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Chapter 12: Exercises 12-1 through 12-3 (page 248 of the text)
Chapter 13: Exercises 13-1 through 13-3 (page 269 of the text)

Chapter

Financial Evaluation of Projects

LEARNING OBJECTIVES

· 1. To develop skills in evaluating the financial consequences of alternative projects.

. To understand what comprises a cash flow.

· 3. To understand the concept of payback as a tool to evaluate the financial desirability of a project.

. To be able to compute discounted cash flow and to use three tools to evaluate the financial impact of projects (i.e., net present value, internal rate of return, and modified internal rate of return).

REAL WORLD SCENARIO

Eugene Righter is manager of strategy for St. Clement’s–Mercy Medical Center in a midwestern city. The medical center is widely regarded for the excellence of its clinical services, in particular its use of cutting-edge technology. At a recent meeting with the organization’s clinical directors, three new projects were proposed for development within the medical center over the next

years. Any of the three projects would enhance the medical center’s image as a progressive healthcare organization, and all of them are consistent with the St. Clement’s mission. As manager of strategy, it was Eugene’s job to assess the financial attractiveness of all new projects; unfortunately, although all three projects could be supported equally from a clinical perspective, the medical center had the financial resources to undertake only one. Eugene realized that because the projects were each designed to operate for a number of years, it was important to consider the financial attractiveness of each over several years. He recalled from his education that there were a number of financial tools that might be useful to assess this long-term financial attractiveness.

LEARNING OBJECTIVE 1: TO DEVELOP SKILLS IN EVALUATING THE FINANCIAL CONSEQUENCES OF ALTERNATIVE PROJECTS

Note: This is the objective for the entire chapter actually, although specific, more focused learning objectives are discussed throughout the chapter.

The concept of the time value of money was introduced in

Chapter 4

, including the tools of compounding and discounting. For a healthcare manager, the most important use of these tools is in evaluating potential organizational projects. This chapter provides examples of how to apply these tools in organizational decision making. Any project must compete for organizational approval and for the capital or funding associated with approval. Capital is limited and must be allocated to meet the many goals and objectives faced by the contemporary healthcare organization. New projects need to be designed to be competitive within this context of organizational priorities and realities.

Every project must compete for capital with existing projects, other new projects, and alternative uses of capital such as capital investment opportunities; e.g., certificates of deposit (CDs), mutual funds, money markets, etc. If an existing project needs to be stopped to furnish the capital needed for a new project, the termination expenses associated with stopping the first project must be added as an expense associated with the new project. However, generally new projects compete against other new projects and alternative capital uses, not existing projects.

In well-managed healthcare organizations, a project never competes only against itself for organizational approval. When organizations consider a new project, it is not enough to know how much a project will cost and how much it can be expected to earn. The manager must also compare a given project with other project alternatives and alternative uses of capital. Well-managed healthcare organizations evaluate projects based upon the implications and alternatives associated with the project and the capital needed to support it.

Most situations requiring managers to evaluate the attractiveness of a potential project or investment opportunity involve understanding and building upon the concept of the time value of money. In general, organizations are required to spend money now, an outflow of cash known as the initial investment or present value (PV). In future years the organization will experience a series of cash flows (cf) as a result of the project; these cash flows may be positive or negative, but in either case, by convention they are generally determined at the end of a defined time period, such as a month or a year. The amount of these cash flows is known as the future value (FV). Cash flows may involve either uneven amounts or equal amounts of money. Cash flows of equal size that occur at equal time intervals are known as annuities or payments (PMT).

Recall from
Chapter 4
in the discussion of compounding and discounting that the rate at which the value of money grows (going forward in time, known as compounding), or declines (going backward in time, known as discounting), is known as the discount rate, cost of capital or opportunity cost (i). The number of time periods (n) involved in the project or investment is the final factor.

The key variables addressed so far are:

· • Present Value: (PV)

· • Cash Flow in

Time

Period n: (cfn)

· • Future Value in Time Period n: (FVn)

· • Annuity (cash flows of equal size separated by equal time periods): (PMT)

· • Discount Rate, Cost of Capital, Opportunity Cost: (i)

· • Number of Time Periods: (n)

Using the formulas and techniques presented in the discussion of the time value of money it is possible to compute any unknown key variable, given sufficient information regarding other variables. For example, the present value (PV) can be computed, if the future value in time period n (FVn), the number of time periods (n), and an appropriate discount rate (i) are known.

