Capital Structure

Decisions

BLOCK 2
INVESTMENT DECISIONS
UNDER CERTAINTY

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Financial Decisions:
An Overview BLOCK 2 INTRODUCTION
Investment decisions under certainty refers to the scenario where the cash
outflows and inflows over a period of time can be predicted with fair degree
of accuracy. These techniques are being widely used in project management.
This block deals with Project Management.

Unit 4 of the block deals with Project Planning in which we discuss about
“nature and types of projects, project life cycle and project work planning.

Unit 5 deals with Capital Budgeting Decisions. In this, units we discuss

about the various techniques both discounted and non discounted which are
used to evaluate and rank the projects.

Unit 6 deals with Project Monitoring and Control. In this unit, we discuss
about designing a monitoring control system, project control concept and
types, and control processes.

Unit 7 deals with Social Cost Benefit Analysis. In this unit, we discuss about
concept and scope of economic appraisal, social cost-benefit analysis
technique, and application of social cost-benefit analysis in project
management and role of non-financial constraints in project appraisal.

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 Project Planning
UNIT 4 PROJECT PLANNING AND and Formulation

FORMULATION

Objectives
The objectives of this unit are:
• to provide an understanding of nature and types of projects,
• to throw light on project life cycle,
• to explain how project work is planned.

Structure
4.1 Introduction
4.2 Nature of a Project
4.3 Classification of Projects
4.4 The Project Life Cycle
4.5 Project Management Defined
4.6 Planning Project Work
4.6.1 Initial Project Coordination
4.6.2 System Integration
4.6.3 Sorting Out the Project
4.6.4 The Work Breakdown Structure and Linear Responsibility Charts
4.7 Summary
4.8 Self-Assessment Questions
4.9 Further Readings

4.1 INTRODUCTION
Effective management of projects is key to the progress of an economy
because development itself is the outcome of a series successfully managed
projects. This is why project management is receiving greater attention in
developing countries like ours, so as to avoid project schedule slippages and
cost overruns, a project needs to be meticulously planned, effectively
implemented and professionally managed in order to accomplish the
objectives of time, cost and performance. This demands fairly good
understanding of nature and types of projects, project life cycle and concept
of project management.

4.2 NATURE OF A PROJECT

The term ‘project’ has a wider meaning to include a set of activities. For
example, construction of a house is a project. It includes many activities like
digging of foundation pits, construction of foundations, construction of walls,
construction of roof, fixing of doors and windows, fixing of sanitary fitting,
wiring etc. Further, project is the non-routine nature of activities.
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Investment In fact, a project is an organized programme of pre-determined group of
Decisions under
Certainty activities that are non-routine in nature and that must be completed within the
given time limit. It is a non-routine, non-repetitive, one-off undertaking,
normally with discrete time, financial and technical performance goals.
The distinguishing features of a project are:
• Purpose: A project is usually a one-time activity with a well-defined set
of desired end results. It can be divided into subtasks that must be
accomplished in order to achieve the project goals. The project is
complex enough that the subtasks require careful coordination and
control in terms of timing, precedence, cost, and performance. The
project itself must often be coordinated with other projects being carried
out by the same parent organization.
• Life Cycle : Like organic entities, projects have a life cycle. From a slow
beginning, they progress to a buildup of size, then peak, begin a decline,
and finally must be terminated. (Also like other organic entities, they
often resist termination.) Some projects end by being phased into the
normal, ongoing operations of the parent organization.
• Single Entity : A project is one entity and is normally entrusted in one
responsibility centre while the participants in the project are many.
• Interdependencies : Projects often interact with other projects carried
out simultaneously by their parent organization; but projects always
interact with the parent’s standard, ongoing operations. While the
functional departments of an organization (marketing, finance,
manufacturing, and the like) interact with one another in regular,
patterned ways, the patterns of interaction between projects and these
departments tend to be changing. Marketing may be involved at the
beginning and end of a project, but not in the middle. Manufacturing
may have major involvement throughout. Finance is often involved at
the beginning and accounting (the controller) at the end, as well as at
periodic reporting times. The project manager must keep all these
interactions clear and maintain the appropriate interrelationships with all
external groups.
• Uniqueness : Every project has some elements that are unique. No two
construction or R&D projects are precisely alike. Though it is clear that
construction projects are usually more routine than research and
development projects, some degree of customization is a distinct feature
of a project. In addition to the presence of risk, as noted above, a project
may be unique in nature, which cannot be completely reduced to routine.
The project manager’s importance is emphasized because, as a devotee
of management by exception, the manager will find there are a great
many exceptions to manage by.
• Complexity : A rich project represents complex set of activities
pertaining to diverse areas. Technology survey, choice of the appropriate
technology, procuring the appropriate machinery and equipment, hiring
the right kind of people, arranging the financial resources, execution of
the projects in time by proper scheduling of various activities contribute
92 to the complexity of the project.
• Team Work : Successful completion of a project calls for teamwork. Project Planning
and Formulation
The team is constituted of members who are specialists in relevant
fields.
• Risk and Uncertainty : Risk and uncertainty are inherent in every
project. However, degree of risk and uncertainty will depend on how a
project passes through its various life cycle phases.
• Customer Specific : A project has always to be customer specific so as
to cater to the needs of customers. As such, the organization should go
for projects that are suited to customers.

4.3 CLASSIFICATION OF PROJECTS

Much of what project will comprise and consequently its management

depends essentially on the category it belongs to. Projects can be categorized
according to type of activity, location, time, ownership, size and need.

According to Type of Activity : Under this category, projects can be

classified as industrial and non-industrial projects Industrial projects are
set up for the production of some goods. Non-Industrial projects
comprise health care projects, educational projects, irrigation projects, soil
conservation projects, highway projects etc.
• According to Location: Location wise, projects can be categorized as
national and international projects. National projects are those set up in
the national boundaries of a country, while international projects are
set up by the government of private sector across the globe.
• According to Completion Time : Projects under this category can be
divided into two types, viz; normal and crash projects. In case of normal
projects, there is no time constraint. Crash projects are those which are
to be completed within a stipulated time, even at the cost of ending up
with a higher project cost.
• According to Ownership: Projects under this category can be grouped
into public, private and joint sector projects. Public sector projects are
owned by the Government. In private sector projects, ownership is in
the hands of the project promoters and investors. Joint sector projects
are those in which ownership is shared by the Government and private
entrepreneurs.
• According to Size: Based on size, there may be three categories of
projects, viz; small, medium and large. As per the present guideline of
the Government, projects with investment on plant and machinery up to
Rs. 1 crore are classified as small and those with investment in plant and
machinery above Rs. 100 crores are categorized as large scale projects.
Those with investment limit between these groups are medium scale
projects.
• According to Need: Based on the need for the project, projects can be
classified as new balancing, expansion, modernization, replacement,
diversification, backward integration and forward integration projects.
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Investment
Decisions under
4.4 THE PROJECT LIFE CYCLE
Certainty
Most projects go through similar stages on the path from origin to
completion. We define these stages, as shown in Figure 4.1, as the project’s
life cycle. The project is born (its start-up phase) and a manager is selected,
the project team and initial resources are assembled, and the work program is
organized. The work gets under way and momentum quickly builds. Progress
is made. This continues until the end is in sight. But completing the final
tasks seems to take an inordinate amount of time, partly because there are
often a number of parts that must come together and partly because team
members “drag their feet” for various reasons and avoid the final steps.

Slow finish
% Project competition

Quick momentum

Slow start

0
Time

Figure 4.1: The Project Cycle

The pattern of slow-rapid-slow progress toward the project goal is common.

Anyone who has watched the construction of a home or building has
observed this phenomenon. For the most part, it is a result of the changing
levels of resources used during the successive stages of the life cycle. Figure
4.2 depicts project effort, usually in terms of man-hours or resources
expended per unit of time (or number of people working on the project)
plotted against time, where time is broken up into the several phases of
project life. Minimal effort is required at the beginning-when the project
concept is being developed and is being subjected to project selection
processes.

If this hurdle is passed, activity rate increases as planning is done, and the
real work of the project gets under way. This rises to a peak and then begins
to taper off as the project nears completion, finally ceasing when evaluation
is complete and the project is terminated. In some cases, the effort may never
fall to zero because the project team, or at least a cadre group, may be
maintained for the next appropriate project that comes along. The new project
will then emerge.

The ever-present goals of performance, time, and cost are the major
considerations throughout the project’s life cycle. Early in the life cycle,
performance takes precedence. Team members focus on how to achieve the
project’s performance goals. We refer to the specific methods adopted to
94
reach these goals as the project’s technology because these methods require Project Planning
and Formulation
the application of a science or art.

Level of effort Peak effort level

Planning, scheduling, Evaluation & Time

Monitoring, control termination
Conception Selection

Figure 4.2: Time distribution of project effort

When the major “how” problems are solved, project workers sometimes get
preoccupied with improving performance, often beyond the levels required
by the original specifications. This search for additional performance delays
the schedule and pushes up the costs.

The middle stages of the life cycle are typified by a growing concern with
cost control. During the latter stages of the life cycle, focus of attention is on
time. With projects nearing completion, there tends to be more flexibility in
cost and efforts are directed towards bringing things into conformity with the
approved schedule-as much as possible, even if it means cost penalties.

It would be a great source of comfort if one could predict with certainty, at

the start of a project, how the performance time, and cost goals would be
met. In a few cases, for example routine construction projects, we can
generate reasonably accurate predictions, but often we cannot. There may be
considerable uncertainty about our ability to meet project goals. The
crosshatched portion of Figure 4.2 illustrates this uncertainty.

Activity 1

a) Identify activities that constitute a project

............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
b) List out five national projects
............................................................................................................
............................................................................................................
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Investment ............................................................................................................
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Certainty ............................................................................................................
c) List out five international projects
............................................................................................................
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............................................................................................................
............................................................................................................
d) List out four stages of a national project.
............................................................................................................
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............................................................................................................
e) Identify four major elements that constitute an international project
plan.
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4.5 PROJECT MANAGEMENT DEFINED

Project management is the process of identifying project opportunities,

formulating profitable project profiles, procuring funds for project
implementation, scheduling of project activities in such a way as to complete
the project within the minimum possible time/cost, and monitoring of the
project after its implementation.

Defining what is to be done and ensuring that it is done and performed as

desired within time and cost budgets fixed for it through a modular work
approach, using organizational and extra-organizational resources is what
project management has to achieve.

4.6 PLANNING PROJECT WORK

Project planning as represents a set of six planning sequences. First comes

preliminary coordination where the various parties involved in the project get
together and make preliminary decisions about what will be achieved (project
objectives) and by whom. These preliminary plans serve as the basis for a
detailed description of the various tasks that must be undertaken and
accomplished in order to achieve the objectives of the project. In addition, the
very act of engaging in the preliminary planning process increases the
members’ commitment to the project.
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These work plans are used for the third and fourth sequences, deriving the Project Planning
and Formulation
project budget and schedule. Both the budget and the schedule directly reflect
the detail (or lack of it) in the project work plan, the detail description of
projects tasks. The fifth planning sequence is a precise-description of all
project status reports, when they are to be produced, what they must contain,
and to whom they will be sent. Finally, plans must be developed that deal
with project termination, explaining in advance how the project pieces will be
redistributed once its purpose has been completed.

But before we begin, we assume that the purpose of planning is to facilitate

accomplishment of its objectives. The world is full of plans that never
become deeds. The planning techniques covered here are intended to smooth
the path from idea to accomplishment. It is a complicated process to manage
a project, and plans act as a map of this process. The map must have
sufficient detail to determine what must be done next but be simple enough
that workers are not lost in a welter of minutiae.

4.6.1 Initial Project Coordination

It is a crucial that the project’s objectives be clearly tied to the overall vision
and mission of the firm. Senior management should define the firm’s intent in
undertaking the project, outline the scope of the project, and describe the
project’s desired end results. Without a clear beginning, project planning can
easily go astray. It is also vital that a senior manager should call an initial
coordinating meeting and be present as a visible symbol of top management’s
commitment to the project.

At the meeting, the project is discussed in sufficient detail the potential

contributors develop a general understanding of what is needed. If the project
is one of many similar projects, the meeting will be quite short and routine, a
sort of “touching base” with other interested units. If the project is unique in
most of its aspects, extensive discussion may be required.

Whatever be the process, the outcome must be that : (1) technical objectives
are established (though perhaps not “cast in concrete”), (2) basic areas of
performance responsibility are accepted by the participants, and (3) some
tentative schedules and budgets are spelt out. Each individual/unit accepting
responsibility for a portion of the project should agree to deliver; by the next
project meeting a preliminary but detailed, plan about how that responsibility
will be accomplished. Such plans should contain descriptions of the required
tasks, budgets, and schedules.

These plans are then reviewed by the group and combined into a composite
project plan. The composite plan, still not completely firm, is approved by
each participating group, by the project manager, and then by senior
organizational management. Each subsequent approval “hardens” the plan
somewhat, and when senior management has endorsed it, any further
changes must be made by processing a formal change order. However, if the
project is not large or complex, informal written memoranda can substitute
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Investment for the change order. The main point is that no significant changes in the
Decisions under
Certainty project are made, without written notice, following top management’s
approval. The definition of “significant” depends on the specific situation
and the people involved.

Project Plan Elements

Given the project plan, approvals really amount to a series of authorizations.

The project manager is authorized to direct activities, spend monies (usually
within preset limits), request resources and personnel, and start the project on
its way to completion. Senior management’s approval not only signals its
willingness to fund and support the project, it also notifies sub-units in the
organization that they may commit resources to the project.

The process of developing the project plan varies from organization to

organization, but any project plan must contain the following elements:

Overview: This is a short summary of the objectives and scope of the

project. It is directed to top management and contains a statement of the
goals of the project, a brief explanation of their relationship to the firm’s
objectives, a description of the managerial structure that will be used for the
project, and a list of the major milestones in the project schedule.

Objectives: This contains a more detailed statement of the general goals

noted in the overview section. The statement should include profit and
competitive aims as well as technical goals.

General Approach: This section describes both the managerial and the
technical approaches to the work. The technical discussion describes the
relationship of the project to available technologies. For example, it might
note that this project is an extension of work done by the company for an
earlier project. The subsection on the managerial approach takes note of any
deviation from routine procedure, for instance, the use of subcontractors for
some parts of the work.

Contractual Aspects: This critical section of the plan includes a complete

list and description of all reporting requirements, customer-supplied
resources, liaison arrangements, advisory committees project review and
cancellation procedures, proprietary requirements, any specific management
agreements (eg., use of subcontractors), as well as the technical deliverables
and their specifications and delivery schedule. Completeness is a necessity in
this section. If in doubt, about whether an item should be included or not,
the wise planner will include it.

Schedules : This section outlines the various schedules and lists all milestone
events. The estimated time for each task should be obtained from those who
will do the work. The project master schedule is constructed from these
inputs. The responsible person or department head should sign off on the
final, agreed- on schedule.
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Resources: There are two primary aspects to this section. The first is the Project Planning
and Formulation
budget. Both capital and expense requirements are detailed by task, which
makes this a project budget. One-time costs are separated from recurring
project costs. Second, cost monitoring and control procedures should be
described. In addition to the usual routine cost elements, the monitoring and
control procedures must be designed to cover special resource requirements
for the project, such as special machines, test equipment, laboratory usage or
construction, logistics, field facilities and special materials.

