Value Management

CONCEPT OF VALUE

The concept of value can be defined as the relationship between satisfying

an organization’s many conflicting needs and the resources required

to meet those needs.

Value can be added to projects in several ways. These include providing

greater levels of client satisfaction, maintaining acceptable levels of

satisfaction while lowering resource expenditures, or some combination of

the two. It is also possible to improve value by simultaneously increasing

satisfaction and resources, provided that satisfaction increases more than

the resources used to achieve it.

When managing projects for value, five fundamental concepts must be

embraced.

Concept #1: Projects derive their value from the benefits the organization

accrues by achieving its stated goals—Remember that projects are typically

initiated as a perceived solution to a goal, need, or opportunity.

Thus, when we want to determine the degree to which a project is being

managed for ‘‘value,’’ it is critical to first ensure that the project falls

in line with organizational goals. Projects that are being run counter to

a firm’s stated goals (e.g., customer satisfaction, commercial success, or

improving health and safety) already fail the first test of value.

Concept #2: Projects can be viewed as investments made by management—

Any investment comes with an expected return for the risk undertaken, and projects are no exception. Because they consume

resources and time, they are expected to yield acceptable returns, based

on internal requirements, along with associated benefits.

Concept #3: Project investors and sponsors tolerate risk—There are

inherent risks in projects, because there is considerable uncertainty

surrounding their outcomes. These risks may be technical (‘‘Does the

technology that is driving the project work?’’), they may be commercial

(‘‘Will the project succeed in the marketplace?’’), they may involve health

and safety issues (‘‘Can we manage the project within appropriate safety

parameters?’’), or some combination of all of the above. Accepting these

risks is recognition that each project is a unique endeavor with unique

unknowns. Investors may not be able to manage these risks, but they

do tolerate them because the potential rewards may far outweigh the

negative impact.

Concept #4: Project value is related to investment and risks—

This fourth concept defines project value as a function of the resources

committed (investment made) and the extent of risks taken. Goodpasture

puts it this way: ‘‘The traditional investment equation of ‘total return

equals principal plus gain’ is transformed into the project equation of

‘project value is delivered from resources committed and risks taken.’’’3

Using these terms, we can see that value will always walk a narrow

line between expected return on investment and risk. When the equation

gets out of balance; that is, when the perceptions of the organization are

that the expected return cannot make up for excessive levels of risk, the

project ceases to produce value. The implication of this concept is that different

projects require different levels of investment with varying levels

of risk. Consequently, the value delivered by each of these projects will

also vary.

Concept #5: Value is a balance among the three key project elements:

performance, resource usage, and risk—Again, if we employ a ‘‘ledger’’

mindset, we can add up the credit column to include drawbacks such

as expenditure (resource usage) and risk accepted. Balanced against

these ‘‘negatives’’ is the company’s expectation of project performance

and positive outcomes. Naturally, the higher the expected performance of

the project, the greater the resource usage and risk a company is willing

to commit.

For most project organizations, the objective measure of value is in

monetary terms. This is because projects consume time, and the longer

it takes to complete the project, the less valuable the money spent.

Therefore, when evaluating a project’s value, the concept of the time

value of money should be taken into account. In addition, monetary

measures allow project managers to acknowledge the future uncertainty

of outcomes by evaluating the financial impact of risk events.

The measures of net present value (NPV), economic value add, and

expected monetary value (EMV) take both of these factors into account.

Net present value, is significant in

that successful projects have a positive NPV over their life cycle. Both

NPV and economic value add employ the discounted cash flow concept;

however, economic value add is a financial measure of project performance

after the project becomes operational. It is defined as the difference between the present value of after-tax earnings from the project and the

benefits from the next-best investment alternative. The logic underlying

economic value add is that if the projected after-tax earnings are less than

the cost of the capital the project consumes, then some other, less-risky

investment alternative may be more attractive. Expected monetary value is also the most appropriate financial measure

when measuring future uncertainty, or when multiple project

outcomes are possible, each with a different cost and schedule. It is

defined as the summation of the value of each outcome in dollars ($),

weighted by the probability of that outcome. For example, consider a

project that needs to be redesigned, and assume that the new approach

involves some risk to accomplish this goal. One possible monetary outcome

is $200,000 with a 40 percent probability of achieving this outcome,

while anothermonetary outcome is $150,000 with a 60 percent probability

of occurrence. The EMV of this project is

EMV = $200,00 ∗ 0.4 + $150,000 ∗ 0.6 = $170,000

If the NPV for this project is also positive, and if all other considerations

are equal, it is worth taking the risk of adopting the new approach to

redesign this project.

