selection criteria so that projects with an IRR below the minimum return rate would not be funded unless there are other factors in the business case.

Project Risk: Project risk must be assessed and evaluated as part of the project selection criteria which establishes the balance of risks vs. rewards in the business case. Often the use of a project risk rating comes in the form of a weighting factor rather than a direct project ranking criteria to be used in project selection. Instead, the project risk rating might drive project risk mitigation requirements depending on the assigned risk rating. This is critical since things like delays in project execution can affect cash flows thereby worsening or possibly negating projected NPV and IRR.

Business Case Risk

Business case risk is the risk of having a flawed business case, or simply the risk of being wrong. This is closely associated with the core cause of the Fallacy of Planning which says we are terrible at estimating how much projects will cost and how long they will take. But it is also about our weakness in understanding basic probabilities where IT governance committees often find themselves making bad bets on IT investments because they do not account for the probability of the business case being wrong and the actual expected value of the proposed projects.

Table showing probability Suppose you have two IT projects under consideration. Project A has an ROI of $450,000 and Project B has a ROI of $350,000. With all other factors being equal, your project selection criteria would approve Project A ahead of Project B. Now consider the probability of each project actually delivering their ROI. What if the odds of Project A achieving its ROI were only 75% while the odds of Project B were 100%. The ROI’s would need to be adjusted to their expected value which would show Project B as having the higher expected value warranting its approval ahead of Project A.

This type of analysis can be done within the financial analysis if you so desired where expected values of revenue/savings can be computed along with expected values for costs to create an adjust NPV and IRR. Since this does get to be too much, most IT governance teams simply have a seat of the pants approach to knowing whose estimates can be relied on and whose cannot.

Project Selection Criteria – Final Thoughts

In the end the only safeguard for developing a sound project selection criteria is to hold project sponsors accountable for delivering the ROI of their business case. This requires a committed IT governance committee and solid project portfolio management along with the support from the CFO to do the ongoing monitoring.

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3 Responses to Project Selection Criteria Using ROI, NPV, IRR and Risk

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