What are Project Selection Methods?

Consider a scenario in which the organization you are working for has been handed a
number of project contracts. But due to resource constraints, the organization cannot
take up all the projects at once. Therefore, a decision has to be made as to which
project needs to be taken up to maximize profitability.
This is where Project Selection Methods come into play. There are various methods to
help you choose a project. These can be divided into two categories, namely:
1. Benefit Measurement Methods
2. Constrained Optimization Methods

Project Selection Methods Type I: Benefit Measurement Methods

1. Benefit Measurement is a project selection technique that is based on the present value of

estimated cash outflow and inflow. Cost benefits are calculated and then compared to other
projects to make a decision.
The techniques that are used in Benefit

Measurement are as follows:

Benefit/Cost Ratio
Cost/Benefit Ratio, as the name suggests, is the ratio between the Present Value of Inflow or the
cost invested in a project to the Present Value of Outflow which is the value of return from the
project. Projects that have a higher Benefit Cost Ratio or lower Cost Benefit Ratio are generally
chosen over others.

Economic Model
The EVA or Economic Value Added is the performance metric that calculates the worth-creation
of the organization while defining the return on capital. It is also defined as the net profit after the
deduction of taxes and capital expenditure.
If there are several projects assigned to a project manager, the project that has the highest
Economic Value Added is picked. The EVA is always expressed in numerical terms and not as a
percentage.

Scoring Model

The scoring model is an objective technique wherein the project selection committee lists
relevant criteria, weighs them according to their importance and their priorities and then adds
the weighted values. Once the scoring of these projects is completed, the project with the
highest score is chosen.

Payback Period
The Payback Period is the ratio of the total cash to the average per period cash. In simpler
terms, it is the time necessary to recover the cost invested in the project.
The Payback Period is a basic project selection method. As the name suggests, the payback
period takes into consideration the payback period of an investment. It is the time frame that is
required for the return on an investment to repay the original cost that was invested. The
calculation for payback is pretty simple.

When the Payback period is being used as the Project Selection Method, the project
that has the shortest Payback period is preferred since the organization can regain the
original investment faster.
There are, however, a few limitations to this method:
1. It does not consider the time value of money
2. The benefits that accrue after the payback period are not considered,
meaning it focuses more on the liquidity while profitability is neglected.
3. Risks involved in individual projects are neglected.

Net Present Value

The Net Present Value is the difference between the projects current value of cash
inflow and the current value of cash outflow. The NPV must always be positive. When
picking a project, one with a higher NPV is preferred.
The advantage of considering the NPV over the Payback Period is that it takes into
consideration the future value of money.
However, there are limitations of the NPV, too:

1. There isnt any generally accepted method of deriving the discount value
used for the present value calculation.
2. The NPV does not provide any picture of profit or loss that the organization
can make by embarking on a certain project.
Opportunity Costs can be great tools for project selection in an organization. We may find a few
questions on the PMP certification exam based on this topic. Like many other decision makers,
project managers should thoroughly evaluate the opportunity costs and plan well to manage
them.
In this article, we will take a detailed look at opportunity costs long with some of the ways for
managing them. We will also take a look at a few sample questions based on this topic for better
PMP exam prep.

What is an opportunity cost?

Opportunity Cost is a key concept in Economics that expresses the basic relationship between
scarcity and choice.

Scarcity results when natural resources, human resources and capital resources are not
available in sufficient quantity to satisfy requirements. So, a producer has to decide what
he wants to produce from a particular resource. For instance, if he chooses to produce
paper for books from a stand of trees, then no other product can be produced from that
stand of trees. Yet, there are many products that could have been produced using the
same natural resources, which are also desired by consumers.
The opportunity cost of the decision thus becomes an important consideration. While
making a choice the producer needs to realize that the next best alternative cannot be
produced.
In Decision Making, therefore, opportunity costs are usually the difference between the
net value of the path that was chosen and the net value of the best alternative that was
not chosen. This concept is also relevant to the profession of Project Management
where, opportunity costs are usually the cost of the opportunities we missed by
investing our money on a particular project. It is based on the theory that a dollar can
only be invested at one place at a time. It is one of the project selection methods that

organizations use, to select projects which are feasible and desirable. For project
selection purposes, the smaller the opportunity costs are, the better as it is not desirable
to miss out on a greater opportunity.

How do we manage our opportunity costs?

By considering opportunity costs, we can make adjustments to reduce costs or reduce
overall future effort. Considering opportunity costs does not by itself reduce or change
costs; it makes those costs explicit so that we can consider them and manage them
appropriately.

Considering opportunity costs improves transparency and makes effective

decision making easier.
If an organization has an investment in dollars that is made available to projects, then it
is quite important to decide which projects should get what amount. This decision is
usually made on the basis of benefit returns to the company.
Usually, benefit returns are risky because they are earned in the future. Therefore,
benefit returns must be adjusted for risks before they are incorporated into the
formula. The opportunity cost is then the difference in returns, after risk adjustment,
between one project opportunity and the next most favorable opportunity that is
competing for the same capital.
The role of a project manager, in this context, is to provide risk management so that the
returns are maximized to the extent possible; and manage capital budgets to minimize
capital expenditures. Those two activities will maximize the returns and minimize
the opportunity cost of the project.