In this chapter, tools for analyzing and comparing the attractiveness of a potential project or investment are described. These tools, the net present value (NPV), the internal rate of return (IRR), and the modified internal rate of return build upon the concept of the time value of money.

So fundamental are these concepts to management decision making that financial and business calculators have keys for each of the important variables to facilitate computation. In addition, spreadsheet programs, such as Excel, have functions to compute the values. Readers are encouraged to utilize such calculators or spreadsheet programs to assist in financial analysis. This chapter also presents how the calculations actually “work,” to provide a better understanding of the nature of the analyses.

LEARNING OBJECTIVE 2: TO UNDERSTAND WHAT COMPRISES A CASH FLOW

Managers of healthcare organizations need to consider many elements when evaluating potential projects. For example, market and competitive factors may influence the effect of the project on market share, the likely impact on the organization’s image, and the organization’s ability to establish and maintain a competitive distinction. Epidemiology too may influence the effect of the project. Health services managers should assess the likely impact of a project on the health status of the community. Managers must also always be sensitive to the impact of new projects on existing personnel and the organization’s ability to attract and retain well-qualified staff. The well-educated and highly trained nature of large portions of the typical health services organization’s staff make these factors especially important.

However, among all relevant factors financial issues are usually weighted most heavily by managers. In particular, managers assess a project’s impact on the organization’s ability to generate cash. This is not surprising, as it is the availability and flow of cash which, in a very real sense “fuel” the organization and its activities. Without an acceptable cash flow, the organization’s survival is in question. For this reason, it is critical to consider cash flow.

As the words suggest, a “cash flow” reflects the actual “movement” of funds in to or out of an organization. Revenues generated by a project are cash inflows.

Expenses

, such as payroll or supply purchases, are cash outflows. The difference between cash inflows and cash outflows is known as net cash flows. For example, if cash inflows for a new patient care service are $

,000 and the cash outflows associated with the project are $

5,000, then the net cash flow for the service is

,000. Net cash flows for any period of time may be either positive or negative.

Most projects involve a series of events that entail either the outflow or inflow of cash. For example, a multispecialty group practice might decide to purchase a new piece of laboratory equipment with the capability of completing multiple blood analyses electronically and much more rapidly than currently available technology. The purchase price of this equipment is $55,000. It is anticipated that the equipment has a useful life of 5 years; i.e., ongoing technological enhancements will make this equipment essentially obsolete in 5 years, and it will need to be replaced. The original vendor has agreed to pay

$500

0 to buy back the equipment at the time of replacement. This $5000 is known as the salvage value or salvage price. During its 5 years of operation, it is estimated that the equipment will generate revenue through charges associated with its use.

Table 13-1

displays estimated net revenue for the equipment.

Net cash flow takes into account both cash inflows and cash outflows. Notice that these numbers refer to actual cash flows. As such, some items recognized as an expense by generally accepted accounting principles are not cash flows. The most noteworthy example of this is depreciation.

Depreciation

expense is an accounting convention that is used to reflect the gradual erosion of an asset’s value because of it use over time. It does not involve any actual flow of cash, however, and thus does not enter into this type of project analysis.

Table 13-1 Estimated

Net Cash Flow

s for Blood Analyzer Project

Table 13-2 Statement of Income—For Profit Nursing Home

(000)

Gross Revenue from Operations			$ 8 ,300
Expenses:
Total except Depreciation	$ 7 ,300
Depreciation	10 0
Total Expenses	($7,400)
Net Income Before Taxes	$ 900
Income Taxes @ 40%	($ 3 6 0)
	Net Income	$ 540
Cash Flow Statement—For Profit Nursing Home (000)
Service Revenue (net of allowances)	$ 8,300
Total Expenses (except depreciation)	(7,300)
Pre-Tax Cash Flows	$ 1,000
Taxes @ 40%	(360)
	Net Cash Flow	$ 640

Consider the case of a private, tax-paying nursing facility. The facility’s income statement and a statement of cash flows are shown as

Table 13-2

. According to accounting convention, net income is calculated including depreciation as an expense. However, depreciation is not a cash expense. It is not included in the statement of cash flows. As a result, net income for the facility is $540,000, whereas the net cash flow for the same period of time is $640,000. The difference between the two,

$10

0,000, is depreciation. The relationship between net income and cash flows is shown in

Equation 13-1

Net Income + Depreciation = Net Cash Flow

Which Cash Flows Should Be Included in Analyzing Projects?