Personnel: This section lists the expected personnel requirements of the

project. Special skills, types of training needed, possible recruiting problems,
legal or policy restrictions on work-force composition, and any other special
requirements, such as security clearances, should be noted here. It is helpful
to index personnel needed for the project schedule. This makes clear when
the various types of contributors are needed and in what numbers. These
manpower projections are important element of the budget, so the personnel,
schedule, and resources sections can be cross-checked with one another to
ensure consistency.

Evaluation Methods: Every project should be evaluated against standards

and by methods established at the project’s inception. This section contains a
brief description of the procedure to be followed in monitoring, collecting,
storing, and evaluating the history of the project.

Potential Problems: Sometimes it is difficult to convince planners to make a

serious attempt to anticipate potential difficulties. One or more such possible
disasters as subcontractor’s default, technical failure, strikes, bad weather,
sudden required breakthroughs, critical sequences of tasks, tight deadlines,
resource limitations, complex coordination requirements, insufficient
authority in some areas, and new, complex, or unfamiliar tasks are certain to
occur. The only uncertainties are which ones will occur and when. In fact, the
timing of these disasters is not random. There are times, conditions, and
events in the life of every project when progress depends on subcontractors,
or the weather, or coordination, or resource availability, and plans to deal
with unfavourable contingencies should be developed early in the project’s
life cycle. Some Project managers disdain this section of the plan on the
grounds that crises cannot be predicted. Further, they claim to be very
effective “fire fighters.” It is quite possible that when one finds such a Project
manager, one has discovered an “arsonist.” No amount of current planning
can solve the current crisis, but pre planning may avert some.
These are the elements that constitute the project plan and are the basis for a
more detailed planning of the budgets, schedules, work plan, and general
management of the project. Once this basic plan is fully developed and
approved, it is disseminated to all interested parties.

4.6.2 Systems Integration

System integration (sometimes called systems engineering) plays a crucial
role in the performance aspect of the project. We are using this phrase to 99
Investment include any technical specialist in the science or art of the project who is
Decisions under
Certainty capable of performing the role of integrating the technical disciplines to
achieve the customer’s objectives. As such, systems integration is concerned
with three major objectives.
• Performance: Performance is what a system does. It includes system
design, reliability, maintainability, and reparability. Obviously, these are
not separate, independent elements of the system, but are highly
interrelated qualities. Any of these system performance characteristics is
subject to over-design as well as undersign but must fall within the
design parameters established by the client. If the client approves, we
may give the client more than the specifications require simply because
we have already designed to some capability, and giving the client an
overdesigned system is faster and less expensive than delivering
precisely to specification. At times, the aesthetic qualities of a system
may be specified, typically through a requirement that the appearance of
the system must be acceptable to the client.
• Effectiveness: The objective is to design the individual components of a
system to achieve the desired performance in a optimal manner. This is
accomplished through the following guideline: Require no component
performance specification unless necessary to meet one or more systems
requirements. Every component requirement should be traceable to one
or more systems requirements. Design components to optimize system
performance, not the performance of a subsystem.
• Cost: Systems integration considers cost to be a design parameter, and
costs can be accumulated in several areas. Added design cost may lead to
decreased component cost, leaving performance and effectiveness
otherwise unchanged. Added design cost may yield decreased production
cost, and production cost may be trade-off against unit cost for materials.
Value engineering examines all these cost trade-offs and is an important
aspect of systems integration. It can be used in any project where the
relevant cost trade-offs can be estimated. It is simply the consistent and
thorough use of cost/effectiveness analysis. For an application of value,
engineering techniques applied to disease control projects.

Systems integrations plays a major role in the success or failure of any

project. If a risky approach is taken by system integration, it may delay the
project. If the approach is too conservative, we forego opportunities for
enhanced project capabilities or advantageous project economics. A good
design will take all these trade-offs into account in the initial stages of the
technical approach. And it will avoid locking the project into a rigid solution
with little flexibility or adaptability in case problems occur later on or
changes in the environment demand changes in project performance or
effectiveness.

4.6.3 Sorting Out the Project

In order to ensure a successful completion of a Project we need to know
exactly what is to be done, by whom, and when. All activities required to
100
complete the project must be precisely delineated and coordinated. The Project Planning
and Formulation
necessary resources must be available when and where they are needed, and
in the correct amounts. Some activities must be done sequentially, but some
may be done simultaneously. If a large project is to come in on time and
within cost, a great many things must happen when and how they are
supposed to happen. In this section, we propose a simple method to assist in
sorting out and planning all this detail.

To accomplish any specified project, there are several major activities that
must be completed. First, list them in the general order in which they would
normally occur. A reasonable number of major activities might be anywhere
between two and twenty. Break each of these major activities into two to
twenty subtasks. There is nothing sacred about the “two to twenty” limits.
Two is the minimum possible breakdown and twenty is about the largest
number of interrelated items that can be comfortably sorted and scheduled
at a given level of task aggregation. Second, preparing a network from this
information, is much more difficult if the number of activities is significantly
greater than twenty.

Sometimes a problem arises because some managers tend to think of

outcomes (events) when planning and other think of specific tasks
(activities). Many mix the two. The problem is to develop a list of both
activities and outcomes that represents an exhaustive, non redundant set of
results to be accomplished (outcomes) and the work to be done (activities) in
order to complete the project.

The procedure proposed here is a hierarchical planning system. First, the

goals must be specified. This will aid the planner in identifying the set of
required activities for the goals to be met, the project Action Plan. Each
activity has an outcome (event) associated with it, and these activities and
events can be decomposed into sub-activities and sub-events, which may, in
turn, be subdivided again. The Project Plan is the set of these Action Plans.
The advantage of the Project Plan is that it contains all planning information
in one document.

4.6.4 The Work Breakdown Structure and Linear

Responsibility Charts
The Work Breakdown Structure (WBS) used in project management is a type
of Gozinto chart and is constructed directly from the project’s Action
Plans.

The WBS may also be perceived as an organization chart with tasks

substituted for people as shown in Figure 4.3. It pictures a project subdivided
into hierarchical units of tasks, work packages, and work units. The end
results is a collection of work units each of which is relatively short in
time span.

Each has definite beginning and ending points along with specific criteria for
evaluating performance. Each part of the project down to the smallest subtask 101
Investment elements is budge table in terms of money, man hours, and other requisite
Decisions under
Certainty resources. Each is a single, meaningful job for which individual
responsibility can be assigned. Each can be scheduled as one of the many
jobs that the organization must undertake and complete.

Organisation Responsibility Work Breakdown Structure

(WBS)

Defined by Facility
responsibility
Organisation
Divisional
responsibility centre Location Location
Section 1 Section 2
Departmental
responsibility
centre Responsibility
Material
Engineering

Departmental
responsibility
centre Responsibility
Installation
Construction

Departmental
responsibility
centre Responsibility
Inspection Inspection

Figure 4.3: Responsibility/WBS relationship

Source: Lavold, G.D., “Developing and Using the Work Breakdown Structure”, in Cleland
D.I., and W.R. King. Project Management Handbook, Van Nostrand Reinhold, 1983.

In constructing the WBS, it is wise to contact the managers and workers who
will be directly responsible for each of the work packages. These people can
develop a hierarchical plan for the package delegated to them.

The WBS can be used to illustrate how each piece of the project is tied to the
whole in terms of performance, responsibility, budgeting, and scheduling.
The following general steps explain the procedure for designing and using
the WBS as it would be used on a large project. For small or moderate-size
projects, some of the steps might be skipped, combined, or handled less
formally than our explanation indicates, particularly if the project is of a type
familiar to the organization.

1) Using information obtained from the people who will perform the work,
break project tasks down into successively finer levels of detail.
Continue the decomposition of work until all meaningful tasks have been
identified and each task can be individually planned, scheduled,
budgeted, monitored, and controlled.
2) For each such work element:
Make up a work statement that includes the necessary inputs, the
102 specification reference, particular contractual stipulations, and specific
 end results to be achieved. List any vendors, contract, and subcontractors Project Planning
and Formulation
who are or may be involved. Identify detailed end item specifications for
each work element regardless of the nature of the end item, whether
hardware, software, test results, reports, etc.

Establish cost account numbers.

Identify the resource needs, such as manpower, equipment facilities,

support, funds, and materials. Cost estimators can assist the Project
Manager in constructing a task budget composed of costs for materials,
manufacturing operations, freight, engineering, contingency reserves,
and other appropriate charges.

List the personnel and organizations responsible for each task. It is

helpful to construct a linear responsibility chart (sometimes called a
responsibility matrix) to show that is responsible for what. This chart
also shows critical interfaces between units that may require special
managerial coordination. With it, the Project Manager can keep track of
who must approve what and who must report to whom.

3) The WBS, budget, and time estimates are reviewed with the people or
organizations that have responsibility for doing or supporting the work.
The purpose of this review is to verify the WBS’s accuracy, budget,
schedule, and to check interdependency of tasks, resources, and
personnel. The WBS may be revised as necessary, but the planner must
be sure to check significant revisions with all individuals who have
previously made inputs. When agreement is reached, individuals should
sign off on their individual elements of the project plan.

4) Resource requirements, time schedules, and subtask relationships are

now integrated to form the next higher level of the WBS; and so it
continues at each succeeding level of the WBS hierarchy. Thus, each
succeeding level of the WBS will contain the same kinds of information
regarding resources, budgets, schedules, and responsibilities as the levels
below it. The only difference is that the information is aggregated to
one higher level.

5) At the uppermost level of the WBS, we have a summary of the project

budget. For the purpose of pricing a proposal, or determining profit and
loss, the total project budget should consist of four elements: direct
budgets from each task as described above; an indirect cost budget for
the project, which includes general and administrative overhead costs
(G&A), marketing costs, potential penalty charges and other expenses
not attributable to particular tasks; a project “contingency” reserve for
unexpected emergencies; and any residual, which includes the profit
derived from the project, which may, on occasion, be intentionally
negative.

6) Similarly, schedule information and milestone events can be aggregated

into a project master schedule. The master schedule integrates the many 103
Investment different schedules relevant to the various parts of the project. It is
Decisions under
Certainty comprehensive and must include contractual commitments, key
interfaces and sequencing, milestone events, and progress reports. In
addition, a time contingency reserve for unforeseeable delays should be
included.

This series of steps complete the use of the WBS as a project planning
document. The WBS is also a key document for implementing,
monitoring, and controlling the project. The remaining steps concern its
use for these purposes.

7) One can now compare required task performance and outputs specified
in the WBS with those specified in the basic project plan in order to
identify potential misunderstandings, problem, and schedule slippages,
and then design corrective actions.

8) As the project is carried out, step by step, the Project Manager can
continually examine actual resource use, by work element, work
package, task, and so on up to the full project level. By comparing actual
against planned resource usage to a given point in time, the Project
Manager can identify problems, harden the estimates of final cost, and
make sure that relevant corrective actions have been designed and are
ready to implement if needed. It is necessary to examine resource usage
in relation to results achieved because, while the project may be over
budget, the results may be further along than expected. Similarly, the
expenses may be exactly as planned, or even lower, but actual progress
may be much less than planned.

9) Finally, the project schedule must be subjected to the same comparisons

as the project budget. Actual progress is compared to scheduled progress,
by work element, package, task, and complete project, to identify
problems and take corrective action. Additional resources may be
brought to those tasks behind schedule so as to expedite them. These
added funds may come out of the budget reserve or from other tasks that
are ahead of schedule.

4.7 SUMMARY

For any developing economy new investments in Greenfield projects,

expansion of existing projects, diversification etc. is an integral part of the
strategy to move towards higher rate of growth. All this requires resources
and strategy to allocate resources as resources are always in short supply.
Apart from allocating resources the various resources has to be coordinated.
All this requires a specialized technique known as project management &
planning. In this unit, we have discussed about the unique features of the
project, the project life cycle which represents the relationship between time
and project completion and also depicts the rate of progress with respect to
time. In the next section, we have discussed about the various elements
104
which has to be kept in consideration while planning the project work we had Project Planning
and Formulation
talked about work Breakdown Structure which shows how each piece of the
project is tied to the whole in terms of performance, responsibility,
budgeting and scheduling.

4.8 SELF ASSESSMENT QUESTIONS

a) What are the six component planning sequences of project planning?

b) Any successful project plan must contain nine key elements. List these
items and briefly describe the composition of each.
c) What are the basic guidelines for systems design that assure that
individual components of the system are designed in an optimal
manner?
d) What are the general steps for managing each “work package” within
a specific project?
e) What percentage of the total project effort do you think should be
devoted to planning? Why?
f) Why do you suppose that the coordination of the various elements of the
project is considered the most difficult aspect of project
implementation?
g) What kinds of problem areas might be included in the project plan?
h) What is the role of systems integration in project management? What are
the three major objectives of systems integration?
i) In what ways may the WBS be used as a key document to monitor and
control a project?
j) Describe the process of subdivision of activities and events which
compose the “tree” diagram known as the Work Breakdown Structure or
Gozinto chart. Why is the input of responsible managers and workers so
important an aspect of this process?

4.9 FURTHER READINGS

Lester, A. (2007). Project Management, Planning and Control: Managing
Engineering, Construction and Manufacturing Projects to PMI, APM and BSI
Standards. Netherlands: Elsevier/Butterworth-Heinemann.
Vanhoucke, M. (2014). Integrated Project Management and Control: First
Comes the Theory, Then the Practice. Germany: Springer International
Publishing.
DelPico, W. J. (2013). Project Control: Integrating Cost and Schedule in
Construction. Germany: Wiley.
Mantel, S. J. (2011). Project Management in Practice. United Kingdom:
Wiley.

105
Investment
Decisions under
UNIT 5 INVESTMENT APPRAISAL-EVALUATION
Certainty CRITERIA

Objectives

The objectives of this unit are:

• to explain nature and utility of Capital Budgeting,
• to provide an understanding of the process of evaluation of Investment
proposals,
• to discuss various tools of ranking of Investment proposals.

Structure

5.1 Nature of Capital Budgeting

5.2 Utility of Capital Budgeting
5.3 Investment Proposals and Administrative Aspects
5.4 Choosing among Alternative Proposals
5.5 Estimating cash flows from Capital Budgeting
5.6 Evaluating Investment Proposals
5.6.1 Payback Method

5.6.2 Return on Asset Method (ROA)

5.6.3 Present Value Method

5.6.4 Internal Rate of Return Method

5.6.5 Profitability Index (PI)

5.7 Capital Budgeting Methods in Practice
5.8 Summary
5.9 Self-Assessment Questions
5.10 Further Readings

5.1 NATURE OF CAPITAL BUDGETING

Capital budgeting is a managerial technique of planning capital expenditures

whose benefits are expected to extend beyond one year, such as expenditure
on acquisition of new buildings, improvement of existing buildings,
replacement of plant and machinery, acquisition of new facilities, new
machines, etc. Permanent addition to working capital, R&D expenditure are
also regarded as capital expenditures.

Capital budgeting technique involves matching of expected net cash inflows

from the project with anticipated cost of the project these two components of
capital budgeting technique are determinant of investment outlay.