Key Principles of VM

The value management approach hinges on three key principles4:

1. An unending quest for enhancing value for the organization, establishing

metrics or estimates of value, and monitoring and controlling

them

2. A focus on clear definition of objectives and identification of targets

before seeking solutions

3. A focus on function, pivotal to maximizing those outcomes that are

innovative, meaningful, and practical

THE VM PROCESS

The detailed VM process and the typical terms used at different stages

of a project are illustrated in the Figure 8.3. Because the elements of

the figure are straightforward, we will focus our discussion of the process

from a strategic perspective. The elements of value management can be

grouped into five major categories:14

• Needs assessment—This phase is concerned with arriving at a shared

understanding of the needs of various project stakeholders, the critical

success factors with the expected benefits defined qualitatively,

and the key performance indicators of time, cost, quality, or functionality,

defined through quantitative measures.

• Idea generation—In this phase, the cross-functional team focuses

on generating creative and innovative alternatives to complete the

project.

• Detailed evaluation—During this phase, the alternatives generated

in the previous phase are evaluated in detail in terms of their feasibility,

achievability, and potential contribution to expected project

benefits. At this stage, modifying alternatives to develop additional

options is also considered.

• Optimum choice—This phase prioritizes the various alternatives and

selects the best alternative.

• Feedback and control—This phase is the formal evaluation and

control process with feedback loops to improve the overallVMprocess.

During this phase, VM practitioners and users must obtain feedback

on its performance to ascertain whether the expected improvement

in value was realized, and to generate other good ideas that can be

adopted and implemented. During the feedback process, factors to

be assessed include the stakeholders’ judgment, involvement, and

support; the system’s appropriateness, use, and effectiveness; and

change management. Actions that can emerge from the feedback

stage include changes to personnel, approach, or the system, and

even repeating the VM exercise as a whole.

Read More

The process of financial management

Project finance involves two main types of contracts: concession agreements

with the government, and off-take contracts with consumers.

The process of financial management involves five major steps:

1.      Conducting feasibility studies,

2.      planning project finance,

3.      arranging the financial package,

4.      controlling the financial package,

5.      and managing financial risk.

Conducting Feasibility Studies

Project alternatives are evaluated using financial appraisal techniques such as net present value analysis (NPV) and internal rate of return (IRR).

During this step, the financial objectives of the project are established.

While these objectives differ between various project stakeholders, the

main concerns of the project sponsor are:

• Raising necessary funds for the project at appropriate times, and in

appropriate currencies

• Minimizing project cost and maximizing revenue

• Appropriate risk-sharing among all project stakeholders, including

financiers

• Establishing adequate control and flexibility, including rescheduling

loan and interest repayments if conditions warrant

• The ability to pay dividends to equity holders

Controlling Financial Risk

The various types of financial risks that can be encountered in a project

are provided in Table

Read More

PRINCIPLES OF FINANCING PROJECTS

TYPES AND SOURCES OF FINANCE

There are two main types of financing: equity and debt. Equity financing

refers to the money subscribed by investors and shareholders, whose

returns on investment are in the form of dividends and capital growth

equivalent to the value of their equity in the project organization. However,

the project organization can make dividend disbursements only

after the interest and scheduled loan repayment obligations have been

met. If the project is successful, the returns on investment for equity

holders can be substantial; if it fails, equity providers may receive no

returns. Consequently, equity holders may demand higher returns than

other debtors.

Debt financing refers to money borrowed from a number of sources,

including banks. This debt involves periodic repayments of the debt and

interest, based on agreed-upon schedules. The money borrowed through

this type of financing arrangement has to be repaid first, before the

repayment of other types of finances. This type of debt is also sometimes

known as senior debt.

Mezzanine debt -  Another type of debt financing involves loans from the project organization’s

equity holders. This type of debt, called Mezzanine debt, involves

a schedule of loan repayments and interest payments at a predetermined

rate. Mezzanine debt, however, is considered secondary to the senior debt

discussed earlier, and all loan and interest repayments on mezzanine,

debt can be made only after financial obligations to the lenders of the

senior debt have been fulfilled. Consequently, mezzanine debt involves

higher risk and correspondingly higher interest rates.

SOURCES OF FINANCE

There are both conventional and unconventional sources of finance. The

conventional sources include the company’s shareholders, banks, suppliers,

export credit, buyer and seller credit, and international investment

institutions such as World Bank and development banks such as the

Asian Development Bank. Unconventional sources of finance include

leasing assets, counter trade, forfeiting, switch trade, and debt/equity

swapping.

• Leasing assets—rather than purchasing a project asset, the project

organization leases it from a third party, who receives a return in

the form of rental for the asset.

• Counter trade—The seller accepts goods or services in lieu of cash.

For example, it is quite common in poorly developed or third world

countries to ‘‘pay’’ for a portion of a large project with commodities,

which the project developer then must sell in order to raise cash.

• Forfeiting—finance is made available through the sale of financial

instruments due to mature at some time in the future. Finance is

then provided by trading in these assets in the futures market.