One fundamental approach to evaluate the attractiveness of a project is to analyze the cash flow’s implications associated with it. Certainly, from a financial perspective, projects that generate larger, positive net cash flows are more attractive than other projects with lower positive, or even negative, net cash flows.

By convention, in assessing project opportunities, not all cash flows are included in the analysis. Only those cash flows directly related to the project should be included. The treatment of several major types of cash flows is described in the following paragraphs.

· 1. Revenues and expenses, other than depreciation, directly related to the project are included in the analysis.

· 2. The impact of the project on areas of the organization apart from the project itself needs to be considered. For example, a hospital opening a freestanding ambulatory surgery center may experience changes in demand for its existing inpatient or hospital-based outpatient surgical services, most likely reduction in demand for these services as a result of implementing the new center, a process known as “cannibalization.” Thus, for the entire organization (in this example, the hospital), some of the revenue realized by the new program is not “new” revenue; rather, it actually represents a shift in revenue brought about by patients using the new center instead of previously existing services. As such, only the “new” or incremental revenue associated with the new venture should be considered in the analysis. In calculating the cash inflows and outflows associated with the project, estimates of the actual incremental impact of the program need to be made. This estimation process, as much an art as a science, requires competence in the forecasting methods as well, as discussed in

Chapter 5

· 3. Sunk costs (i.e., a cost that has already been incurred or has been committed), are not included in the cash flow analysis. For example, the hospital may have retained consulting services to analyze the feasibility of the freestanding ambulatory care surgery center before analyzing its feasibility. This cost is a sunk cost; whether or not the hospital decides to proceed with the surgery center, the money has already been spent. Therefore, the expenditure does not represent a relevant cash flow for the analysis.

LEARNING OBJECTIVE 3: TO UNDERSTAND THE CONCEPT OF PAYBACK AS A TOOL TO EVALUATE THE FINANCIAL DESIRABILITY OF A PROJECT

A vital analysis completed by managers is an assessment of the net cash flows of a project, taking into account the timing of these cash flows. The timing of cash flows builds upon the concept of the time value of money. For example, a manager may determine that the project being analyzed is projected to generate a series of negative cash flows, followed by a large positive cash flow. This cash flow pattern is not uncommon for a new product or service that builds market share over a period of several years.

Table 13-3

displays such a cash flow for a planned health screening program.

The initial investment in the project is

$10,000

, shown as a negative cash flow in time period 0, which represents the present time. Operations in years 1 to 4 each generate a negative cash flow of $3000. Finally, in year 5, a positive cash flow of $25,000 is realized. It is assumed that year 5 is the final year of the project; i.e., no cash flows related to this project, positive or negative, occur after this point.

Table 13-3 Net Cash Flow—Health Screening Program

The question facing a manager is, “As a project, is this a good financial investment?” One way to formulate a response to this question is to assess the project’s cash flows.

It might seem intuitive to sum up the positive cash flows (cash inflows) and negative cash flows (cash outflows) associated with the project and make a decision based on whether the resulting net figure is positive or negative. After all, this approach does recognize the importance of cash flows. However, this approach is not adequate as it totally ignores the time value of money.

Alternatively, a manager might calculate what is known as the payback period. This is the length of time it takes to recoup the project’s initial investment. In this example, the project’s investment is recovered in the fifth year of the project. Based on this knowledge, a decision on whether or not to proceed with the project would be made. Does 5 years represent a reasonable time to recoup an initial investment of $10,000? This is essentially a judgment or value-driven call for the organization.

Although used relatively frequently, calculation of the payback period is also an incomplete approach, incomplete because it does not directly take into account the time value of money. As such, the approach is overly simplistic, and its use is discouraged.