106
 Project Planning
5.2 UTILITY OF CAPITAL BUDGETING and Formulation

Capital budgeting is the most potent technique employed in assessing

financial viability of projects and for that matter, allocating prudently the
funds among the projects by providing useful guidelines in identifying useful
projects and ranking them in terms of economic desirability to choose the
most promising one. Thus, it helps a firm in strengthening its financial health
and so also its competitive position.

Capital budgeting also acts as a planning and control device. As a planning

tool, it helps the managements to determine long-term capital requirements
and timings of such requirements. It also serves as a control device when
it is employed to control expenditures.

However, capital budgeting as a technique of decision-making suffers from

the problems involved in predicting future cash benefits, cost of capital.
Further, it fails to take cognizance of total consequences of the decision.

5.3 INVESTMENT PROPOSALS AND

ADMINISTRATIVE ASPECTS

Capital budgeting process involves several steps. The first step in the capital
budgeting process is to assemble a list of proposed new investments, together
with the data necessary to appraise them. Although practices vary from firm
to firm, proposals dealing with asset acquisitions are frequently grouped
according to the following four categories:

• Replacements of existing/old projects.

• Expansion: additional capacity in existing product lines.
• Growth: new product lines.
• Other (for example, pollution control equipment)

Other important aspects of capital budgeting involve administrative matters.

Approvals are typically required at higher levels within the organization as
we move away from replacement decisions and as the sums involved
increase. One of the most important functions of the board of directors is to
approve the major outlays in a capital budgeting program as well as the total
capital budget for each planning period. Such decisions are crucial for the
future well-being of the firm.

The planning horizon for capital budgeting programs varies with the nature
of the industry. When sales can be forecast with a high degree of reliability
for 10 to 20 years, the planning period is likely to be correspondingly long;
electric utilities are an example of such an industry. Also, when the product-
technology developments in the industry require an 8-to-10-year cycle to
develop a new major product, as in certain segments of the aerospace
industry, a correspondingly long planning period is necessary.

107
Investment After a capital budget has been adopted, funding must be scheduled.
Decisions under
Certainty Characteristically, the finance department is responsible for scheduling and
acquiring funds to meet scheduled requirements. The finance department is
also primarily responsible for cooperating with the operating divisions to
compile systematic records on the uses of funds and the installation of
equipment purchased. Effective capital budgeting programs require such
information as the basis for periodic review and evaluation of capital
expenditure decisions - the feedback and control phase of capital budgeting,
often called the post-audit review.

The foregoing represents a brief overview of the administrative aspects of

capital budgeting; the analytical problems involved are considered in the
following paragraphs.

5.4 CHOOSING AMONG ALTERNATIVE

PROPOSALS

In most firms, there are more proposals for projects than the firm is able or
willing to finance. Some proposals are good, others are poor, and methods
must be developed for distinguishing between the good and the poor.
Essentially, the end product is a ranking of the proposals and a cutoff point
for determining how far down the ranked list to go.

In part, proposals are eliminated because some are mutually exclusive.

Mutually exclusive proposals are alternative methods of doing the same job.
If one piece of equipment is chosen, other will not be required. Thus, if there
is a need to improve the materials handling system in a chemical plant, the
job may be done either by conveyer belts or by forklift trucks. The selection
of one method makes it unnecessary to use the others: They are mutually
exclusive items.

Independent projects are those that are being considered for different kinds of
tasks that need to be accomplished. For example, in addition to the materials
handling system, the chemical firm may need equipment to package the end
product. The work would require a packaging machine, and the purchase of
equipment for this purpose would be independent of the equipment
purchased for materials handling. The firm may undertake any or all
independent projects.
Finally, projects may be contingent. For example, there may be only one way
to build a football stadium but two ways of housing it (in a metal structure or
a geodesic dome). Because the stadium and its housing are contingent, the
analysis requires that we consider them together. Hence, we would want to
compare the stadium within a metal structure with the alternative of the
stadium within a geodesic dome.
To distinguish among the many proposals that compete for the allocation of
the firm’s capital funds, a ranking procedure must be developed. This
procedure requires calculating the estimated cash flows from the use of
108
equipment and then translating them into a measure of their effect on Project Planning
and Formulation
shareholders’ wealth.

First, we turn our attention to the problem of estimating cash flows for capital
budgeting purposes.

5.5 ESTIMATING CASH FLOWS FOR CAPITAL

BUDGETING
Cash flows for capital budgeting purposes are defined as the after-tax cash
flows for an all-equity financed firm. Algebraically, this definition is
equivalent to earnings before interest and taxes, EBIT, less the taxes the firm
would pay if it had no debt, T(EBIT), plus noncash depreciation charges,
∆ dep.
∆ Cash flow = ∆ EBIT - T (∆ EBIT) + ∆ depreciation

Note that this definition of cash flows is unaffected by the firm’s financing
decision, for example the amount of debt which it uses. Consequently, the
investment decision and the financing decision are kept separate when we use
this definition of cash flows for capital budgeting purposes.

We focus on how the firm’s cash flows will be changed. Table 5.1 provides
an example of a pro-forma income statement which can be used to illustrate a
cash flow calculation.

To arrive at the change in after-tax cash flows created by the project, we start
with increased revenues, ∆ R, then subtract out all items which are expensable
for tax purposes (∆ VC + ∆ FCC + ∆ dep). The result is taxable income,
assuming the firm has no debt. Next, we subtract the change in taxes and add
back the change in depreciation because depreciation is not a cash
outflow. The appropriate algebraic expression is:

∆ Cash flow = (∆ R – ∆ VC - ∆ FCC - ∆ dep) – T(∆ R – ∆ VC – ∆ FCC - ∆

dep) + ∆ dep.

Table 5.1 Pro-forma Income Statement

Description Symbol Amount

Change in sales revenue DR Rs.145,000
Change in variable operating cost DVC -90,000
Change in fixed cash costs DFCC -10,000
Change in depreciation Ddep -15,000
Change in earnings before interest and DEBIT 30,000
taxes
Change in interest expense Dr D -5,000
Change in earnings before tax DEBT 25,000
Change in taxes (@T=40%) Dtax -10,000
Change in net income DNI 15,000
109
Investment This equation can be simplified as follows:
Decisions under
Certainty
∆ Cash flow = (1–T) ( ∆ R – ∆ VC – ∆ FCC – ∆ Dep) + ∆ Dep

Note that the term in brackets is the same as the change in earnings before
interest and taxes, DEBIT; hence, the equation becomes:

∆ Cash flow = (1-T) ∆ EBIT + ∆ dep.

Substituting in the numbers from Table 5.1, we have:

∆ Cash flow = (1 – .4)(Rs.145,000 – Rs.90,000 – Rs.10,000 – Rs.15,000) +
Rs.15,000
= .6 (Rs.30,000) + Rs.15,000
= Rs.33,000

The procedure described above starts with revenues at the top of the income
statement and then works down to obtain the definition of cash flows for
capital budgeting purposes. Alternately, one can start at the bottom of the
income statement, with changes in net income (WNI) and build upward to
arrive at the same definition. Sometimes this approach is easier to use. The
algebraic expression for the change in cash flows is

∆ Cash flow – ∆ NI + ∆ dep + (1 – T) ∆ r

Activity 1

a) Identify expenditures that are considered in Capital Budgeting

technique.
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
b) List out steps involved in evaluating investment proposals.
............................................................................................................
............................................................................................................
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............................................................................................................
c) Explain why net cash flows after tax is considered for decision
making.
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110
d) Explain how depreciation is treated while considering investment Project Planning
and Formulation
proposals.
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................

5.6 EVALUATING INVESTMENT PROPOSALS

The point of capital budgeting - indeed, the point of all financial analysis - is
to make decisions that will maximize the value of the firm. The capital
budgeting process is designed to answer two questions: (1) Which of several
mutually exclusive investments should be selected? (2) How many projects,
in total, should be accepted?

Among the many methods used for evaluating investment proposals, five are
discussed here.
1) Payback method (or payback period): Number of years required to
return the original investment.
2) Return on assets (ROA) or return on investment (ROI): An
average rate of return on assets employed.
3) Net present value (NPV) method: Present value of expected future
cash flows discounted at the appropriate cost of capital, minus the cost of
the investment.
4) Internal rate of return (IRR) method: Interest rate which equates the
present value of future cash flows to the investment outlay.
5) Profitability Index (PI): It shows the relative profitability of any
project, or the present value of benefits per rupee of costs.

General Principles

When comparing various capital budgeting criteria, it is useful to establish

some guidelines. What are the properties of an ideal criterion? The optimal
decision rule should have four characteristics:

1) It will select from a group of mutually exclusive projects the one which
maximizes shareholders’ wealth.

2) It will appropriately consider all cash flows.

3) It will discount the cash flows at the appropriate market-determined

opportunity cost of capital.

4) It will allow managers to consider each project independently from all

others. This has come to be known as the value additivity principle.

111
Investment The value additivity principle implies that if we know the value of separate
Decisions under
Certainty
projects accepted by management, then simply adding their values, V’ will
give us the value of the firm. If there are N projects, then the value of the
firm will be:
N
V v j , j 1,.....N
j 1

This is a particularly important point because it means that projects can be

considered on their own merit without the necessity of looking at them in an
infinite variety of combinations with other projects.

Table 5.2 gives the cash flows for four mutually exclusive projects. They
all have the same life, five years, and they all require the same investment
outlay, Rs.1,500. Once accepted, no project can be abandoned without
incurring the outflows indicated. For example, Project A has negative cash
flows during its fourth and fifth years. Once the project is accepted these
expected cash outflows must be incurred. An example of a project of this
type is a nuclear power plant. Decommissioning costs at the end of the
economic life of the facility can be as large as the initial construction costs
and they must be taken into account.

Table 5.2: Cash Flows of Four Mutually Exclusive Projects

Year A B C D PVIF@10%
0 -1,500 -1,500 -1,500 -1,500 1.000
1 150 0 150 300 .909
2 1,350 0 300 450 .826
3 150 450 450 750 .751
4 -150 1,050 600 750 .683
5 -600 1,950 1,875 900 .621

The last column of Table 5.2 shows the appropriate discount factor for the
present value of cash flows, assuming that the appropriate opportunity cost of
capital is 10 percent. Since all four projects are assumed to have the same
risk, they can be discounted at the same interest rate.

Now we turn our attention to the actual implementation of the five above-
mentioned capital budgeting techniques (1) the payback method, (2) the
return on assets, (3) the net present value,(4) the internal rate of return, (5)
Profitability Index. We shall see that only one technique - the net present
value method - satisfies all four of the desirable properties for capital
budgeting criteria.

5.6.1 Payback Method

The payback period is the number of years required to recover the initial
capital outlay on a project. The payback periods for the four projects in
112 Table 5.2 are given below.
Project A, 2-year payback Project Planning
and Formulation
Project B, 4-year payback
Project C, 4-year payback
Project D, 3-year payback.

If management were adhering strictly to the payback method, then Project A

would be chosen as the best among the four mutually exclusive alternatives.
Even a casual look at the numbers indicates that this would be a bad decision.
The difficulty with the payback method is that it does not consider all cash
flows and it fails to discount them. Failure to consider all cash flows results
in ignoring the large negative cash flows which occur in the last two years of
Project A. Failure to discount them means that management would be
indifferent between the following two cash flow patterns:

Cash Flows
Year G G*
0 -1,000 -1,000
1 100 900
2 900 100

because they have the same payback period. Yet no one with a positive
opportunity cost of funds would choose Project G because Project G* returns
cash much faster.

The payback method also violates the value additivity principle. Consider the
following example. Projects 1 and 2 are mutually exclusive but Project 3 is
independent. Hence, it is possible to undertake Projects 1 and 3 in
combination, 2 and 3 in combination, or any of the projects in isolation.

The only arguments in favour of using the payback method is that it is easy to
use, but with the advent of pocket calculators and computers, we feel that
other more correct capital budgeting techniques are just as easy to use.

5.6.2 Return on Assets (ROA)

The return on assets (ROA) which is also sometimes called the return on
investment (ROI)is an average rate of return technique. It is computed by
averaging the expected cash flows over the life of a project and then dividing
the average annual cash flow by the initial investment outlay. For example,
the ROA for Project B in Table 5.2 is computed from the following
definition:
n
ROA cash flow/n Io
t 0

where
Io = Initial cash outlay = Rs.1,500
n = Life of the project = 5 years.
113
Investment Substituting in the correct numbers from Table 5.2, we have
Decisions under
Certainty Rs. 1,500 Rs.0 Rs.0 Rs.450 Rs.1, 050 Rs.1,950
ROA Rs.1,500
5
Rs.1,950
Rs.1,500
5
Rs.390
26%
Rs.1,500
The ROA’s for the four projects are
Project A, - 8%
Project B, 26%
Project C, 25%
Project D, 22%

The ROA criterion chooses Project B as best. The major problem with ROA
is that it does not take the time value of money into account. We would have
obtained exactly the same ROA for Project B, even if the order of cash flows
had been reversed with Rs.1,950 received now, Rs.1,050 at the end of
Year 1, Rs.450 at the end of Year 2 and -Rs.1,500 at the end Year 5. But
no one with a positive opportunity cost of capital would be indifferent
between the alternatives. The opposite ordering of cash flows would always
be preferred.

5.6.3 Present value method

Another method based on discounted cash flow approach employed to
evaluate financial viability of investment projects is the present value
method, which involves discounting of streams of future cash earnings to
present value at required rate of return to the firm (cost of capital). For
ranking projects under this method, net present value is computed. Project
with highest positive net present value is accorded the highest priority.

The equation for calculating the net present value of a project is :

n
CFt
t Io
t 1 1 K

Here CF1,CF2, and so forth represent the net cash flows; k is the firm’s cost
of capital; I0 is the initial cost of the project; and n is the project’s
expected life.

The net present value of Project C in Table 5.2 is calculated below by

multiplying each cash flow by the appropriate discount factor (PVIF),
assuming that the cost of capital, k, is 10 per cent.

114
 Year Cash Flow X PVIF = PV Project Planning
and Formulation
0 -1,500 1.000 -1,500.00
1 150 .909 136.35
2 300 .826 247.80
3 450 .751 337.95
4 600 .683 409.80
5 1,875 .621 1,164.38
NPV = 796.28

The net present value of all four projects in Table 5.2 are:

Project A NPV = Rs. –610.95.

Project B NPV = Rs. 766.05
Project C NPV = Rs. 796.28
Project D NPV = Rs.778.80

If these projects were independent instead of mutually exclusive, we would

reject A and accept B,C, and D. Why? Since they are mutually exclusive, we
select the project with the greatest NPV, Project C. The NPV of the project is
exactly the same as the increase in shareholders’ wealth. This fact makes it
the correct decision rule for capital budgeting purposes. The NPV rule also
meets the other three general principles required for an optimal capital
budgeting criterion. It takes all cash flows into account. All cash flows are
discounted at the appropriate market-determined opportunity cost of capital
in order to determine their present values. Also, the NPV rule obeys the value
additivity principle.
The net present value of a project is exactly the same as the increase in
shareholders’ wealth. To see why, start by assuming a project has zero net
present value. In this case, the project returns enough cash flow to do three
things:
1. To pay off all interest payments to creditors who have lent money to
finance the project.
2. To pay all expected returns (dividends and capital gains) to shareholders
who have put up equity for the project, and
3. To pay off the original principal, I0, which was invested in the
project?

