In this lesson, you’re expected to learn about:
– earned value management
– incorporating capital allocation into project management
– how to carry out value schedule and budget calculations
Project management is a highly complex topic that involves a wide range of specialisms in management.
For the purpose of this lesson, the only aspect you need to be concerned with is the evaluation and control of the project’s finances, which are calculated using information about earned value management (EVM).
What is Earned Value Management (EVM)?
EVM allows you to calculate, quite accurately, the amount of value being contributed to, or derived from, an investment project.
The goal of this lesson is understanding the nature of this evaluation and ensuring that everything remains on schedule, under budget and, most of all, efficiently profitable.
Not only do you have a problem if you’re falling behind, which is especially bad, but you also have a problem if the project is generating value ahead of schedule to the extent that the company’s assets could’ve been managed more efficiently.
The difference between earned value (EV) at time t and planned value (PV) for time t is called the schedule variation (SV), and you calculate it using the following equation:
Schedule Variation = Earned Value – Planned Value
=> SV = EV – PV
This equation says that the schedule variation is equal to the earned value less the planned value.
– EV = PV: If the earned value that you generate at any given point in time is equal to the value that you planned to generate at that point in time, the schedule variation is zero.
– EV > PV: Being above zero is also a good thing, but it still warrants an explanation so that you can figure out how to improve projections or repeat successes in the future.
– EV < PV: A schedule variation less than zero is obviously not desirable.
1) The project may not be generating as much value as anticipated.
You can discover this scenario fairly easily by closely looking at each of the cash flows from the investment to determine why cash flows are deviating from their planned net value, and whether that trend is going to continue or influence the total rate of returns for the life of the investment.
2) Earned value is taking longer to realize.
A possibility is that the operating cycle is longer than expected. Merely being behind schedule, as opposed to an under-planned value, is certainly the less harmful scenario, although neither situation is good.
Another way to look at the variance between EV and PV is through a ratio calculation called schedule performance (SP), which you calculate as follows:
Schedule Performance = Earned Value / Planned Value
=> SP = EV / PV
For example, if a project is taking longer than expected, that would be a deviation in SPt, whereas a deviation in dollar value would be measured in SP$ (or whatever other currency you’re using).
– SP = 1: The investment is generating value exactly as planned.
– SP < 1: The project is coming in behind schedule or under value.
– SP > 1: The project is coming in ahead of schedule or over value.
In the latter two cases, the company isn’t using its assets as effectively as possible. Even if the investment is generating more value than anticipated, the company has no plan in place to reinvest that surplus income to optimize returns. Perhaps it could have pursued another investment with it, or more effectively managed its economic capital.
In any case, the performance of EVM is usually based on performance ratios at given time milestones. The value and time performance of a project ends up at 1 no matter how you measure it, and so these measurements are taken at intervals chosen before the investment is made.
A common approach is to measure the investment’s performance at, for example, 10% repayment period, 50% repayment period, 50% asset lifespan or any other intervals, usually measuring multiple times over a given duration.
In this section, we return to the subject of budgeting (which we introduced in the Capital Budgeting lesson two weeks ago).
When allocating resources to an investment to generate value from it, the company must develop a budget for that investment.
For example, you can’t just buy a machine without allocating resources to the operation, maintenance and financing of that machine.
The performance of an investment also comes through in the updated calculations of the MIRR (Modified Internal Rate of Return)* over time, but some additional calculations are frequently performed in EVM that are concerned specifically with budgetary issues, in order to identify why deviations in the MIRR may occur over time.
As the name implies, MIRR is a modification of the internal rate of return (IRR) and as such aims to resolve some problems with the IRR.
The amount of value that a company can generate from an investment at a given cost is a large concern for an organization.
So reaching the anticipated 100% value from your investment on-budget is preferred. Here’s the calculation if some variation exists:
CV = EV – AC
where the cost variance (CV) is equal to the earned value (EV) less the actual cost (AC).
If the actual cost is lower for a given point in earned value, you need to start planning how to use the surplus budgetary funding.
As with time-schedule calculations (that we just saw in the previous section), another way to look at cost measurements is through a ratio.
This particular ratio is called the cost performance (CP) ratio and it’s measured in the following way:
Cost Performance = Earned Value / Actual Cost
=> CP = EV / AC
This ratio measures the earned value at a given point to the actual cost (AC) at that point.
You can measure the total cost of the capital investment at its completion with a simple equation called estimate at completion (EAC):
Estimate at Completion
= Budget at Completion ÷ Cost Performance
=> EAC = BAC ÷ CP
By doing so, you get a monetary value that tells you how much the investment actually cost compared to how much you planned on it costing.
EAC = $12,000 / 1.2 = $10,000
i.e. you’re $2,000 under budget.
That $2,000 is called the estimate to complete (ETC). Here’s the formal calculation:
ETC = EAC – AC
You subtract the actual costs from the estimated cost at completion to see how much cost you have left to finish the project.
Whether or not the investment is worth pursuing after it has already begun to go over budget depends on whether the ETC is lower than the potential present value of future cash flows, calculated as:
Efficacy of investment = NPV – ETC
If the ETC exceeds the net present value (NPV) of future cash flows, you’re just throwing money away by continuing the project.
You calculate whether a company can improve the financial efficiency of an investment to make that investment worth pursuing by using the to-complete performance (TCP):
TCP = (BAC – EV) / (BAC – AC) You subtract the earned value (EV) from the budget at completion (BAC) and divide the result by the BAC less the actual cost (AC).
So, for example, if the TCP on a company’s project is 1.10, it needs to improve efficiency by 10 per cent in order to get the project back on track to complete it on budget.