LEARNING OBJECTIVE 4: TO BE ABLE TO COMPUTE DISCOUNTED CASH FLOW AND TO USE THREE TOOLS TO EVALUATE THE FINANCIAL IMPACT OF PROJECTS (I.E., NET PRESENT VALUE, INTERNAL RATE OF RETURN, AND MODIFIED INTERNAL RATE OF RETURN)

Taking into consideration the information on compounding and discounting presented earlier, it should be apparent that “adjustments” must be made to account for the timing of the anticipated cash flows. To assess the financial value of the project, the present value of cash flows associated with the project should be computed. Recall that in computing this present value, cash flows that are more distant in the future are discounted over more time periods. Thus, cash flows received earlier in the project’s life are worth more in current (present) dollars than those received later.

This process of calculating the present value of future cash flows is known as calculating a discounted cash flow. The goal of computing a discounted cash flow is to derive the present value of a project’s cash flows. The present value provides a measure of the project’s value at the current time (time = 0), so managers can compare present values among various projects; i.e., it creates an “apples and apples” framework for financial analysis. The arithmetic sum of the present value of the project’s cash flows is known as the net present value (NPV) of the project.

Determining a net present value requires discounting and involves these steps:

· 1. Select an appropriate discount rate and use it consistently to discount all future cash flows to the current time (i.e., time = 0).

· 2. Calculate the net present value of these discounted cash flows.

· 3. Compare the calculated net present value with a previously stated criterion or compare the net present values of various projects against one another.

In general, the management decision rule is that projects with a positive NPV are attractive, and that projects with larger positive NPVs are more attractive than those with smaller NPVs. Strictly from a financial perspective, projects with a negative NPV are not attractive.

Virtually all projects entail an initial investment, so it is essential that these funds be available at the time they are needed for the project. Regardless of the NPV, if the initial investment required for the project is not available, then the project may not be feasible. It may be possible for the organization to obtain financing (short or long term) to meet the initial investment requirement. The financial impact (in terms of cash flows, ability to take on additional debt, debt service requirement, etc.) would need to be woven into the cash flow analysis as well.

Recall that an important component of discounting is determining the appropriate discount rate. This topic is considered in greater depth later in this chapter. Assume that after careful research, the manager determines that the $10,000 available for investment could be used to purchase a CD for 5 years at an interest rate of 4.5%. Assuming an essentially equivalent level of risk between the CD and a new project opportunity, 4.5% would be an appropriate discount rate to use in calculating net present value. This calculation is depicted on

Table 13-4

, showing the present value of each future cash flow. The NPV of the potential project is –$702, not an attractive outcome from a financial perspective. Based on this analysis, then, investing in the CD would be more attractive financially.

This simple example is useful to illustrate several concepts regarding NPV as a decision tool. For example, although the project is not financially viable under current conditions, what initial investment would make the project attractive?

Table 13-4 Present Value of Future Cash Flows for Health Screening Program

−$ 3000

(assume discount rate of 4.5%)
				Year		Net Cash Flow	PV of Cash Flow
	0		−$10,000		−$10,000
	1						−$ 3000	−$ 2871
	2	−$ 2747
	3	−$ 2629
	4	−$ 2516
	5	$25,000	$20,061
NPV = −$ 702

If the project’s NPV can be increased to a positive value, then it becomes a viable project; i.e., if the NPV can be increased by over $702. In effect, if any of the cash flows can be modified to result in a positive present value of at least this amount, then the project becomes financially viable. For example, management can determine that if its initial investment (cash outflow in time = 0) can be reduced to less than $9298, the project becomes financially attractive. At an initial investment of exactly $9298, the NPV is equal to 0. If management has defined a philosophy to accept “break even” projects in some circumstances, this project would then be acceptable.

Alternatively, using the cash flows and the discount rate it is possible to compute other changes that would generate a positive NPV. Management can then assess various strategic and tactical options (pricing, marketing, distribution, etc.) to assess whether any such changes are possible. For example, what positive cash flow must be generated in year 5 to result in a positive NPV? This is the same as asking what cash flow, discounted for 5 years at 4.5%, results in a present value of at least $20,763 (the negative discounted net cash flow excluding year 5). By using a hand-held calculator or a spreadsheet program (or working through the mathematics in detail, one cash flow at a time) the answer is $25,874. If the project is able to generate a positive net annual cash flow for year 5 of at least $25,874, then the NPV is greater than or equal to zero.