Thus, a zero net present value project is one which earns a fair return to
compensate both debt holders and equity holders, each according to the
returns which they expect for the risk they take. A positive NPV project earns
more than the required rate of return, and equity holders receive all excess
cash flows because debt holders have a fixed claim on the firm.
Consequently, equity holders’ wealth increases by exactly the NPV of the
project. It is this direct link between shareholders’ wealth and the NPV
definition which makes the net present value criterion so important in
decision making.
115
Investment 5.6.4 Internal Rate of Return Method
Decisions under
Certainty
The internal rate of return (IRR) is defined as the interest rate that equates the
present value of the expected future cash flows, or receipts, to the initial cost
outlay. The equation for calculating the internal rate of return is:
Cf1 Cf 2 Cf n
1 2 ... n I0 0
1 IRR 1 IRR 1 IRR
n
Cf t
t I0 0
t 1 1 IRR

Here we know the value of I0 and also the values of CF1,CF2,.....CFn, but we
do not know the value of IRR. Thus, we have an equation with one unknown,
and we can solve for the value of IRR. Some value of IRR will cause the sum
of the discounted receipts to equal the initial cost of the project, making the
equation equal to zero, and that value of IRR is defined as the internal rate of
return.

The internal rate of return may be found by trial and error. First, compute the
present value of the cash flows from an investment, using an arbitrarily
selected interest rate - for example, 10 percent. Then compare the present
value so obtained with the investment’s cost. If the present value is higher
than the cost figure, try a higher interest rate and go through the procedure
again. Conversely, if the present value is lower than the cost, lower the
interest rate and repeat the process. Continue until the present value of the
flows from the investment is approximately equal to its cost. The interest rate
that brings about this equality is defined as the internal rate of return.

Table 5.3 shows computation for the IRR for Project D in Table 5,2 and
Figure 5.1 graphs the relationship between the discount rate and the NPV of
the project.
Table 5.3: IRR for Project D

Year Cash Pv@10% PV@20% PV@25% [email protected]%

Flow
0 -1,500 1.000 -1,500.00 1.000 -1,500.00 1.000 -1.500.00 1.000 -1,500.00
1 300 .909 272.70 .833 249.90 .800 240.00 .797 239.10
2 450 .826 371.70 .694 312.30 .640 288.00 .636 286.20
3 750 .751 563.25 .579 434.25 .512 384.00 .507 380.25
4 750 .683 512.25 .482 361.50 .410 307.50 .404 303.00
5 900 .621 558.90 .402 361.80 .328 295.20 .322 289.80
1650 778.80 219.75 14.70 -1.65

116
 NPV Project Planning
and Formulation
Rs. 2,000

Rs. 1,00
IRR = 25.4%

0
10% 20% 30% 40% 50%

Rs. -1,000
If K→∞, then NPV →Rs. -1,500

Rs. -2,000
Figure 5.1: NPV of Project D at Different Discount Rates

In Figure 5.1 the NPV of Project D’s cash flows decreases as the discount
rate is increased. If the discount rate is zero, there is no time value of money
and the NPV of a project is simply the sum of its cash flows. For Project D,
the NPV equals Rs.1,650 when the discount rate is zero. At the opposite
extreme, if the discount rate is infinite, then the future cash flows are
valueless and the NPV of Project D is its current cash flow, –Rs.1,500.
Somewhere between these two extremes is a discount rate which makes the
NPV equal to zero. In Figure 5.1, we see that the IRR for Project D is 25.4
per cent. The IRR’s for each of the four projects in Table 1 are given
below.
Project A IRR = - 200%
Project B IRR = 20.9%
Project C IRR = 22.8%
Project D IRR = 25.4%

If we use the IRR criterion and the projects are independent, we accept any
project which has an IRR greater than the opportunity cost of capital, which
is 10 percent. Therefore, we would accept Projects B, C, and D. However,
since these projects are mutually exclusive, the IRR rule leads us to accept
Project D as best.

Profitability Index (PI)

Another method that is used to evaluate projects is the profitability index

(PI), or the benefit/cost ratio, as it is sometimes called:

Present value methods had the merit of simplicity in as much as it helps the
management in choosing the most profitable proposal. Further, while
evaluating and ranking projects it focuses on one of the primary objectives of
a firm, i.e., increasing value of the firm.

117
Investment However, main drawback of this approach is that it does not take into
Decisions under
Certainty consideration size of investment outlay and net cash benefits together while
ranking projects. This may at times lead to faulty decisions.

Profitability Index (PI) method has come to be employed to overcome the

above drawback and to ensure rational investment decision by establishing
relationship between the present values of the net cash inflows and net
investment outlay.

The equation to compute ‘PI’ of a project is :

n
CIFt
t
PV benefits t 0 1 K
PI
PV Costs n
COFt
2
t 0 1 K

Here CIFt represents the expected cash inflows, or benefits, and COFt
represents the expected cash outflows, or costs. The PI shows the relative
profitability of any project, or the present value of benefits per rupee costs.
The PI for Project C, based on a 10 percent cost of capital is:

Similarly:
Project A PI = 0.59
Project B PI = 1.51
Project D PI = 1.52

A project is acceptable if its PI is greater than 1.0, and the higher the PI, the
higher the project ranking. Mathematically, the NPV, the IRR, and the PI
methods must always reach the same accept/reject decisions for independent
projects: If a project’s NPV is positive, its IRR must exceed k and its PI must
be greater than 1.0. However, NPV, IRR, and PI can give different rankings
for pairs of projects. This can lead to conflicts between the three methods
when mutually exclusive projects are being compared.

Activity 2

1) Contact Finance Managers of five PSUs and five Indian Companies to

find out the existing capital budgeting evaluation methods used by
them.
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118
2) Approach Finance Managers of three MNCs to ascertain what methods Project Planning
and Formulation
are used to evaluate the projects.
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
3) Explain why.
i) Future Net Cash flows are discounted
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
ii) Expected Investment outlay is not discounted
............................................................................................................
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............................................................................................................
............................................................................................................

5.7 CAPITAL BUDGETING METHODS IN

PRACTICE

The above discussion leads us to conclude that IRR, NPV and PI methods
will result in the same decision, except in certain cases involving mutually
exclusive projects or non-normal cash flows. The question that arises which
capital budgeting techniques do firm actually use in practice. Lawrence
Gitman and John Forester conducted a survey to help answer this question.

Gitman and Forester received 103 usable responses from a survey sent to 268
major companies known to make large capital expenditures. They found that
the responsibility for capital budgeting analysis generally rests with the
finance department. The respondents also stated that defining projects and
estimating their cash flows were the most difficult and the most critical steps
in the capital budgeting process.

Table – 5.4 summarizes the capital budgeting methods used by the

respondent firms. The results indicate a strong preference for discounted cash
flow (DCF) capital budgeting techniques, that is, NPV, IRR, and PI, with the
dominant method being IRR. However, the heavy use of ROA and payback
as primary ranking techniques indicates that not all U.S. firms were
technologically up to part in an economic sense.

119
Investment Table 5.4: Capital Budgeting Methods Used
Decisions under
Certainty
Primary Secondary
Method Number Percent Number Percent
IRR 60 53.6% 13 14.0%
ROA 28 25.0 13 14.0
NPV 11 9.8 24 25.8
Payback period 10 8.9 41 44.0
PI 3 2.7 2 2.2
Total 112 100.0% 93 100.0%

It may also be noted that almost all the respondents used at least two methods
in their analysis, and as evidenced by the 112 primary methods from 103
respondents, some firms use more than one primary method. Although the
questionnaire did not bring this point out, we suspect that many of the
analysts of firms which use the IRR as the primary method recognize its
drawbacks, yet use it anyway because it is easy to explain to non-financial
executives but

use NPV as a check on IRR when evaluating mutually exclusive or non-

normal projects. It is also doubtful the payback method can be used as a
liquidity and/ or risk indicator, hence to help choose among competing
projects whose NPVs and/or IRRs are close together. One interesting, and
encouraging note is that when compared with earlier surveys, Gitman and
Forester found that the discounted cash flow methods are gaining in usage.

As regards the use of assessment methods employed by Indian corporate,

study of 100 medium and large scale companies conducted in 1994, reveals
that Indian Companies have started using discounting techniques more than
non- discounting approaches. Although some companies are still using
payback period approach, it is the net present value technique which is used
quite widely, particularly by companies which have high sales volume and
large-paid-up capital. Small and new companies are still relying on
traditional approach like pay-back period.

5.8 SUMMARY

For any economy/company, there are many avenues of investments, but one
can’t go and invest in all of these avenues. This gives rise to problem of
selection of a particular project out of the many available. Here capital
budgeting techniques play an important role in deciding which project to
select & which to reject. Capital budgeting technique involves matching of
expected net cash inflows from the project with anticipated cost of the
project. Capital budgeting techniques are broadly classified in two categories.
Discounted and non discounted the major difference between these two is
that in former the future cash flows are discounted at appropriate discount
rate (usually cost of capital) to get net present value of future cash flows.
120
 Project Planning
5.9 SELF ASSESSMENT QUESTIONS and Formulation

i) Are there conditions under which a firm might be better off if it chose a
machine with a rapid payback rather than one with the largest rate of
return?
ii) Company X uses the payback method in evaluating investment proposals
and is considering new equipment whose additional net after-tax
earnings will be Rs.150 a year. The equipment costs Rs.500, and its
expected life is ten years (straight-line depreciation). The company uses
a three-year payback as its criterion. Should the equipment be purchased
under the above assumptions?
iii) What are the most critical problems that arise in calculating a rate of
return for a prospective investment?
iv) What other factors in addition to rate of return analysis should be
considered in determining capital expenditures?
v) A firm has an opportunity to invest in a machine at a cost of Rs.6,56,670.
The net cash flows after taxes from the machine would be Rs.2,10,000
per year and would continue for five years. The applicable cost of capital
for this project is 12 percent.
a) Calculate the net present value for the investment.
b) What is the internal rate of return for the investment?
c) Should the investment be made?

5.10 FURTHER READINGS

Baker, H. K., English, P. (2011). Capital Budgeting Valuation: Financial
Analysis for Today's Investment Projects. United Kingdom: Wiley.

Berk, J., De Marzo, P., Venanzi, D. (2009). Capital budgeting. Italy: Pearson.
Dayananda, D., Herbohn, J., Harrison, S., Irons, R., Rowland, P. (2002). Capi
tal Budgeting: Financial Appraisal of Investment Projects. United
Kingdom: Cambridge University Press
Herbst, A. F. (2003). Capital Asset Investment: Strategy, Tactics and
Tools. Germany: Wiley.

Peterson, P. P., Fabozzi, F. J. (2004). Capital Budgeting: Theory and

Practice. Germany: Wiley.

Senthilnathan, S. (2021). Capital Budgeting - The Tools for Project

Evaluation. (n.p.): ELIVA Press.

Tamilmani, B. (2004). Capital Budgeting: Decision, Implementation And

Evaluation. India: Kanishka Publishers, Distributors.

121
Investment
Decisions under UNIT 6 PROJECT IMPLEMENTATION
Certainty
AND CONTROL

Objectives

The objectives of this unit are:

• to provide an understanding of how the implementation system is

designed,
• to explain concept of control and its various types,
• to focus on types of control Processes,
• to throw light on designing of control system.

Structure

6.1 Introduction
6.2 Designing of the Monitoring System
6.3 How to Collect Data
6.4 Information needs and the Reporting Process
6.5 Report Types
6.6 Project Control
6.7 Types of Control Processes
6.7.1 Cybernetic Control
6.7.2 Go/No-go Control
6.7.3 Post Control

6.8 Design of Control System

6.9 Control of creative Activities
6.10 Progress Review
6.11 Personnel Reassignment
6.12 Control of Input Resources
6.13 Summary
6.14 Self Assessment Questions
6.15 Further Readings

6.1 INTRODUCTION

Monitoring is collecting, recording, and reporting information concerning

any and all aspects of project performance that the project manager or others
in the organization wish to know. In our discussion it is important to
remember that monitoring, as an activity, should be kept quite distinct from
controlling (which uses the data supplied by monitoring to bring actual
performance into approximate congruence with planned performance), as
122
well as from evaluation (through which judgments are made about the quality Project
Implementation
and effectiveness of project performance). and Control

6.2 DESIGNING OF THE MONITORING SYSTEM

The first step in setting up any monitoring system is to identify the key
factors to be controlled. Clearly, the project manager wants to monitor
performance, cost, and time but must define precisely which specific
characteristics of performance, cost, and times should be controlled and then
establish exact boundaries within which control should be maintained. And
there may also be other factors of importance worth noting, at least at
certain points in the life of the project. for example, the number of labour
hours used, the number or extent of engineering changes, the level of
customer satisfaction, and similar items may be worthy of note on individual
projects.

But the best source of items to be monitored is the project Action Plan -
actually, the set of Action Plans that describe what is being done, when, and
the planned level of resource usage for each task, work package, and work
unit in the project. The monitoring system is a direct connection between
planning and control. If it does not collect and report information on some
significant element of the plan, control can be faulty or missing. The
measured and reported to the control system, but it is not sufficient. For
example, the project manager might want to know about changes in the
client’s attitudes toward the project. Information on the morale of the project
team might be useful in preparing for organizational or personnel changes
on the project. These two latter items may be quite important, but are not
reflected in the project’s action plan.

Unfortunately, it is common to focus monitoring activities on data that are

easily gathered - rather than important - or to concentrate on “objective”
measures that are easily defended at the expense of softer, more subjective
data that may be more valuable for control. Above all, monitoring should
concentrate primarily on measuring various facets of output rather than
activity. It is crucial to remember that effective project managers are not
primarily interested in how hard their project teams work. They are
interested in results.

Given all this, performance criteria, standards, and data collection procedures
must be established for each of the factors to be measured. The criteria and
data collection procedures are usually set up for the life of the project. The
standards themselves, however, may not be constant over the project’s life.
They may change as a result of altered capabilities within the parent
organization or a technological breakthrough made by the project team; but,
perhaps more often than not, standards and criteria change because of factors
that are not under the control of the project manager.

123
Investment Next, the information to be collected must be identified. This may consist of
Decisions under
Certainty accounting data, operating data, engineering test data, customer reactions,
specification changes, and the like. The fundamental problem in this regard is
to determine precisely which of all the available data should be collected. It is
worth repeating that the typical determinant for collecting data too often
seems to be simply the ease with which it can be gathered. Of course, the
nature of the required data is dictated by the project plan, as well as by the
goals of the parent organization, and by the fact that it is desirable to improve
the process of managing projects.

Therefore, the first task is to examine the project plans in order to extract
performance, time, and cost goals. These goals should relate to some fashion
to each of the different levels of detail; that is, some should relate to the
project, some to its tasks, some to the work packages, and so on. Data must
be identified that measure achievement against the goals, and mechanisms
designed for gathering and storing such data. Similarly, the process of
developing and managing projects should be considered and steps taken to
ensure that information relevant to the diagnosis and treatment of the
project’s organizational infirmities and procedural problems are gathered.

