Candidate project evaluation and prioritization is typically a weighted assessment of strategy alignment, anticipated benefit, project risks and cost. Capital project portfolio optimization is achieved by prioritizing projects within funding and resource capacity constraints.
One of the key considerations is maintaining the overall risk profile across the portfolio, balancing the number of high-risk and potentially high-benefit projects with lower-risk and lower-benefit projects. This overall risk assessment of each project is an element of the prioritization evaluation. The portfolio governance board needs to ensure the overall risk profile remains in line with the risk strategy, or risk appetite, of the organization, as set by the board.
A risk strategy set by the organization might be that no more than a quarter of projects should be high-risk. In this example capital project portfolio management would be expected to work with the project manager and sponsor to ‘move’ some of these projects to a lower-risk position. This could be by reducing the scope, bringing in specialist suppliers at additional expense who are familiar with the technology, or breaking the project up and finding different solutions to the riskier parts.
Conversely, it is not in the stakeholders best-interest for an organization to invest exclusively in low-risk, low-return initiatives. Shareholders can diversify their own investments. They expect an organization to deliver a return commensurate with its weighted average cost of capital, which incorporates a risk premium based on the nature of its operations. To achieve this return, the organization will be compelled to make bold strategic capital investments in new technologies, products, processes and geographies.
Balancing Strategic Priorities
It may be advantageous to reallocate resources from a particular project, which may have a good business case and a high net present value, to a project with a less-attractive business case, but which enables a key component of a corporate goal to be met earlier.
Sometimes goals are contradictory – for example, profit maximization and corporate social responsibility may be in contention in the short-term. There will be conflicting pressures that the board will need to resolve. But that is the key role of the portfolio manager and the sponsors: maintaining a balanced portfolio that substantially achieves all strategic goals at the lowest cost and risk.
There will be many different portfolio options combining different mixes of strategic projects and business-as-usual sustenance activities, with varying degrees of risk and benefit. The ‘efficient frontier’, originally developed for financial portfolios, is a modern portfolio technique that compares the risk and return for the various portfolio options, and recommends the selection of projects that delivers the best return, given the risk appetite of the organization.
When comparing investment initiatives, it is tempting to assume that both the project investment and return can be estimated accurately. Experience suggests that fixed-scope project definitions and business cases tend to assert costs, benefits, and durations that are over-optimistic. Properly delivered agile projects should have more predictable time and cost elements of their business cases than fixed-price (‘waterfall’) methodologies but can only assert to the ‘minimum viable product’ (MVP) benefits. Benefits beyond the MVP are realized through iterative sprints in a low-risk manner. The portfolio planner must be sensitive to this and should be willing to assign a likely benefit above the MVP benefit, or else lower-risk agile projects may consistently appear less beneficial than higher-risk fixed-scope candidates.
To be included in the portfolio, candidate projects should include:
- Defined contribution to achieving one or more strategic goals;
- Having a committed sponsor with the delegated capital budget approval authorization;
- A valid business case with a positive Net Present Value or risk mitigation outcome, depending on the investment reason;
- A valid rationale (urgency) for undertaking the project, whether based on direct risk or opportunity cost;
- An assessment of the complexity of the project, or level of risk of not achieving the project objectives;
- Demand on critical internal resources – if they are not available when required, the timeframe of the potential project may need to be revised;
- Resource loading and the impact on the business. A ‘heat map’ of change impact can be included in the overall balancing and optimization of the portfolio to assess whether the business can cope with the proposed change.
The program and project prioritization criteria will be based on a range of factors, including:
- Ranking/prioritization/weighting of the corporate goals – some will be more important than others;
- Relative contributions to delivering the strategy and corporate goals – quantitative and qualitative;
- Benefits anticipated – to be assessed in comparable formats (for tangible and intangible benefits);
- Timing – investment in short-term gains may take priority over longer-term investments, provided that this does not regularly lower the priority of longer-term projects and programmes (or vice versa);
- Legal, regulatory and/or industry standard requirements – such ‘compliance’ may be mandatory but should be properly assessed; and
- Level of risk – the probability/likelihood of adverse impact from not undertaking the project (risk of not doing), as well as the risk of not achieving the specified benefit (risk of doing).
Note that cost is itself not a factor in the ranking of project utility, but rather the key constraint. Simply put, once the project ranking (utility) is established, the goal of portfolio construction is to maximize the utility and minimize the risk in accordance with capital, resource and risk constraints.
Establish the Optimal Capital Project Portfolio
Given financial funding constraints, human resource constraints and risk-management constraints it is challenging to choose an optimal investment portfolio.
The sponsor is accountable for proposing and ensuring that individual initiatives are governed effectively and deliver the objectives that meet identified needs. The aim of portfolio management is to balance the overall risk-adjusted benefits, the investment of human and capital resources, and implementation risks by selecting the projects that most effectively and efficiently achieve the strategic goals.
Stratex Online provides a flexible framework for scoring candidate projects and provides a dynamic interface for selecting the optimal project portfolio. Stratex Online assists executive management with establishing the optimal capital project portfolio budget annually and throughout the year as circumstances change.