The impact of the discount rate selected can also be illustrated by this example. Suppose the discount rate used were 3% instead of 4.5%. With the new discount rate (

Table 13-5

), the net present value is $414.

Table 13-5 Present Value of Future Cash Flows for Health Screening Program

Year

Net Cash Flow

PV of Cash Flow

−$10,000

−$ 3000

(assume discount rate of 3.0%)
−$ 2913
−$ 2828
−$ 2745
−$ 2665
$25,000	$21,565
NPV = $ 414

Annuities: A Particular Series of Cash Flows

Cash flows may occur in a variety of patterns. As in the examples presented earlier, the initial investment is followed by a series of uneven cash flows; i.e., the net annual cash flows differ among years. When this is the case, calculating the discounted present value of these cash flows involves a discounting calculation for each time period.

Table 13-6 Project with Equal Cash Flows—an Annuity

Net Cash Flow

$ 9500

Year

−$40

,000

$ 9500

Other projects may generate equal cash flows. For example,

Table 13-6

shows a project that generated net annual cash flows of $9,500 for each of the next 5 years. This pattern of cash flows is known as an annuity. An annuity is a series of equal cash flows occurring over time at equal intervals. In this example, $9500 is received every year; both the amount and the timing of the cash flow are fixed and equal. An annuity is simply a specific pattern of cash flows. The cash flows involved with an annuity can be either net cash inflows or cash outflows. By convention, and for use with business or financial calculators or spreadsheet applications, cash flows associated with annuities are known as payments (PMT).

There are two types of annuities that differ only in the timing of when the payment takes place. If the payment occurs at the end of the time period specified, the annuity is referred to as an ordinary annuity. If the payment takes place at the beginning of the time period specified, the annuity is an annuity due. The majority of annuities are ordinary annuities.

Table 13-7

is an example of an ordinary annuity in which the purchaser will receive a series of $500 payments after each of the next 5 years. This is spoken of as a 5-year ordinary annuity. Notice that the first payment of $500 is received at the end of year 1, the second payment at the end of year 2, and so on for 5 years. A typical question that arises is, How much should an individual be willing to pay now for this annuity?

It should be clear that this question is a version of the present value computations already discussed. As always, the individual needs to determine an appropriate discount rate or cost of capital. Suppose an alternative investment is identified, i.e., a 5-year CD with an interest rate of 6%. As described, this represents the opportunity cost of purchasing the annuity. This problem becomes one of discounting each annual cash flow of $500 at the rate of 6% to determine the present value.

Table 13-7 Pattern of Cash Flows in an Ordinary Annuity—Payment Received at End of Period Indicated

Year

$ 500

		Net cash flow
0	−$2000
		1	$ 500
		2
		3
		4
		5

The calculated present value of $2106 is the purchase price at which the individual should be financially indifferent between the two investments; i.e., there is no financial advantage in purchasing one over the other. Obviously if the annuity
is priced at less than $2106 it becomes a more attractive investment; prices over $2106 are less attractive.

Many standard calculators have a “PMT” key, which enables the user to enter the amount of the annual payment once along with the number of time periods of the annuity, rather than having to enter the same cash flow amount (the payment) for each year of the annuity. This computational function is not only convenient, but it also protects against the risk of entering data incorrectly. Common examples of an annuity are a home mortgage or a car loan, both of which typically involve a series of equal payments (the annuity).

Often, situations arise in which there is an annuity embedded within a series of annual cash flows (

Table 13-8

). This cash flow has a series of 6 payments of $750 each from years 3 through 8 of the project. Assume a discount rate of 7%, what is the present value of this project (i.e., what is the most that should be invested in this project)?

There are two ways to go about solving this problem. The long way is to calculate the discounted present value of each annual cash flow and determine the NPV. This approach requires that each cash flow be entered individually.