6.3 HOW TO COLLECT DATA

Given that we know what type of data we want to collect, the next question is
how to collect this information. At this point in the construction of a
monitoring system, it is necessary to define precisely what pieces of
information should be gathered and when. In most cases, the project
manager has options questions then arise. Should cost data be gathered
before or after some specific event? Is it always mandatory to collect time
and cost information at exactly the same point in the process? What do we do
if a specific piece of desirable data is difficult to collect because the data
source (human) fears reporting any information that might contribute to a
negative performance evaluation? What do we do about the fact that some
use of time is reported as “hours charged” to our project, and we are quite
aware that our project has been charged for work done on another project that
is over budget? Are special forms needed for data collection? Should we set up
quality control procedures to ensure the integrity of data transference from its
source to the project information system? Such questions merely indicate the
broad range of knotty issues that must be handled.

A large proportion of the data collected may take one of the following forms,
each of which is suitable for some types of measures.

1) Frequency Counts: A simple tally of the occurrence of an event. This

type of measure is often used for “complaints,” “number of times a
project report is late,” “bugs in a computer program” and similar items.
The data are usually easy to collect and are often reported as events per
unit time or events as a percent of a standard number.
124
2) Raw Numbers: Dates, hours, physical amounts of resources used, and Project
Implementation
specifications are usually reported in this way. These numbers are and Control
reported in a wide variety of ways, but often as direct comparisons with
an expected or standard number. Also, “variances” are commonly
reported as the ratios of actual to standard. Comparisons on ratios can
also be plotted as a time series to show changes in system
performance.

3) Subjective Numeric Ratings: These number are subjective estimates,

usually of a quality, made by knowledgeable individuals or groups. They
can be reported in most of the same ways that objective raw numbers are,
but care should be taken to make sure that the numbers are not
manipulated in ways only suitable for quantitative measures. Ordinal
rankings of performance are included in this category.

4) Indicators: When the project manager cannot measure some aspect of

system performance directly, it may be possible to find an indirect
measure on indicator. The speed with which change orders are processed
and changes are incorporated into the project is often a good measure of
team efficiency. Response to change may also be an indicator of the
quality of communications on the project team. When using indicators to
measure performance, the project manager make sure that, the linkage
between the indicator and the desired performance measure is as direct
as possible.

5) Verbal Measures: Measures for such performance characteristics as

“quality of team member cooperation,” “morale of team members,” or
“quality of interaction with the client” frequently take the form of verbal
characterization. As long as the set of characterizations is limited, and
the meanings of the individual terms are consistently understood by all,
these data serve their purposes reasonably well.

After data collection has been completed, reports on project progress should
be generated. These include project status reports, time/cost reports, and
variance reports, among others. Causes and effects should be identified and
trends noted. Plans, charts, and tables should be updated on a timely basis.
Where known, “comparables” should be reported, as should statistical
distributions of previous data if available. Both help the project manager (and
others) to interpret the data being monitored.

The purpose of the monitoring system is to gather and report data. The
purpose of the control system is to act on the data. To aid the project
controller, it is helpful for the monitor to carry out some data analysis.
Significant variances from plan should be highlighted or “flagged” so that
they cannot be overlooked by the controller. The methods of statistical
quality control are very useful for determining what size variances are
“significant” and sometimes even help in determining the probable cause(s)
of variances. Where causation is known, it should be noted. Where it is not
known, an investigation may be in order. The decisions about when an 125
Investment investigation should be conducted, by whom, and by what methods are the
Decisions under
Certainty prerogative of the project controller, although the actual investigation may be
conducted by the group responsible for monitoring.

In creating the monitoring system, some care should be devoted to the issues
of honesty and bias. The former is dealt with by setting in place an internal
audit. The audit serves the purpose of ensuring that the information gathered
is honest. No audit, however, can prevent bias. All data are biased by those
who report them, advertently or inadvertently. The controller must
understand this fact of life. The first issue is to determine whether or not the
possibility of bias in the data matters significantly. If not, nothing need be
done. Biased findings and correcting activities are worthwhile only if data
with less or no bias are required.

There is some tendency for project monitoring systems to include an analysis

directed at the assignment of blame. This practice has doubtful value. While
the managerial dictum “rewards and punishments should be closely
associated with performance” has the ring of good common sense, it is
actually not good

advice. Instead of motivating people to better performance, the practice is

more apt to result in lower expectations. If achievement of goals is directly
measured and directly rewarded, a tremendous pressure will be put on people
to understate goals and to generate plans that can be met or exceeded with
minimal risk and effort.

6.4 INFORMATION NEEDS AND THE

REPORTING PROCESS

Everyone concerned with the project should be tied into the project reporting
system. The monitoring system ought to be so constructed that it addresses
every level of management, but reports need not be of the same depth or at
the same frequency for each level. Lower-level personnel have a need for
detailed information about individual tasks and the factors affecting such
tasks. Report frequency is usually high. For the senior management levels,
overview reports describe progress in more aggregate terms with less
individual task detail. Reports are issued less often. At times, it may be
necessary to move information among organizations, as illustrated in Figure
6.1, as well as among managerial levels.

Reports must contain data relevant to the control of specific tasks that are
being carried out according to a specific schedule. The frequency of reporting
should be great enough to allow control to be exerted during or before the
period in which the task is scheduled for completion.

In addition to the criterion that reports should be available in time to be used

for project control, the timing of reports should generally correspond to the
timing of project milestones. This means that project reports may not be
126 issued periodically-excepting progress reports for senior management. There
seems to be no logical reason, except for tradition, to issue weekly, monthly, Project
Implementation
quarterly, etc., reports. Few projects require attention so neatly consistent and Control
with the calendar. This must not be taken as advice to issue reports “every
once in a while.” Reports should be scheduled in the project plan. They
should be issued on time. The report schedule, however, need not call for
periodic reports.

Company
Consultant

V.P.
Ventures

Steering
Committee
Marketing

Project Project
Manager Manager

Technical
Assistant

---------Denotes information flow

Figure 6.1: Reporting and information flows between organisations working on a

common project

Identification of project milestones depends on who is interested. For senior

management, there are only a few milestones even in large projects. For the
project manager, there may be many critical points in the project schedule at
which major decisions must be made, large changes in the resource base must
be initiated, or key technical results achieved. The milestones relevant to
lower levels relate to finer detail and occur with higher frequency.
The nature of the monitoring reports should be consistent with the logic of
the planning, budgeting, and scheduling systems. The primary purpose is, of
course, to ensue achievement of the project plan through control. There is,
therefore, little reason to burden operating members of the project team with
extensive reports on matters that are not subject to control - at least not by
them. The scheduling and resource usage columns of the project Action Plan
will serve as the key to the design of project reports.
There are many benefits of detailed reports delivered to the proper people on
a timely basis. Among them are :
• Mutual understanding of the goals of the project.
• Awareness of the progress of parallel activities and of the problems
associated with coordination among activities.
• More realistic planning for the needs of all groups and individuals
working on the project.
127
Investment • Understanding the relationships of individual tasks to one another and to
Decisions under
Certainty
the overall project.
• Early warning signals of potential problems and delays in the project.
• Minimizing the confusion associated with change by reducing delays in
communicating the change.
• Faster management action in response to unacceptable or inappropriate
work.
• Higher visibility to top management, including attention directed to the
immediate needs of the project.
• Keeping the client and other interested outside parties up to date on
project status, particularly regarding project milestones and deliverables.

6.5 REPORT TYPES

For the purposes of project management, we can consider three distinct types
of reports: routine, exception, and special analysis. The routine reports are
those issued on a regular basis; but, as we noted above, regular does not
necessarily refer to the calendar. For senior management, the reports will
usually be periodic, but for the project manager and lower-level project
personnel, milestones may be used to trigger routine reports.

At times, it may be useful to issue routine reports on resource usage

periodically, occasionally on a weekly or even daily basis.

Exception reports are useful in two cases. First, they are directly oriented to
project management decision making and should be distributed to the team
members who will have prime responsibility for decisions or who have a
clear “need to know.” Second, they may be issued when a decision is made
on an exception basis and it is desirable to inform other managers as well as
to document the decision - in other words, as part of a sensible procedure for
protecting oneself.

Special analysis reports are used to disseminate the results of special studies
conducted as part of the project or as a response to special problems that arise
during the project. Usually they cover matters that may be of interest to other
project manager, or make use of analytic methods that might be helpful on
other projects. Studies on the use of substitute materials, evaluation of
alternative manufacturing processes, availability of external consultants,
capabilities of new software, and descriptions of new governmental
regulations are all typical of the kind of subjects covered in special
analysis reports. Distribution of these reports is usually made to anyone who
might be interested.

The real message carried by project reports is in the comparison of activity to

plan and of actual output to desired output. Variances are reported by the
monitoring system, and responsibility for action rests with the controller.

128
Because the project plan is described in terms of performance, time, and cost, Project
Implementation
variances are reported for those same variables. Project variance reports and Control
usually follow the same format used by the accounting department, but at
times, they may be presented differently.

This variance report shows the ratio of the material estimated to the material
used in projects. As a result of this information, the program manager decides
that it would be less expensive for the company to carry small inventories in
a few of the commonly used high alloys, and to estimate (and price) material
use closer to actual expectations.

The Earned Value Chart

Thus far, we have covered monitoring for parts of projects. The monitoring of
performance for the entire project is also crucial because performance is the
raison d’etre of the project. Individual task performance must be monitored
carefully because the timing and coordination between individual tasks is
important. But overall project performance is the crux of the matter and must
not be overlooked. One way of measuring overall performance is by using an
aggregate performance measure called earned value.

A serious difficulty in comparing actual expenditures against budgeted or

baseline expenditures for any given time period is that the comparison fails to
take into account the amount of work accomplished relative to the cost
incurred. The earned value of work performed for those tasks in progress is
found by multiplying the estimated percent completion for each task by the

planned cost for that task. The result is the amount that “should” have been
spent on the task thus far. This can then be compared with the actual amount
spent. A graph such as that shown in Figure 6.2 can be constructed and
provides a basis for evaluating cost and performance to date. If the planned
(baseline) total value of the work accomplished is in balance with the planned
cost (i.e., minimal scheduling variance), then top management has no
particular need for a detailed analysis of individual tasks. Thus, the concept
of earned value combines cost reporting and aggregate performance reporting
into one comprehensive chart.

129
Investment
Decisions under
Certainty

Cost Schedule Plan

(Baseline)

Rupees
Actual
Cost Total
Variance Spending Variance
of Cost Overrun
Schedule (quantity and price)
Variance

Value Completed

1 2 3

Time Variance
(10 day delay)

Figure 6.2: Earned value Chart

Three variances can be identified on the earned value chart. The spending
variance is the actual cost less the value completed, the schedule variance is
the value completed less the baseline plan, and the total variance is the sum
of the two: actual less planned cost. Top management, as mentioned above, is
usually most concerned with the schedule (or time) variance, whereas the
project controller is probably concerned with the spending variance (cost
overrun) and the controller of the parent will track the total variance. The
project manager is concerned with all the three, of course.

If the earned value chart shows a cost overrun or performance under-run, the
project manager must figure out what to do to get the system back on target.
Options include such things as borrowing resources for activities performing
better than expected, or holding a meeting of project team members to see if
anyone can suggest solutions to the problems, or perhaps, notifying the client
that the project may be late or over budget.

Activity 1

Managing Director of a Pharmaceutical of Company has approached you to

design the monitoring system for his organization.

a) List out the steps that you would take to design the monitoring system
for the organization.
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
130
b) How would you collect the required data for monitoring purposes? Project
Implementation
............................................................................................................ and Control

............................................................................................................
............................................................................................................
............................................................................................................
c) What information would you provide in your Report to the Managing
Director?
............................................................................................................
............................................................................................................
............................................................................................................

6.6 PROJECT CONTROL

Nature of Control

Control is the act of comparing the planned performance with the actual and
reducing the difference between the two. It is also the last element in the
implementation cycle of planning-monitoring-controlling. Information is
collected about system performance, compared with the desired (or planned)
level, and action taken if actual and desired performance differ sufficiently
that the controller (manager) wishes to decrease the difference. Note that
reporting performance, comparing the differences between desired and actual
performance levels, and accounting for why such differences exist are all
parts of the control process.

Objectives of control are :

1) The regulation of results through the alteration of activities.

2) The stewardship of organizational assets.

Most discussions of the control function are firmly focused on regulation.

The project manager needs to be equally attentive to both regulation and
conservation. The Project Manager is shepherd of the organization’s
resources. The project manager must guard the physical assets of the
organization, its human resources, and its financial resources. The processes
for conserving these three different kinds of assets are different.
Types of Control
Physical Asset Control

Physical asset control requires of the use of these assets. It is concerned with
the asset maintenance, whether preventive or corrective. At issue also is the
timing of maintenance or replacement as well as the quality of
maintenance.

If the project uses considerable amount of physical equipment, the project

manager also has the problem of setting up maintenance schedules in such a
131
Investment way as to minimize interference with the ongoing work of the project. It is
Decisions under
Certainty critical to accomplish preventive maintenance prior to the start of that final
section of the project life cycle known as the Last Minute Panic (LMP).

Physical inventory, whether equipment or material, must also be controlled.

It must be received, inspected (or certified), and possibly stored prior to use.
Records of all incoming shipments must be carefully validated so that
payment to suppliers can be authorized. The same precautions applicable to
goods from external suppliers must also be applied to suppliers from inside
the organization. Even such details as the project library, project coffee
maker, project room furniture, and all the other minor bits and pieces should
be accounted, maintained, and conserved.

Human Resource Control

Human resources also need both regulation and conservation. Stewardship of

human resources requires controlling and maintaining the growth and
development of people. Projects provide particularly fertile ground for
cultivating people. Because projects are unique, differing one from another in
many ways, it is possible for people working on projects to gain a wide range
of experience in a reasonably short time.

Measurement of physical resource conservation is accomplished through the

familiar audit procedures. The measurement of human resource conservation
is far more difficult. Such devices as employee appraisals, personnel
performance indices, and screening methods for appointment, promotion, and
retention are not particularly satisfactory devices for ensuring that the
conservation function is being properly handled. The accounting profession
has worked for some years on the development of human resource account,
and while their efforts have produced some interesting ideas, human resource
accounting is not well accepted by the accounting profession.

Financial Resource Control

Though accountants have not succeeded in developing acceptable methods

for human resource accounting, their work on techniques for the conservation
(and regulation) of financial resources have most certainly resulted in
excellent tools for financial control. This is the best developed of the basic
area needing control. It is difficult to separate those control mechanisms
aimed at conservation of financial resources from those focused on
regulating their use. Most financial controls do both. Capital investment,
controls work to conserve the organization’s assets by insisting that certain
conditions be met before capital can be expended, and those same conditions
usually regulate the use of capital to achieve the organization’s goals of a
high return on its investments.

The techniques of financial control, both conservation and regulation, are

well known. They include current asset controls. These controls are exercised
through a series of analyses and audits, conducted by the accounting/
132 controller function for the most part. Representation of this function on the
project team is mandatory. The structure of the techniques applied to projects Project
Implementation
does not differ appreciably from those applied to the general operation of the and Control
firm, but the context within which they are applied is quite different. One
reason for the differences is that the project is accountable to an outsider - an
external client, or another division of the parent firm, or both at the same
time.

6.7 TYPES OF CONTROL PROCESSES

No matter what our purpose in controlling a project, there are three basic
types of control mechanisms that we can use: cybernetic control, go/no-go
control, and post control. In this section, we will describe these three types of
control and briefly discuss the information requirements of each.

