Page 174 - DMGT521_PROJECT_MANAGEMENT

Unit 10: Measuring Project Profitability

different perspective; one cannot be a substitute for another, as the constitution of each is different, Notes
and each has been devised to assess a performance from a specific perspective.
Is that all about a project when it comes to profitability assessment; may be not.

One may usually start from ROI (IRR, NPV, and Payback Period (including McFarlan’s analysis,))
to assess from returns perspective; however, it may not be true for s/w projects that we carry out
for customers because this step would have already been done by customer. Nonetheless, it is
the starting point for a project, though this accountability may not lie at our end, or we may not
carry out the analysis exactly under those heads.
Having said that, a project (unless it runs to some millions of dollars, or is of strategic importance)
may not require these overall measures, instead we would be interested in data in terms of
“Earn vs. Burn” (Earned Value). This is profitability from “delivery” aspect. It has been in
practice for more than a decade, and has matured over a period of time. Though, there are many
variations and measures for this, a quick look upon CPI, SPI, and TCPI should provide enough
pointers; getting into details, where these measures point trouble (may be potential one) is the
subsequent step.

10.1 Pay Back Period

Payback period in capital budgeting refers to the period of time required for the return on an
investment to “repay” the sum of the original investment. For example, a $1000 investment
which returned $500 per year would have a two year payback period. The time value of money
is not taken into account. Payback period intuitively measures how long something takes to
“pay for itself.” All else being equal, shorter payback periods are preferable to longer payback
periods. Payback period is widely used because of its ease of use despite the recognized limitations
described below.
The term is also widely used in other types of investment areas, often with respect to energy
efficiency technologies, maintenance, upgrades, or other changes. For example, a compact
fluorescent light bulb may be described as having a payback period of a certain number of years
or operating hours, assuming certain costs. Here, the return to the investment consists of reduced
operating costs. Although primarily a financial term, the concept of a payback period is
occasionally extended to other uses, such as energy payback period (the period of time over
which the energy savings of a project equal the amount of energy expended since project
inception); these other terms may not be standardized or widely used.
Payback period as a tool of analysis is often used because it is easy to apply and easy to understand
for most individuals, regardless of academic training or field of Endeavour. When used carefully
or to compare similar investments, it can be quite useful. As a stand-alone tool to compare an
investment to “doing nothing,” payback period has no explicit criteria for decision-making
(except, perhaps, that the payback period should be less than infinity).

The payback period is considered a method of analysis with serious limitations and qualifications
for its use, because it does not account for the time value of money, risk, financing or other
important considerations, such as the opportunity cost. Whilst the time value of money can be
rectified by applying a weighted average cost of capital discount, it is generally agreed that this
tool for investment decisions should not be used in isolation. Alternative measures of “return”
preferred by economists are net present value and internal rate of return. An implicit assumption
in the use of payback period is that returns to the investment continue after the payback period.
Payback period does not specify any required comparison to other investments or even to not
making an investment.
Payback period is usually expressed in years. Start by calculating Net Cash Flow for each year:
Net Cash Flow Year 1 = Cash Inflow Year 1 - Cash Outflow Year 1. Then Cumulative Cash Flow

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