Basic Project Management – Cost Evaluation
By Willy-Peter Schaub
This article is very simple explanation of Cost Evaluation in Project Management. The article uses easy to grasp examples to explain concept.
The following table showing cash flow projections for two 5 year projects, will serve as example data for the duration of this article:
|Year||Project A||Project B||Project C|
Net Profit is the difference between the total cost and the total income of the project.
Looking at Project A, B and C we get:
- Project A: 20,000 + 20,000 + 20,000 + 10,000 + 70,000 – 100,000 = 40,000
- Project B: 400,000 + 400,000 + 400,000 + 400,000 + 100,000 – 2,000,000 = –300,000
- Project C: 400,000 + 400,000 + 100,000 + 100,000 + 10,000 – 1,000,000 = 10,000
Therefore Project A and C are making a profit, Project B is not. Based on Net Profit, I would personally pick project A, because there is more money left over.
Payback Period defines the time it takes to break even and be able to payback the initial investment.
- Project B is looking grim as we have not broken even after 5 years.
- Project A looks a bit better, because after 4 years we have a cash flow of –30,000. With us making 70,000 in year 5, we will have broken even after 4.43 years.
- Project C looks slightly better, because after 4 years we have a zero balance … which is what all of us would love to see after a one million loan.
Based on the payback period, I would personally pick project C as the payback period is the shortest.
Return of Investment (ROI)
Return of Investment (ROI) is also known as the accounting rate of return (APR) and in principal provides a way of comparing the net profitability to the investment required.
The calculation for ROI is the (average annual profit / investment) * 100. Hence:
- Project A = ((40,000/5)/100,000)*100 = 8%
- Project B = ((-300,000/5)/-2,000,000)*100 = –3%
- Project C = ((10,000/5)/1,000,000)*100= 0.2%
Based on ROI, I would personally pick project A again as it has the highest ROI percentage.
Net Present Value
Net Present Value is a project evaluation technique, that takes into account the profitability of a project and the timing of the cash flows produced.
- The present value is defined as = ( value in year X ) / ( 1 + discount rate ) to the power of the number of years into the future that the cash flow occurs.
- To calculate the discount factor (DF in table below) we calculate as 1 / ( ( 1 + discount rate ) to the power of the number of years, whereby we are borrowing the investment at an interest of 5%, or a discount rate of 0.05.
We will select project A and call Excel for assistance:
The Project A discounted cash flow looks worse than the net profit, but the good news is that we are still making a profit.
Willy-Peter Schaub started his IT career in the early 1980’s during his Electrical Engineering studies, focusing on the BTOS/CTOS operating systems until he moved over primarily to Microsoft technologies in the early 90’s. Since then his passion has been to investigate, research and evangelize technology, best practices and striving for simplicity and maintainability in software engineering. Willy wrote several books including “.NET Enterprise Solutions … Best Practices” and “Software Engineers on their way to Pluto”.