6.7.1 Cybernetic Control

Cybernetic, or steering control is by far the most common type of control
system. (Cyber is the Greek work from “helmsman.”) The key feature of
cybernetic control is its automatic operation.

Figure 6.3 shows that a system is operating with inputs being subjected to a
process that transforms them into outputs. It is this system that we wish to
control. In order to do so, we must monitor the system output. This
function is performed by a sensor that measures one or more aspects of the
output, presumably those aspects one wishes to control. Measurements taken
by the sensor are transmitted to the comparator, which compares them with a
set of predetermined standards. The difference between actual and standards.
The difference between actual and standard is sent to the decision maker,
which determines whether or not the difference is of sufficient size to deserve
correction. If the difference is large, enough to warrant action, a signal is sent
to the effector, which acts on the process or on the inputs to produce output
that conform more closely to the standard.

Figure 6.3: A cybernetic control system

A cybernetic control system that acts to reduce deviations from standard is

called a negative feedback loop. If the system output moves away from
standard in one direction, the control mechanism acts to move it in the
opposite direction. The speed or force with which the control operates is, in
133
Investment general, proportional to the size of the deviation from standard. The precise
Decisions under
Certainty way in which the deviation is corrected depends on the nature of the
operating system and the design of the controller.

6.7.2 Go/No-go Controls

Go/No-go controls take the form of testing to see if some specific
precondition has been met. This type of control can be used on almost every
aspect of a project. For many facets of performance, it is difficult to know
that the predetermined specifications for project output have been met. The
same is often true of the cost and time elements of the project plan.

It is, of course, necessary to exercise judgment in the use of go/no-go

controls. Certain characteristics of output may be required to fall within
precisely determined limits if the output is to be accepted by the client. Other
characteristics may be less precisely defined. In regard to time and cost, there
may be penalties associated with nonconformance with the approved
plans. Penalty clauses that make late delivery costly for the producer are
often included in the project contract. At times, early delivery can also carry
a penalty. Cost overruns may be shared with the client or totally borne by the
project.

The project plan, budget, and schedule are all control documents, so the
project manager has a predesigned control system complete with pre-
specified milestones as control checkpoints. Control can be exercised at any
level of detail that is supported by detail in the plans, budgets, and schedules.
The parts of a new jet engine, for instance, are individually checked for
quality conformance. These are go/no-go controls. The part passes or it does
not, and every part must pass its own go/no-go test before being used in
an engine.

While cybernetic controls are automatic and will check the operating systems
continuously or as often as designed to do so, go/no-go controls operate only
when the controller uses them. In many cases, go/no-go controls function
periodically, at regular, preset intervals. The intervals are usually determined
by clock, calendar, or the operating cycles of some machine system. Such
periodicity makes it easy to administer a control system, but it often allows
errors to be compounded before they are detected. Things begin to go awry
just after a quarterly progress check, for instance, and by the time the next
quarterly check is made, some items may be seriously out of control. Project
milestones do not occur at neat, periodic intervals; thus, controls should be
linked to the actual plans and to the occurrence of real events, not simply
to the calendar.

For an early warning system to work, it must be clearly understood that a

messenger who brings bad news will not be shot, and that anyone caught
sweeping problems and mistakes under the rug will be. An important rule for
any subordinate is the Prime Law of Life on a project : “Never let the boss be
surprised!”
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6.7.3 Post-control Project
Implementation
and Control
Post-controls (also “post-performance controls” or “post-project controls”)
are applied after the fact. One might draw parallels between post-control and
“locking the barn after the horse has been stolen,” but post-control is not a
vain attempt to alter what has already occurred. Instead, it is a full
recognition of George Santayana’s observation that “Those who cannot
remember the past are condemned to repeat it.” Cybernetic and go/no-go
controls are directed toward accomplishing the goals of an ongoing project.
Post-control is directed toward improving the chances for future projects to
meet their goals.

Post-control is applied through a relatively formal document that is usually

constructed with four distinct sections.

a) The Project Objectives: The post-control will contain a description of

the objectives of the project. Usually, this description is taken from the
project proposal, and the entire proposal often appears as an appendix
to the post-control report. As reported here, project objectives include
the effects of all change orders issued and approved during the
project.

Because actual project performance depends in part of uncontrollable

events) strikes, weather, failure of trusted suppliers, sudden loss of key
employees, and other acts of God), the key initial assumptions made
during the preparation of the project budget and schedule should be
noted in this section. A certain amount of care must be taken in
reporting these assumptions. They should not be written with a tone
that makes them appear to be excuses for poor performance. While it is
clearly the prerogative, if not the duty, of every project manager to
politically protect himself, he or she should do so in moderation to
be effective

b) Milestones, Checkpoints, and Budgets: This section starts with a full

report of project performance against the planned schedule and budget.
This can be prepared by combining and editing the various project
status reports made during the project’s life. Significant deviations of
actual schedule and budget from planned schedule and budget should
be highlighted. Explanations of why these, deviations occurred will be
offered in the next section of the post-control report. Each deviation
can be identified with a letter or number to index it to the explanations.
Where the same explanation is associated with both a schedule and
budget deviation, as well often be the case, the same identifier can
be used.

c) The Final Report on Project Results : Note that in the previous

section, when significant variations of actual from planned project
performance were indicated, no distinction was made between
favourable and unfavourable variations. Like the tongue that invariably
135
Investment goes to the sore tooth, project managers focus their attention on trouble.
Decisions under
Certainty While this is quite natural, it leads to complete documentation on why
some things went wrong and title or no documentation on why some
things went particularly well. Both sides, the good and the bad,
should be chronicled here.

Not only do most projects result in outputs that are more or less satisfactory,
most projects operate with a process that is more or less satisfactory. The
concern here is not on what the project did but rather on how it did it.
Basically descriptive, this part of the final report should cover project
organization, an explanation of the methods used to plan and direct the
project, and a review of the communication networks, monitoring systems,
and control methods, as well as a discussion of intraproject interactions
between the various working groups.

Recommendations for Performance and Process Improvement: The

culmination of the post-control report is a set of recommendations covering
the ways future projects for improving. Many of the explanations appearing
in the previous section are related to one-time happenings, sickness, weather,
strikes, the appearance of a new technology, etc., that themselves are not apt
to affect future project-although other different one-time events may affect
them. But some of the deviations from plan were caused by happenings that
are very likely to recur. Provision for such things can be factored into future
project plans, thereby adding to predictability and control.

Just as important, the process of organizing and conducting projects can be

improved by recommending the continuation of managerial methods and
organizational systems that appear to effect, together with the alteration of
practices and procedures that do not. In this way, the conduct of projects will
become smoother, just as the likelihood of achieving good results, on time
and on cost, is increased.

Activity 2

President of an MNC has asked you to develop control system for his
organization:

a) List out the activities that you would cover while developing control
system for the organization.
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
b) List out the various assets of the organization that would require
control.
............................................................................................................
............................................................................................................
136
 ............................................................................................................ Project
Implementation
............................................................................................................ and Control

c) List out the three basic types of control mechanisms that you would
employ in the organization.
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................

6.8 DESIGN OF CONTROL SYSTEMS

Irrespective of the type of control used, there are some important questions to
be answered while designing any control system: who sets the standards?
How realistic are the standards? How clear are they? Will they achieve the
project’s goals? What output, activities, behaviours should be monitored?
Should we monitor people? What kinds of sensors should be used? Where
should they be placed? How timely must be monitoring be? How rapidly
must it be reported? How accurate must sensors be?

If the control system is to be, acceptable to those who will use it and those
who will be controlled by it, the system must be designed so that it appears to
be sensible. Standards must be achievable by the mechanical systems
used. Control limits must be appropriate to the needs of the client that is, not
merely set to show “how good we are.” Like punishment, rewards and
penalties should “fit the crime.”

In addition to being sensible, a good control system should also possess some
other characteristics as set out below:

• The system should be flexible. Where possible, it should be able to react

to and report unforeseen changes in system performance.
• The system should be cost-effective. The cost of control should never
exceed the value of control. As we noted above, control is not always
less expensive than scrap.
• The control system must be truly useful. It must satisfy the real needs of
the project, not the whims of the project manager.
• The system must operate in a timely manner. Problems must be reported
while there is still time to do something about them, and before they
become large enough to destroy the project.
• Sensors and monitors should be sufficiently accurate and precise to
control the project within limits that are truly functional for the client and
the parent organization.
• The system should be as simple to operate as possible.
• The control system should be easy to maintain. Further, the control
system should signal the overall controller if it goes out of order.
137
Investment • The system should be capable of being extended or otherwise altered.
Decisions under
Certainty • Control systems should be fully documented when installed and the
documentation should include a complete training program in system
operation.

No matter how designed, all of the control systems described above use
feedback as a control process. Let us now consider some more specific
aspects of control. To a large extent, the Project Manager is trying to
anticipate problems or catch them just as they begin to occur. The Project
Manager wants to keep the project out of trouble because upper
management often bases an incremental funding decision on a review of the
project. This review typically follows some particular milestone and, if
acceptable, leads to a follow- on authorization to proceed to the next review
point. If not all is going well, other technological alternatives may be
recommended; or if things are going badly, the project may be terminated.
Thus, the project manager must monitor and control the project quite
closely.

The control of performance, cost, and time usually requires different input
data. To control performance, the project manager may need such specific
documentation as engineering change notices, test results, quality checks,
rework tickets, scrap rates, and maintenance activities. For cost control, the
manager compares budgets to actual cash flows, purchase orders, labour hour
charges, amount of overtime worked, absenteeism, accounting variance
reports, accounting projections, income reports, cost exception reports, and
the like. To control the schedule, the project manager examines bench mark
reports, periodic activity and status reports, exception reports, PERT/CPM
networks, Gantt charts, the master project schedule, earned value graphs, and
probably reviews the Action Plans.

Some of the most important analytical tools available to the project manager
to use in controlling the project are variance analysis and trend projection.

Earned value analysis was also described earlier. On occasion, it may be

worthwhile, particularly on large projects for the project manager to calculate
a set of critical ratios for all project activities. The critical ratio is.

(Actual Progress/Scheduled Progress) x (Budgeted Cost/Actual Cost)

If this ratio is exactly one, then the activity is probably on target. If the ratio
differs from one, then the activity may need to be investigated. The closer the
ratio is to one, the less important is the investigation. Consider Table 6.1 for
example.

We can see that the first task is being scheduled but below budget. If delay is
no problem for this activity, the project manager need take no action. The
second task is on budget but its physical progress is lagging. Even if there is
slackness in the activity, the budget will probably be overrun. The third task
is on schedule but cost is running higher than budget, creating another
138
probable cost overrun. The fourth task is on budget but ahead of schedule. A Project
Implementation
cost saving may result. Finally, the fifth task is on schedule and is running and Control
under budget, another probable cost saving.

Task 4 and 5 have critical ratios greater than one and might not concern some
project manager but the thoughtful manager would like to know why they are
doing so well (and the project manager may also want to check the
information system to validate the unexpectedly favourable findings). The
second and third activities need attention, and the first task may need
attention also. The project manager may set some critical-ratio control limits
intuitively.

Table 6.1: (Actual Progress/Scheduled Progress) x (Budget Cost/Actual Cost)

Task Actual Scheduled Budgeted Cost Actual Cost Critical

Number Progress Progress Ratio
1 (2 / 3) × (6 / 4) = 1.0
2 (2 / 3) × (6 / 4) = .67
3 (3 / 3) × (4 / 6) = .67
4 (3 / 2) × (6 / 6) = 1.5
5 (3 / 3) × (6 / 4) = 1.5

6.9 CONTROL OF CREATIVE ACTIVITIES

Some brief attention should be paid to the special case of controlling research
and development projects, design projects, and similar processes that depend
intimately on the creativity of individuals and teams. First, the more
creativity involved, the greater the degree of uncertainty surrounding
outcomes. Second, too much control tends to inhibit creativity. Control is not
necessarily the enemy of creativity; nor, popular myth to the contrary, does
creative activity imply complete uncertainty. While the exact outcomes of
creative activity may be more or less uncertain, the process of getting the
outcome is usually not uncertain.

In order to control creative projects, the project manager must adopt one or
some combination of three general approaches to the problem: (1) progress
review, (2) personnel reassignment, and (3) control of input resources.

6.10 PROGRESS REVIEW

The progress review focuses on the process of reaching outcomes rather than
on the outcomes per se. Because the outcomes are partially dependent on the
process used to achieve them - uncertain though they may be - the process is
subjected to control. For example, in the case of research projects the
researcher cannot be held responsible for the outcome of the research, but can
most certainly be held responsible for adherence to the research proposal, the
budget, and the schedule. The process is controllable even if the precise
results are not.
139
Investment
Decisions under
6.11 PERSONNEL REASSIGNMENT
Certainty
This type of control operates in a very straightforward way. Individuals who
are productive are retained. Those who are not to be retained are moved to
other jobs or to other organizations. Problems with this technique can arise
because it is easy to create an elite group. While the favoured few are highly
motivated to further achievement, everyone else tends to be demotivated. It is
also important not to apply control with too fine an edge. While it is not
particularly difficult to identify those who falls in the top and bottom
quartiles of productivity, it is usually quite hard to make clear distinctions
between people in the middle quartiles.

6.12 CONTROL OF INPUT RESOURCES

In this case, the focus is of efficiency. The ability to manipulate input

resources carries with it considerable control over output. Obviously,
efficiency is not synonymous with creativity, but the converse is equally
untrue. Creativity is not synonymous with extravagant use of resources.

The results flowing from creative activity tend to arrive in batches.

Considerable resource expenditure may occur with no visible results, but
then, seemingly all of a sudden, many outcomes may be delivered. The
milestones for application of resource control must, therefore, be chosen with
great care. The controller who decides to withhold resources just before the
fruition of a research project is apt to become an ex-controller.

Sound judgment argues for some blend of these three approaches when
controlling creative projects. The first and third approaches concentrate on
process because process is observable and can be affected. But process is not
the matter of moment; results are. The second approach requires us to
measure (or at least to recognize) output when it occurs. This is often quite
difficult. Thus, the wise project manager will use all three approaches:
checking process and method, manipulating resources, and culling those
who cannot or do not produce.

6.13 SUMMARY

Project is a set of complex interrelated activities. A bottleneck at any one of

the stages has an impact on the completion schedule of other stages, therefore
for any project a monitoring system is a must. The frequency and the type of
monitoring as well as data collection for monitoring will vary from project to
project. Project monitoring reports are basically of three types 1) Routine, 2)
Exception, 3) Special Analysis.