A second, somewhat shorter, way to solve this problem is to utilize the fact that there is an annuity embedded in the cash flow stream. In effect, the cash flow stream is divided into multiple parts, those included in the annuity and those separate from it. The steps to solve this problem using the embedded annuity are described below and illustrated in

Table 13-9

Table 13-8 Pattern of Cash Flows with an Embedded Annuity (Years 3–8)

Year

Net cash flow

$ 750

$ 500

$ 1000
	$ 500
		$ 750
6
7
8
9
10	$ 100

Table 13-9 Calculation of

Net Present Value

including Cash Flow Stream with an Embedded Annuity (Discount rate 5 7%)

· 1. Calculate the present value of the discounted cash flow for those periods not included in the annuity; i.e., years 1, 2, 9, and 10. Calculated present values are:

Year 1:	$934.58
Year 2:	$436.72
Year 9:	$271.97
Year 10:	$ 50.83

· 2. Calculate the present value of the embedded annuity. For this computation, the payment is $750, the interest rate is 7%, and the number of periods is six, the length of the annuity. This calculation yields a present value for the annuity of $3574.89. However, the annuity cash flows have been discounted only to the end of time period 2, the point at which the embedded annuity begins, not time period 0. Therefore, this calculated value must be discounted for an additional two periods to arrive at a present value at time 0. The calculated value of the embedded annuity portion of the cash flow stream at time = 0 is $3122.45.

· 3. Total the calculated present values to arrive at the NPV for the project. This amount equals $4816.55 for this example. The organization should be willing to invest no more than $4816.55 in this project.

Obviously, either approach to solving the problem should arrive at the same NPV. Viewing the project as an annuity simplifies the calculation somewhat. If the annuity is embedded in the middle of a cash flow stream, care must be taken to ensure that the cash flow of the annuity is fully discounted to the present time.

Internal Rate of Return

The NPV measures the present value of discounted cash flows for a project, assuming a particular discount rate. This is useful input for organizational decision making. On the other hand, the manager might be interested to know what rate of financial return is, in fact, generated by the project. This rate is known as the internal rate of return (IRR).

Table 13-10

displays the anticipated cash flows for a large respite care program planned by a nursing facility. Management of the facility has determined that an appropriate discount rate for this project is 6%. The NPV of the project is $5103, as calculated in the following. Because the NPV is positive, the organization decides to pursue the project.

Management may also be interested in calculating the actual rate of return (i.e., the IRR) for this project; that is the same as determining what discount rate generates an NPV of zero. Using a financial calculator with an IRR key to accomplish this computation, the IRR is 9.9%. As a check, the NPV is computed using a discount rate of 9.9%. As shown in

Table 13-11

, the NPV using these data is ($3), a value essentially equivalent to zero. This indicates that the calculated IRR is correct.

Table 13-10 Internal Rate of Return

Year

Net cash flow

($40,000)

$10,000

$15,000

PV (discounted at 6%)
	0 (initial investment)		( $40,000 )
$ 5000	$ 4717
		$10,000	$ 8900
$ 8396
	$15 ,000	$11,881
$11,209
Net Present Value	$ 5103

Managers, particularly in industries other than health care, speak of something known as the “hurdle rate,” which refers to the minimum rate of return required for a project to be accepted or pursued by the organization. Hurdle rates may be established formally by boards, committees, or management teams, or they may be informal expectations of an organization. Suppose the formally established hurdle rate of the nursing facility is 10%. This means that it is willing to pursue only projects with an IRR greater than 10% (i.e., 10% is the financial return hurdle that must be “cleared” by the project).

Table 13-11 Estimated Cash Flows and NPV for Respite Care Program at Discount Rate = 9.9%

Year

Net cash flow

0 (initial investment)

−$40,000

$10,000

$15,000

PV (discounted at 9.9%)
$ 5000	$ 4550
	$10,000	$ 8280
$ 7534
	$15,000	$10,283
$ 9356
NPV =	$ −3

Based on the information presented, independent from other nonfinancial considerations, the proposed respite care program would not be pursued, because the IRR is less than the approved hurdle rate. If the IRR exceeds the hurdle rate, then the project exceeds the required minimum return, and all other things being equal it is financially acceptable to the organization. As stated, there are always nonfinancial factors, such as community need and impact on health status, that must be considered before making a final decision on health services projects.

