Is the project you are realizing profitable or not? How is it possible to measure the profitability of a project? Every organization should estimate whether its project is profitable or not. However, determining profit is not an easy task.
- 7 key points for the profitability of a project
- Hidden business management
- Structured installation
- Cost control
- Always keep track of the scope of the project
- Increase transparency and communication
- Evaluate regularly
- Use project management tools
- How to measure the profitability of a project
- Present value of future cash flows
- Present value of future cash flows
- Profitability index
Many project managers can be surprised to discover that all their hard work is leading to unprofitable projects.
Let’s see then what are the elements to consider in order to understand if a project can be profitable or not and, then, how to concretely calculate the profitability of a project.
7 key points for the profitability of a project
To assess whether a project is affordable (profitable) or not, we can start from 7 key points.
Each of these points is essential and a good PM should always keep them in mind.
Hidden business management
Staying competitive is clearly a key element that will affect the organization’s activity.
The key performance indicators of the organization in general are important to understand in order to increase the profitability of the company and to understand the role of the specific project based on the key company goals.
Each project should be set up in such a way as to allow efficient management from the beginning and throughout its life cycle.
This means defining a set of goals for each project and reflecting this in a basic project budget.
This will be the control point for all project costs.
It will be possible to keep track of the costs – and therefore the profitability – of the project only if a basic budget has been defined.
In all projects, the priority should be to control the actual costs and balance them with the estimated costs in the budget.
Always keep track of the scope of the project
You can easily lose track of the project’s scope, due to new customer needs and changes.
If the project has a fixed price, any activity that is not part of the original scope will involve additional efforts and costs, for which the team will not be paid.
And this will instantly affect the general profitability of the project.
Increase transparency and communication
As we have discussed in several previous articles, we know that communication and transparency are the basis of a successful and, therefore, profitable project.
This can be a problem in the case of organizations that still rely on manual or dated methods to organize their data.
Moreover, project performance is difficult to predict when there is no clarity between departments and teams.
It is necessary to evaluate each project in relation to the basic budget, this will allow to avoid and foresee delays and risks.
It is very important to manage upcoming costs and add costs as they occur, as this will provide a clear idea of the total costs to completion.
Use project management tools
Many project management tools are very effective. If you have never used one before, we recommend trying TWproject for free.
This type of technology will make it possible to have a single point from which control all the costs of the project.
Moreover, thanks to these tools it will be possible to obtain faster and more precise project reports.
How to measure the profitability of a project
To concretely measure the profitability of a project, there are several methods that can be taken into consideration. Let’s see which they are.
Present value of future cash flows
A determining factor in calculating the profitability index is the present value of future cash flows that the investment, and therefore the project, should return.
The current value formula measures the current value of a future amount that has to received, given a specific period of time and interest rate.
The current value can be calculated with the formula: Vp = Vf / (1 + r) n
Vp = Present value
Vf = Future value
r = Interest rate
n = Number of years
For example, if an investment is expected to return 100,000 euros in 3 years with an interest rate of 3.5%, the calculation of the present value will be similar to this:
Vp = 100.000 / (1 + 0,035) 3 = 100.000 / 1,109 = 90.194,27 euro
The calculation shows that € 90,194.27 invested today at an annual interest rate of 3.5% will be worth € 100,000 in three years.
Net present value
The net present value, or NPV, is the present value of future cash flows deriving from the investment, less the amount invested.
This number shows the difference between what the company has to spend to get the desired return and what it is actually going to spend.
The NPV uses the time value of money to determine whether the amount spent today to provide a future return will result in a profit or not.
For example: If the actual amount invested is 85,000 euros and the present value of future cash flows is 90,194.27 euros, the NPV corresponds to 90,194.27-85,000, or 5,194.27 euros.
The positive NPV therefore shows that the investment will produce a profit. If the NPV turns out to be negative, it means that the project is not profitable.
Investments with high profitability indexes can help an organization to get the maximum profit with a minimum investment.
While the NPV shows whether the investment will produce a profit (positive NPV) or a loss (negative NPV), the profitability index shows the degree of profit or loss.
Project managers can use the current value of future cash flows (PV) or net present value (NPV) to calculate the profitability index.
Profitability index = (PV / invested amount) = 1 + (NPV / invested amount)
Using the previous example: An organization plans to receive 100,000 euros in three years on an investment of 85,000 euros.
The interest rate should remain at 3.5 percent for those three years.
Profitability index (PV) = (90.194,27 / 85.000) = 1.061
Profitability index (VAN) = 1 + (5.194,27 / 85.000) = 1.061
A profitability index of 1.061 would probably be considered a marginal investment.
If the time interval was extended from three to five years, the calculation would be:
Vp = 100,000 / (1 + 0,035) 5 = 100,000 / 1,188 = 84,197.32 euros
and the calculation of the profitability index would therefore be:
Profitability index (PV) = (84.197,32 / 85,000) = 0.991
making it a slightly losing investment.
As a general rule: If the result is greater than 1, the project will generate value and the organization should proceed with the project. If the result is less than 1, the project destroys value and the organization should not proceed with the project. If instead the result obtained is equal to 1, the project can be interrupted since it brings neither a gain nor a loss and the organization is totally indifferent.
Clearly, the higher the profitability index, the more attractive the investment.
Before proceeding with a project, whatever it is, it is important that the project manager has carried out at least one of these analyses.
Without a proper profitability calculation of the project, it will be like stepping into a forest in total darkness without knowing where the path will lead.