Project control is the act of comparing the planned performance with the
actual and reducing the difference between the two. Project control has
three domains 1) Physical Asset Control, 2) Human Resource Control, 3)
Financial Resource Control.
140
 Project
6.14 SELF ASSESSMENT QUESTIONS Implementation
and Control
1) What is the purpose of control? To what is, it directed?
2) What are the three main types of control systems? What questions should
a control system answer?
3) What tools are available to the project manager to use in controlling a
project? Identify some characteristics of a good control system.
4) What is the mathematical expression for the critical ratio? What does it
tell a manager?
5) How might the project manager integrate the various control tools into a
project control system?
6) How could a feedback control system be implemented in project
management to anticipate client problems?
7) Define monitoring. Are there any additional activities that should be part
of the monitoring function?
8) Calculate the critical ratios for the following activities and indicate which
activities are probably on target and which need to be investigated.
Activity Actual Scheduled Budgeted Actual
Cost Progress Progress Cost
A 4 days 4 days Rs. 60 Rs. 40
B 3 days 2 days Rs. 50 Rs. 50
C 2 days 3 days Rs. 30 Rs. 20
D 1 day 1 day Rs. 20 Rs. 30
E 2 days 4 days Rs. 25 Rs. 25

a) Give the following information, which activities are on time, which are
early, and which are behind schedule?

Activity Budgeted Cost Actual Cost Critical Ration

A Rs. 60 Rs. 40 1.0
B Rs. 25 Rs. 50 0.5
C Rs. 45 Rs. 30 1.5
D Rs. 20 Rs. 20 1.5
E Rs. 50 Rs. 50 0.67

6.15 FURTHER READINGS

Badiru, A. B. (2021). Project Management Essentials: Analytics for Control. United Kingdom: CRC
Press
Cobb, C. G. (2011). Making Sense of Agile Project Management: Balancing Control and
Agility. Ukraine: Wiley.
Kuehn, U. (2010). Integrated Cost and Schedule Control in Project Management. United
States: Berrett-Koehler Publishers.
Kerzner, H. (2009). Project Management: A Systems Approach to Planning, Scheduling, and
Controlling. Germany: Wiley.
Wilson, R. (2014). A Comprehensive Guide to Project Management Schedule and Cost Control:
Methods and Models for Managing the Project Lifecycle. United Kingdom: Pearson Education

141
Investment
Decisions under UNIT 7 SOCIAL COST BENEFIT
Certainty
ANALYSIS (SCBA)

Objectives
The objectives of this unit are to:
• provide an overview Social Cost Benefit Analysis
• explain the concept of market efficiency
• explain the conceptual foundation of SCBA
• explain the pricing mechanism in absence of market price

Structure
7.1 Introduction
7.2 Concept of Market Efficiency
7.3 Market Failures
7.4 Types of SCBA
7.5 Basic Steps of SCBA
7.6 Conceptual Foundation of SCBA
7.7 Valuation Methods
7.8 Summary
7.9 Self-Assessment Questions
7.10 Further Readings

7.1 INTRODUCTION
The starting point for any project/policy formulation is the economic analysis
involving estimation of cost and benefits. Estimation of cost and benefits is
core of any economic analysis and is the natural way in which individuals
and commercial enterprises take decisions before allocating resources for any
economic activity. However when governments and multilateral development
organizations decides about project and policies and allocating resource for
them, economic analysis is not the sole guiding criteria. Apart from the
economic analysis, they are much more interested in gains accruing to the
society as a whole by executing the project/policy.

In order to estimate the gains accruing to the society Social Cost Benefit
Analysis technique is used. This technique is based on the branch of
economics known as welfare economics. Welfare economics analyses the
“public decisions that impact the economic interest of more than one person
or society at large”. The issues, which SCBA tries to address, are “what
social choices/decisions are best when the available choice will affect welfare
of different sections of society differently or even oppositely”? For e.g. in
construction of multipurpose dam the beneficiaries are labour construction
materials market, farmers in the downstream area flood control tourism and
142 electricity market whereas people residing near the upstream area are going
to be adversely effected as their homes and agricultural land would be Social Cost Benefit
Analysis (SCBA)
submerged and they would be displaced from their original habitat. In general
Cost Benefit Analysis (CBA) is used by private sector and unit of
measurement is monetary units for revenue and expenses used to evaluate the
opportunity cost to investors. Financial CBA fails to add social perspective
and macro economic impact. When social perspective and macroeconomic
effects are added to CBA it is known as Social Cost Benefit Analysis
(SCBA). In SCBA in addition to financial perspective we incorporate the
following aspects:

• impact on input and output markets

• shadow pricing using market prices or benefit transfers
• use of non market valuation techniques to account for missing or
incomplete markets where price is not a true indicator of the value of
transaction.
In order to understand application of SCBA let us first understand what is
market failure and why government need to intervene in economic sphere
even in developed and advanced economies.

7.2 CONCEPT OF MARKET EFFICIENCY

The objective of any economic system is to generate wealth, welfare and
employment for the society in which it operates. The economic system uses
economic resources, which are scares having multiple claimants and
allocated either through free market mechanisms or through government
intervention. The market mechanisms is often a better way for effective
utilization of resources whereas government intervention is used for equitable
allocation and guiding economy towards a particular path as envisaged in
economic policy of the government. The main function of the market is to
facilitate exchange and transaction of goods and services and seek efficient
allocation of resources across alternative uses..The main drawback of using
market for allocation of resources is that rational individuals/institutions act
to maximize self-interest rather than societal interest. Now the question of
market efficiency comes in play. Efficiency in terms of Pareto Efficiency is
described as “an efficient outcome in the market is such that all agents have
maximized their personal gains and no further gain is mutually possible”.
This implies that no one can be made better off without making anybody else
worse off. Inefficient allocation is the one where gains from the markets have
not been fully exploited & exhausted and there exists a potential for further
improvement. This potential for further improvement is not explored due to
variety of reasons, the main being huge requirement of funds, lack of access
to technology and long gestation period. Now let us discuss what the reasons
for inefficiency are and how they lead to market failures.

7.3 MARKKET FAILUERS

In the context of society economic efficiency is achieved when Marginal
Social Benefits (MSB) is equal to Marginal Social Cost (MSC). When the
market is perfectly competitive and in absence of any distortions like taxes,
143
Investment subsidy and restrictive regulations demand and supply would be:
Decisions under
Certainty Demand=Marginal Social Cost=D(MSB)

Supply=Marginal Social Cost=S(MSC)

Figure 7.1: https://uq.pressbooks.pub/socialcba/chapter/social-perspective-to-cba/

As shown in figure 7.1 equilibrium is achieved when D(MSB)=S(MSC) at

the intersection of price P* and Quantity Q*. At equilibrium point producer
and consumer surplus is maximized leading to maximization of Social
Surplus. It also implies that there is an allocative efficiency in allocation of
resources and there is no potential for improvement meaning that no
economic agent can be made better off without making another one worse
off.

Now if MSB> MSC it would lead to more investment as both consumers and
producers would gain additional surplus leading to higher social surplus. In
case if MSC> MSB this would lead to withdrawal of investment as the cost is
higher than the benefits leading to withdrawal of existing investment and no
new investment leading to underinvestment..

Theoretically, in a perfectly competitive market private sector would invest

in projects where net benefit is positive. As a result, no unproductive projects
would be ever taken up as private firms/individuals take rational economic
decisions to maximize profit and in the process would maximize benefit to
the society. This implies that the private sector can achieve allocative
efficiency without intervention of governments.

However in real situations we know that there is no economic system which

can be called perfectly competitive and at the same time cater to the often
complex and diverse demands of the economy. Due to this reason,
governments often intervene in the market. Few of the reasons, which lead to
government intervention, are:

144 • market failures

• improving the allocation of scare economic resources Social Cost Benefit
Analysis (SCBA)
• welfare measures
• redistribution of income, resources and welfare gains
• to harness the potential of unused resources requiring huge capital outlay
and are often the projects with long gestation periods meaning no
economic return is there for quite a bit of time.
Economic decisions that result in inefficient allocation of resources are
termed as market failure and consequences are market outcomes which are
inefficient. Market inefficiency manifests itself in the form of either over
production or under production of goods and services. There are two aspects
of market failure namely demand side market failures and supply side market
failures. In case of demand side market failures the demand curve fails to
incorporate the full willingness of consumers to pay and in case of supply
side market failure the supply curve fails to incorporate the full cost of
production. The major reasons for market failures are:
• market power
• externalities
• public goods
• incomplete information
Market power or monopoly power of a producer enable producer to price
goods over and above the marginal cost. It also results in lower output as
compared to output required for equilibrium of supply and demand. In
extreme case of monopoly over resources can give rise to missing markets.
Externalities are conditions when cost of benefits is not reflected in market
price. For example the cost of air pollution caused by burning of fossil fuels
is neither born by consumers or producers but by the society as a whole.
Similarly use of insecticides in food production and consequent effects of
residual insecticides in food and water results in cost to the society as a whole
and this cost is not reflected in market price of food products. Externalities
can be positive or negative. Positive externalities occur when an action of one
party confers benefits to another party and the benefiting party does not pay
for the benefits. The four possible types off externalities are:
• negative production externalities
• positive production externalities
• negative consumption externalities
• positive consumption externalities
Negative production externalities arise when production of goods and
services causes others to bear associated cost and these others are in no way
connected to either production or consumption. For example air and water
pollution caused by factories. The main feature of negative production
externalities is that neither the producer nor consumer pays for this associated
cost.
Positive production externalities arise when you due to the production
process benefits are conferred to the others and they do not pay for these
benefits. For example beekeeping increases the pollination process in
145
Investment surrounding agricultural field’s thereby increasing yield. Another example is
Decisions under
Certainty
hydroelectric generation dam increases ground level of water table in
surrounding areas thereby leading to lesser cost of irrigation. Similarly in
downstream areas flood and soil erosion is controlled.
Negative consumption externalities are created when consumption leads to
external cost on others, example passive smoking, vehicular pollution
electronic waste etc.
Positive consumption externalities are created when external benefits are
created for others in addition to the consumers for example immunization
leads to healthy society and workforce. Similarly good schools and colleges
provide well trained workforce to the industry.
The main features of externality is that the cost is not borne by the producer
or consumer and this gives rise to market inefficiency as they hinder the
ability of market mechanism to price the goods.
Public Goods:
Public goods are goods which yields utility to people and their consumption
is essentially collective in nature and distinguishing feature is that no direct
payment by the consumers is involved. Another feature of public goods is
that they are non rival in nature and are also non excludable. Due to unique
nature of public goods competitive private markets will fail to generate
economically efficient output of public goods. This is one of the main
reasons why these kind of services like hospitals educations law and order are
most often in short supply within brackets( under production)
Incomplete Information:
For a competitive market to operate efficiently both the producers and
consumers shall have access to full and fair information. The absence of
which may hamper the allocative efficiency of resources. Incomplete
information leads to misallocation of resources leading to non establishment
of equilibrium through price mechanism. This results in market failure
A situation in which one party to the transaction has access to information
which is not available to other party to transaction is called as asymmetric
information. Asymmetric information often leads to adverse selection and
this in turn eliminates economic efficiency of markets leading to market
failures.

7.4 TYPES OF SCBA

There are four major types of SCBA, which can aid in decision-making:
• Ex Ante SCBA : This type of SCBA is conducted before the start of the
project the findings of this type of SCBA is input for authorities to make
decision about the project regarding continuous or otherwise and about
the quantum and timing of allocation of funds& resources
• Ex post SCBA: This type of SCBA is undertaken after the completion
of the project. The timing of undertaking this type of SCBA is crucial, as
some of the outcomes (positive or negative) will only be evident after a
lag of time. Important point in Ex post SCBA is that by the time this
exercise is conducted all the cost are sunk meaning that all the resources
146
 allocated has been used therefore it will have no bearing on current Social Cost Benefit
Analysis (SCBA)
allocation of resources for the project. This SCBA may provide
benchmark for future similar kind of projects and reveal what to do and
not to do for future projects and policies.
• In Media Res SCBA: This type of SCBA is planned and conducted
midway during the project policy under investigation this type of SCBA
has two-way benefits. First it reveals whether or not to continue and
allocate further resources and secondly mid way correction to reduce or
expand the scope. The findings of this exercise can also be used for ex
ante analysis of future projects.
• Comparative SCBA: This type of a SCBA compares the findings of ex
ante analysis with that of ex post or in media res SCBA . This is mainly
done to evaluate the efficiency of ex ante and in media res SCBA for
decision making and evaluation. This kind of a SCBA will also pinpoint
the accuracy of assumptions and estimates used in Ex ante SCBA

7.5 BASIC STEPS OF SCBA

Conducting SCBA is a detailed and time consuming, complex and is often
based on assumptions. In order to make it practical and manageable the
whole process of SCBA is divided into 7 basic steps. These steps are as
follows.

Step 1: Define policy and counterfactuals

Any project/policy starts with defining a problem or opportunity for e.g.
recurrent floods can be a problem and generating hydro electricity from the
same source can be an opportunity. Once the problems and opportunities are
clearly identified, define policy/project alternatives solution and
counterfactuals. Counterfactual is the situation where nothing is done to
tackle the problem or cash on the potential opportunity implying status quo is
maintained, no intervention by the government. It is also described as ‘do
nothing’ or do minimum situation. Here one thing which you should keep in
mind is that the counterfactuals are not going to remain static over the
evaluation period as there are likely to be behavioural and technical evolution
in the evaluation period. Counterfactual is to be characterised accurately as it
is the benchmark against which the cost and benefits of policy alternatives
would be measured. The alternatives should include the best from an
economic perspective even if they are not consistent with stated objectives of
the policy makers because policy makers should be aware of what they are
choosing and what they are rejecting.

Step 2: Identify which section of society gains and which looses

All the people affected by project/policy should be in the reference frame of
analysis. SCBA is often conducted with national perspective because action
of one department/agency can impose cost and benefits on the nation as a
whole including taxpayers, for e.g. multipurpose irrigation projects I will
development of inland waterways etc. Sections of the society directly bears
the cost and read the benefits should be taken into consideration reading cost
and benefits guard why the intermediate re is the ultimately affected sections 147
Investment would be reasonably good proxy weather what the intermediate re play
Decisions under
Certainty
example multipurpose irrigation projects mini pics

Step 3: Identify the cost and benefits (the impact categories), classify
them and select measurement indicators
Cost and benefits (C&B) needs to the identified comprehensively as possible
given the constraints and shall be characterized in terms of impact on people
that are measureable preferably in monetary terms. For e.g. in India
government are running programmes on universal immunization, polio
eradication, TB eradication and more recently on Covid 19 vaccine. Here
impact should not be measured in terms of cost incurred by the government
but by the cost saving by the population as a whole due to decrease in infant
and maternal mortality, reduced mortality, savings in medical expenses and
increased earnings of individuals due to non-occurrence of these diseases.

As a general principle only real cost and benefits which affect real resources
should be taken in consideration. In this context

• Payments to suppliers shall be included in cost

• Accounting depreciation should be ignored as this would lead to double

counting of capital investment
• Interest and capital charges should be ignored as the same is represented
by discount factor by which future C&B are discounter

• Capital gains should be ignored as they represent a change in market

discount rate or NPV of increased future earnings or capitalized value of
benefits that project or policy brings about

• Avoided cost or benefits that are there due to project & policy should be
included along with the opportunity cost of resources likely to be used in
project

In nutshell, only those cost and benefits that are directly attributable to the
project or policy shall be included and if they occur without project/policy
intervention, they shall not be included in CBA analysis.

Step 4: Predict the impact quantitatively over the life of the project
Once the cost and benefits (impacts) have been identified the next logical
step is to quantify the impact for each time period during the life of the
project. This step is important but at the same time is difficult and complex
when projects are unique, have long time horizon and the relationship
between various variables (inputs and outputs) are complex.