Sample Questions for the PMP certification Exam

We may find a few questions in the PMP certification exam which is based on the concept of
opportunity cost. For the exam opportunity cost is usually a monetary value. Let us take a look
at a few sample questions based on this concept.

Sample Question 1
You work in the PMO of a mid-sized company. Your PPM tool shows that there are currently 3
new projects waiting for selection. They are Project Diamond with an NPV of Rs.15,00,000,
Project Gold with an NPV of Rs 17,00,000 and Project Silver with an NPV of Rs.13,00,000. You
present these 3 projects at the monthly project selection board meeting. After initial discussion it
was immediately decided that Project Silver will not be pursued at all. At this point a lengthy
discussion begins about the benefits of both Project Diamond and Project Gold. After about an
hour, the CEO asks you: What is the opportunity cost of selecting Project Diamond instead of
Project Gold? What should be your answer?
A.) Rs.17,00,000
B.) Rs.15,00,000
C.) Rs.20,00,000
D.) Rs.25,00,000

Answer: Although the question is presented to us as a complex problem, it is quite simple to

answer the question .The opportunity cost when selecting between two projects is simply the
value of the project that is not selected. Project Gold has an NPV of Rs.17,00,000. If this project
is not done, then the lost opportunity is Rs.17,00,000.
It is also important to note that Project Silver was never a part of the equation. The CEO only
wanted to know the opportunity cost when selecting between the other two projects (i.e Project
Diamond & Project Gold).

Sample Question 2
Project Apple has an IRR of 19% and an NPV of $26,000 for 3 year duration. Project Banana
has an IRR of 24% and an NPV of $28,000 for 5 year duration. What is the opportunity cost, if
you select project Apple instead of project Banana?
A.)$ -2,000
B.) $2,000
C.) $26,000
D.) $28,000

Answer: When selecting between two projects, the opportunity cost is simply the value of the
project that was not selected. In this case, we selected project Apple over project Banana. This

means that our opportunity cost = the value of project Banana = $28,000. The IRR and duration
of the projects are irrelevant here.

Conclusion
Opportunity cost is the difference between the net value of the path that was chosen and the net
value of the best alternative that was not chosen. It is a great tool for project selection in many
organizations. Risk management and capital budget management are some of the ways in
which a project manager can minimize the opportunity costs and maximize the returns in his
projects. We may find a few questions based on this concept in the PMP certification exam.

Discounted Cash Flow

It's well-known that the future value of money will not be the same as it is today. For
example, $20,000 will not carry the same worth 10 years down the line from today.
Thus, during calculations of cost investment and ROI, one must consider the concept
of discounted cash flow.

Internal Rate of Return

The Internal Rate of Return is the interest rate at which the Net Present Value is zero.
This state is attained when the present value of outflow is equal to the present value of
inflow.
It is defined as the annualized effective compounded return rate or the discount rate that
makes the net present value of all cash flows (both positive and negative) from a particular
investment equal to zero. The IRR is used to select the project with the best profitability.
When using the IRR as the project selection criteria, care should be taken to ensure this is not
used exclusively to judge the worth of a project. This is because a project with a lower IRR might
have a higher NPV and, assuming there is no capital constraint, the project with the higher NPV
should be chosen as this increases the shareholders' wealth.

When picking a project, the one with the higher IRR is chosen.

Opportunity Cost
The Opportunity Cost is cost that is being given up when picking another project. During project
selection, the project that has the lower opportunity cost is chosen.
Generally, most organizations use Benefits Measurement Methods to lead them into making a
decision.

Constrained Optimization Methods

Constrained Optimization Methods, also known as the Mathematical Model of Project Selection,
are used for larger projects that require complex and comprehensive mathematical calculations.
The techniques that are used in Constrained Optimization Methods are as follows:

These topics, however, are not discussed in detail in the PMP certification. For the
exam, all that is necessary to know is that this is the list of Mathematical Model
techniques that are used in Project Selection.

Non-Financial Considerations
There are non-financial gains that an organization must consider and these factors are related to the
overall organization goals. The organizational strategy is a major factor in project selection methods that
will affect the organizations choice in the choice of project.

Customer service relationship is chief among these organizational goals. An

important necessity in todays business world is to build an effective and cordial
relationship with the customers.
Other organizational factors may include: Political reasons, change of management,
speculative purposes, shareholders' requests, etc.

Implementation of the Methods Chosen

As you now know, Project Selection may be carried out in a number of ways. It is best for an organization
to try different methods before choosing a project to be absolutely certain that the best decision is made
for the company, and consider a wide range of factors rather than only concentrating on a few. Thus,
every project will need careful consideration.

Conclusion
Although time consuming, employing these methods is essential for an effective
business plan. The Selection Techniques in Project Management help you pick a project
that could provide a better return on investment as well as recognition. There are
various documented methods to select a project, but a rule-of-thumb to employ is this: if
it is a small project that isnt very complex, then the Benefit Measurement Model is
useful, whereas if it is a complex and large project then the Constrained optimization
Method is a better fit.