• Switch trade—This process makes use of a credit surplus between

two parties to finance a relationship with a third party. For example,

if country A has a credit surplus with country B, exports from C to A

can be financed with payments from B to C.

• Debt/equity swapping—A multinational company may buy a host

country’s debt at a discount. This is redeemed in local currency

at favorable exchange rates and is used to set up local companies.

These are used by the multinational company to transfer technology,

generate foreign exchange, and create employment in the host

country.

COST OF FINANCING

The cost associated with borrowing money depends on the particular form

of capital borrowed. For example,

• The cost of equity is the dividends paid to shareholders plus any

estimate of the equity’s capital growth. The cost of equity is usually

calculated using the capital asset pricing model (CAPM). (More can

be learned about this model in any finance textbook.)

The cost of debt is the cost of debt financing, or the interest paid

on the money borrowed. While the cost of equity is payable out of

untaxed income, the cost of debt is payable out of taxed income.

• The cost of capital is the average cost of various forms of finance

used by the project organization; specifically, it is the weighted average

of the cost of the different types of capital borrowed. For example,

if the project is financed through both debt and equity, then

Cost of capital = Ratio of equity ∗ Cost of equity

+ Ratio of debt ∗ Cost of debt

PROJECT FINANCE

Project finance refers to unsecured, nonrecourse,

off-balance sheet financing of an individual project.

Project finance involves two main types of contracts: concession agreements

with the government, and off-take contracts with consumers.

Read More

PAYMENT ARRANGEMENTS

Cost-reimbursable Arrangements

A cost-reimbursable arrangement is often the simplest form of contract,

particularly if the work is ill defined at the outset. This is also called

the ‘‘cost-plus-fee’’ or ‘‘cost-plus’’ contract. It is sometimes referred to as

a ‘‘limit-of-liability’’ contract, because it is normal for the sponsor to set

limits on the amount of funds that he or she is willing to allocate.

Cost-reimbursable Arrangements fixed-price (lump sum) – contractors can bill monthly. If the project is revised, the budget may be revised as well.

stage payment -  in this arrangement, the project

is divided into a series of blocks of work, or ‘‘stages,’’ each with a budget

attached. Usually, Unlike milestones, which are discrete events that occur in sequence, it

is possible for work on several stages to be performed concurrently. If the

stages are relatively large, billing can be done monthly up to some fixed

percentage, as is done in the milestone plan, Beyond that point, billing

is not allowed until the agreed-upon stage is completed.

Claims and Variations

It is the rare project that is completed without changes. Not only are

changes expected, but they are also taken into account by most contracts.

In extreme cases, sponsors have attempted to employ ‘‘all-risk, ceiling

price’’ contracts, which state quite clearly that whatever may transpire on

the project, the contractor is expected to complete the work and the sponsor

will not pay any more than the agreed-upon ceiling price. With more normal contractual arrangements, the cost of work over and above that covered in the contract can normally be recovered in two ways:

claims and variations. A claim is generally a retrospective demand for compensation for costs

properly incurred. Claims can be made whenever additional expenditure

has been incurred for labor or expenses that are not in the agreed-upon

scope of work.

Cost Variation Due to Inflation and Exchange

Rate Fluctuation

Methods to counter currency exchange rate movements include

forward-buying the currency at a fixed exchange rate, and agreements to revalue the contract work at fixed times in the future, based on the prevalent exchange rates at those times.

Price Incentives

Occasionally, situations arise where there is a possibility that cost savings

can be made during the course of the project. This can happen when

uncertainties are so great that it is impossible to agree to a fixed-price

contract without including excessive contingencies. Sponsors naturally

want to avoid this option, and may instead propose a contract that

includes an inducement for the contractor to finish the project at a price

lower than the fixed amount. This inducement is in the form of increased

profit, even though the total contract value may be less, and means

that the customer is sharing a proportion of the cost savings with the

contractor. Inducements can be in the form of a price adjustment formula

that relates to the final profit, or a bonus payable if agreed-upon cost

thresholds are met. Bonuses can also be paid for early completion.

It is normal to fix, at the outset, both the maximum price (the ceiling

price) and the assumed minimum level of profit. Below the ceiling price,

a lower figure is agreed upon as the target price, which contains a

higher level of profits that the contractor feels he or she should be able to

achieve. As the contract proceeds, claims are made in stages, according to

a payment plan and observed progress. Profit at the low level can also be

included in these claims. At the end of the contract, a formula is applied

to the value of the claims, and if the total value is below the ceiling price

an additional payment is made.

Retentions

Despite the fact that work may appear to be completed satisfactorily, there

may be reasons to withhold an amount of money until final settlement

is made with the contractor. This practice is called retention. Usually,

retentions are used to ensure that if any defects are discovered in the

project work, the contractor will properly rectify them.

Read More