Step 5: Monetize all impacts

Once the impacts are quantitatively assessed, the next step is to convert these
impacts into a monetary unit. Quantifying direct cost is a simple task but
quantifying associated cost like environmental, social and other impact is a
difficult and complex exercise. The value of output can be measured easily
through appropriate demand curve if the market demand curve exists for the
148 output, but in absence of market or poorly functioning market where market
prices do not reflect the social cost and benefits objectively, willingness to Social Cost Benefit
Analysis (SCBA)
pay is estimated by indirect methods discussed latter in the unit.

In addition, estimates from previous studies can also be used as plug in

values.

Step 6: Discount benefits and costs to obtain present values and compute
NPV.
In order to assess the total impact of the project we discount the cash flows
occurring in different time periods in order to calculate the present value of
the impact due to the project. Here one important consideration is about the
discount rate to be used.

In developing countries often the government is involved in execution of

large scale mega projects often financing the projects through government
barrowings both from domestic and international sources. In order to reflect
the economic impact the discount rate should be the weighted average cost of
funds but when factors other than economic opportunity cost of funds are
taken into consideration (such as human health, environment etc.) the value
of the discount rate is lower than that arrived based purely on weighted
marginal cost of funds,. These are also known as social discount rates.

For a project with a life span of n years the present value of benefits PV (B)
and present value of costs PV (C) is estimated as follows:
n
Bt
PV (B) = t
t 0 1 s
n
Ct
PV (B) = t
t 0 1 s

Where Bt and Ct are benefits and costs in year t and S is the social discount
rate. Once the present value of benefits and cost is computed the net present
value (NPV) would be

NPV = PV (B) – PV(C)

If the project/policy has no alternative and is measured against the status quo
then projects having positive NPV should be accepted. In case more than one
alternative is being examined the alternative in relation to status quo and each
of the alternatives is mutually exclusive then the alternative with highest
positive NPV should be selected. Negative NPV would result in rejection of
all the alternatives and the status quo would be maintained.

Step 7: Perform sensitivity analysis

Sensitivity analysis is performed by changing the values of certain key
parameters and recalculating the NPV based on altered values. Sensitivity
analysis will reveal what will be the NPV in case the assumptions on which
NPV is calculated deviates. Sensitivity analysis is important due to the
uncertainty associated in predicting the project cost and benefits. The

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with the highest NPV may not be feasible.

7.6 CONCEPTUAL FOUNDATION OF SCBA

Whether to use SCBA as an additional tool for decision-making or to
completely avoid it broadly depends on the objectives of the policy or
project. However if it is used as input for decision-making we shall be very
clear about the conceptual foundations of this method. The broader objective
of SCBA is to measure the efficiency of alternative projects and in context of
SCBA efficiency is described in terms of Pareto efficiency. Pareto efficiency
is described as: An allocation of resources I ‘Pareto efficient’ if no alternative
allocation can make at least one person better off without making anyone else
worse off”.

If the projects have positive social net benefits then it is possible to estimate a
set of transfers or side payments that are Pareto efficient. These set of
transfers will make at least one person better off without making any one else
worse off.

The linkage between SCBA and Pareto efficiency can be explained in terms
of how benefits and costs are measured in SCB. The benefits/output of a
policy/project is measured through the Willingness To Pay (WTP) and
Willingness to Accept (WTA) principle. The WTP of an individual is the
amount s/he is willing to pay for an incremental unit of goods or services. It
measures the economic value to the individual and aggregate of these
economic values is economic benefit to the society. Conversely WTA is the
minimum amount of money an individual is willing to accept for not
receiving the benefits of proposed policy/project. These concepts expressed
in terms of utility are Equivalent Variation (EV) and Compensating Variation
(CV).

• EV is the amount of additional income the individual would need to

obtain the same level of utility that they would get form consuming the
non-market goods after its provision.

• CV is the amount of income, which would need to be taken away from

the individual after consumption the goods to return the individual to
their original level of utility.

EV is used when goods and services are provided and is similar to WTP
where as CV is used when there is a reduction in goods and services and is
similar to WTA.

Valuing Benefits and Costs

The main aim of SCBA is to estimate the changes in net social benefits
arising out of proposal policy/project. The change in net social benefit is
derived from the difference between total consumer benefits and total
producers cost. These two variables are directly associated with the changes
in social surplus. Social surplus is sum total of consumer surplus, production
surplus and government surplus and is given in eq. 7.1.
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Social surplus = C.S + P.S+G.S. 7.1 Social Cost Benefit
Analysis (SCBA)
In case no impact on government surplus is observed eq. 7.2 becomes
Social surplus – C.S+P.S 7.2

Now let us discuss now producer surplus and consumer surplus is calculated
with help of demand and supply curves. Before we proceed further let us
briefly discuss the basic characteristics of demand and supply curves and
how they are related to consumer and producer surplus.

Demand Curves
Individual demand curves slope down (have a negative slope) due to
diminishing marginal utility. The market demand curve is the horizontal sum
of individual demand curves. It also slopes down.

It is important to distinguish between an ordinary demand curve where q = f

(p), and an inverse demand curve in which p = f-1(q). The inverse market
demand curve can be interpreted as a (societal) marginal benefits (MB)
curve: it indicates how much (actually the maximum) someone is willing to
pay for an additional unit of a good – the marginal unit.

SUPPLY CURVES
The upward sloping segment of a firm’s marginal cost curve above its
average variable cost curve is its supply curve (below the average variable
cost, the firm would shut down). The marginal cost curve indicates the
additional cost to produce each additional unit of the good. The area under
the curve represents the total variable cost of producing a given amount of
the good. Producer surplus is the supply-side equivalent of consumer surplus.
It is the difference between total revenues and total variable costs.
Diagrammatically, it is the area between the price and the supply curve.
Consumer Surplus: Consumer surplus is the difference between the amount
consumers is willing to pay for the goods and services and the amount
actually paid by the consumer. Now let us derive CS form a demand curve.
As shown in fig 7.2 the demand curve depicts the maximum amount a
consumers are willing to pay for a given market quantity of the goods and as
the quantity of goods increase in the market how progressively the prices
come down the price line. The prices revealed by the demand curve represent
the consumer’s marginal willingness to pay. The area OCDE under the
demand curve CD represents of two parts rectangle OBDE, which represents
consumer total expenditure, and Area BCD, which is formed under the
demand curve and above the price line from the origin to the quantity
purchased. Area BCD is consumer surplus and is the difference between the
areas representing consumer’s total benefit and total consumer expenditure.

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Figure 7.2: Consumer Surplus

Producer Surplus: Producer surplus is the difference between the amount

received from actual sells of goods and the opportunity cost of producing it.
Producer Surplus is supply equivalent f consumer surplus. Just as there is a
direct connection between consumer surplus and the demand curve similarly
there is a direct connection between producer surplus and supply curve of
goods. The supply curve depicts the minimum amount which a producer is
willing to accept for a given quantity of goods, in other words it is the cost of
the marginal producer Figure 7.3 the total revenue of the producer is
represented by the rectangles OBDE. This rectangle OBDE consists of two
sub figures ABD and OADE. Figure OADE represents the total cost to
seller/producer and triangle ABD represents the producer surplus. The
producer surplus areas are formed above the supply curve and below the
market price line.

Figure 7.3: Producer Surplus

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Perfectly competitive market is one in which there are large number of Social Cost Benefit
Analysis (SCBA)
buyers and sellers and none of them can influence the price and market
distortions in form of subsidiaries and taxes is absent. In such a market social
surplus is as represented in fig 7.4. The social surplus is represented by areas
ADC which is sum of area ADB representing producer surplus and area BCD
representing consumer surplus.

Figure 7.4: Social Surplus In Competitive Market

SOURCE FOR FIG.7.2, 7.3 and 7.4 Lumen Learning, "ECON Open
Course,"
2015.[Online].available:https://lumen.instructure.com/courses/196787/pages/
Section9-10?module_item_id=4541568
Until now, we have ignored the role of government surplus/deficit in our
analysis, but in most cases, project and policies have impact on government
revenues. If the output of the project is priced at market price as in the case of
toll roads, the projects are going to result in government surplus due to
additional taxes arising out of increased economic activity due to the
project/policy. However if the output is not priced at market price as in case
of irrigation projects, healthcare projects and policies the projects are likely
to contribute to government fiscal deficit. So in any case these impacts shall
also be factored in while conducting SCBA.

In this analysis it is assumed that the functional forms of demand and supply
curves are known in the relevant market before and after the changes induced
by policy/project but that is not the case form most of the projects and
policies. For this kind of situation other techniques are used which we are
going to discuss in next section.

7.7 VALUATION METHODS

In the previous section we had discussed about measuring social surplus
based on known demand and supply curves based on assumption of preferred
markets, but in real economic situation they rarely exist and markets are often
distorted by some kind of market failure such as monopoly, information
asymmetry, externalities, public goods etc. in these situations where the
observed price of goods and services do not reflect their social values or for
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to measure the benefits, which are as follows:

1. Correcting market price for distortions

2. Revealed Preference Method
a) Hedonic Price method
b) The travel cost method
c) Averting Behaviour method
d) Cost of illness method
3. Stated Preference Method
4. Benefit Transfer Method
1. Correcting market price for distortions: In competitive markets not
distorted by taxes or subsidies the market price of goods and services
provide the best estimates of benefits, however if markets are distorted
economic prices needs to be adjusted to quantity cost and benefits.
It taxed are imposed consumer pays a higher amount than the market
prices by the amount of taxes. In case consumers fore go their
consumption of certain goods and services the benefit associated with
change in level of consumption should be measured as gross of tax
values as the WTP for these goods and services is inclusive of tax values.
In case of subsidies, the cost measured should be the sum of the market
price plus subsidies: Taxes need to be excluded from cost.
In case of regulated markets, SCBA shall include the cost created by
regulations.
In case of labour markets, labour market externalities may be credited
due to regulator actions like unemployment allowance or deployment of
labour in employment generation schemes. These regulatory actions
distort the opportunities cost of labour and such distortions shall be
factored in SCBA.
2. Revealed Preference Methods: These methods are used to estimate the
value of non market goods such as health, environment and other goods
by observing the actual choices made by individuals in related markets
which have some of the associates attributes under study that is how
these non market goods affect the prices of market goods. Price
differentials in market goods having certain attributes and not having
certain attributes provide estimates for WTP and WTA. The most
commonly used revealed preference methods are:
a) The hedonic price method: This method has been extensively used
in the property (housing) and labour markets to find the value of non
markets attributes associated with these markets. The price
difference between two identical houses expect for their exposure
level of non market goods and beds such as pollution, noise level,
crime, sun light or in vicinity of hospitals, educational institutes,
sports facilities, shopping facilities relationship of these attributes
expressed as hedonic price function can be estimated using ordinary
154 least square (OLS) techniques. On establishing a functional
 relationship the coefficients can be estimated for each attributes and Social Cost Benefit
Analysis (SCBA)
the shadow price of an attribute can be established by partial
differentiation. These shadow prices represents WTP for marginal
increase or decrease in attribute depending on whether it is good or
bad. Similarly in labour market estimates for job security,
occupational hazard etc. can be made.
b) The travel cost method: This is method is used to estimate the
value of recreational sites such as riverfront, beaches, fort and
palaces, gardens etc. The approach in this method is to place a value
on non-market environmental goods by using consumption
behaviour data is related markets. The value of recreational activity
is measured by cost of travelling plus the cost of time associated
with travelling which is the opportunity cast of time of that
particular individual or household. In this method consumer surplus
is estimated by the area under the demand curve between the cast
(price) of their visit and the price at which the visit frequency would
be zero also known as Choke Price.
c) Averting behaviour method: In this method values is inferred from
observing cast accrued by individual to change their behaviour in
response to changes in the quality of environment, health or safety.
For e.g. With rise in air pollution people start buying air purifiers, in
case of road safety people with pay extra for good helmets and cars
with extra air bags.
d) Cost of illness method: In this method explicit marked cost is
estimated which occurs due to change in the incidence of a given
illness. These costs include cost such as direct treatment,
rehabilitation etc. One of the reasons why the governments all over
the world focuses on universal immunization is the direct medical
cost which the government will have to bear in absence of universal
immunization.
3. Stated Preference Method: This method uses specially constructed
questioners to estimate the WTP or WTA associated with particular
project or policy – instead of using indirect observation methods.
Generally two types of stated preference methods are used which are as
follows:
a) Contingent valuation method where the focus is on the valuation of
non-market good as a whole. In this method, response is elicited
through questioners which is based on a hypothetical market and
also contains information about goods, made of delivery and method
and frequency of payments. Through this information and question
analysts inter the WTP or WTA. The questions in the questioners
can be in many forms including open ended, closed ended, bidding
game, payment card and dichotomous choice. In addition to this
questioners may also elicit information about socio economic profile
of respondents, their attitude towards the goods and reasons for the
staked valuation.

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characterized as a handle of attributes, some attributes being more
desirable than others. For e.g. Project to clean rivers may have
certain attributes take clean water, reduction in odour, development
of aquatic life, development of inland waterways etc and each of
these attributes will have different utility for different people. In this
method to estimate the value of the attributes the questioner presents
respondents with a series of alternative description of project and
policy and each alternative description varies the level of attributes –
and then respondents are asked to rank (contingent ranking) chose
(choice experiments), rate (contingent rating) or chose then rate
(paired comparison) the alternative description. From these
responses WTA and WTP estimates are made.
4. Benefit Transfer Method: in this method, information from already
done studies is taken as a proxy for the value of non market goods.
However these estimates cannot be exactly the same under all
circumstances. Before using estimate from other studies following
precaution should be taken
a) The reference study should be of the same nature as the present
project/policy
b) WTP and WTA should be comparable to the project/policy issue.

7.8 SUMMARY
Economic evaluation of project and policies is done through cost benefit
analysis. Cost benefit analysis is primarily based on observable and
measureable costs and benefits but many of the projects have cost and
benefits which are not measurable, their impact is also borne by the
stakeholders who are in no way associated with the project/policy. In order to
estimate the gains accruing to the society Social Cost Benefit Analysis
technique is used. This technique is based on the branch of economics known
as welfare economics. Welfare economics analyses the “public decisions that
impact the economic interest of more than one person or society at large”.
SCBA is a technique through which projects and policies are evaluated in
macro perspective taking into consideration both the direct as well as indirect
impact on society. This technique is little complex as many assumptions are
to be made regarding pricing of benefits for which market prices are not
available.

7.9 SELF-ASSESSMENT QUESTIONS

1. What is market efficiency?
2. What are the reasons for market failures

3. Eplain the basic steps involved in conducting SCBA.

4. Describe the valuation techniques used for SCBA

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 Social Cost Benefit
7.10 FURTHER READINGS Analysis (SCBA)

Brown, R. P. C., Campbell, H. F. (2015). Cost-benefit Analysis: Economic

and Financial Appraisal Using Spreadsheets. United Kingdom: Routledge.

Cost-Benefit Analysis for Development: A Practical Guide. (2013).

Philippines: Asian Development Bank.

Johansson, P. (1991). An Introduction to Modern Welfare Economics. United

Kingdom: Cambridge University Press.

Toh, R., Quah, E. (2011). Cost-Benefit Analysis: Cases and Materials. United
Kingdom: Taylor & Francis.

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