Modified Internal Rate of Return

Taking a closer look at IRR, it should be apparent that what is being done in calculating the IRR is that each future cash flow is, in effect, being compounded at the IRR percentage. In the respite care example this amounts to compounding at a rate of 9.9%. That is, an assumption is being made that funds could be invested and generate a return of 9.9%. Although the mechanics of the calculation may be clear, this IRR rate may or may not be an appropriate (or available) interest rate. The question is really one of whether money could actually be invested at this rate; i.e., it may be higher than or lower than the actual financial rate of return that could be obtained. To reflect this discrepancy, the IRR is frequently modified or adjusted to take into account any disparity between the IRR and the rate of financial return actually available in the financial market. This new measure can be referred to as the modified IRR.

Determining the modified IRR involves what is known as the terminal value. The terminal value is the value (taken at the final or terminal year of the project) of all cash flows compounded to this terminal year at an appropriate cost of capital. The specific steps to complete to determine the modified IRR are:

· 1. Determine an appropriate cost of capital or discount rate.

· 2. Compound all net cash inflows forward to the terminal year using this cost of capital. This compounded value is known as the terminal value. Compute the sum of the terminal values in the terminal year.

· 3. Use the cost of capital to discount all cash outflows back to year 0 of the project. Frequently, there may be only one cash outflow, the initial investment. Because this outflow takes place in year 0, no discounting is required.

· 4. The modified IRR is the discount rate that equates the present value of the terminal value to the present value of cash outflows.

Table 13-12

displays the discounted and compounded cash flow values for the respite care project. For this example, management has determined that 7% is an appropriate cost of capital (step 1). That is, 7% is the rate of return actually available for this project.)

Table 13-12 Modified Internal Rate of Return for Respite Care Program (000)

$10

$15

Terminal value
	0		1	2	3	4	5	@ 7%
−$40
$5	$ 6554
	$10	$12,250
$11,449
	$15	$16,050
$15,000
Net Terminal Value	$61,303

Table 13-13 Timeline for Mammography Center

$10,000

−$25,000

$700

$20,000

The terminal value of each cash flow is computed by compounding each cash flow by the cost of capital 7%. For example, the terminal value of the $5000 cash flow projected for year 1 is the future value of this amount compounded for 4 years at 7%, or $6554. The sum of terminal values for the project is $61,303. The only cash outflow in this example is the initial investment of $40,000 which takes place at time 0, so it need not be discounted.

The modified IRR is the discount rate which equates the present value of the terminal value to the present value of the cash outflows. In this example, the adjusted IRR is the discount rate that “equates” $61,303 with $40,000. Taken another way, it is the compounding factor that grows an investment of $40,000 to a value of $61,303 in 5 years. The adjusted IRR is 8.91%.

To illustrate another example, suppose a group of hospitals and several physicians are considering developing a state-of-the-art mammography center. To participate, hospital A needs to contribute $25,000 now. Its anticipated net cash flows over the next 3 years are $7000, $10,000, and $20,000, respectively. The board of trustees of hospital A has identified 14% as the organization’s hurdle rate for this type of project. The chief financial officer has identified an opportunity cost of 7%. Based only on financial factors, should hospital A participate in the project?

Table 13-13

displays the timeline for this project. Using a PV or initial investment of $25,000, and the net cash flows anticipated, an IRR of 18.6% is computed. Using 7% as the discount rate or cost of capital yields an adjusted IRR of 15.7%.

Both the IRR and the modified IRR exceed the hurdle rate of 14%, so hospital A should pursue the mammogram project.

CONCLUSION

This chapter presents three tools to assist in analyzing projects: the net present value, the internal rate of return, and the modified rate of return. In actual practice, the internal rate of return is the most frequently used tool. Discussions regarding hurdle rates are not uncommon in finance and executive management meetings. Although in some respects the modified IRR is a more accurate assessment of the return of a project, it is infrequently encountered in management suites or boardrooms. NPV falls somewhere in between in terms of frequency of use. Capable healthcare managers should be equally competent in the use of all three tools, and in fact, it may be useful to compare the outcomes of the three approaches in arriving at a final determination regarding a potential project.

Determining the Discount Rate, and a Brief Look at Risk

From the material presented in this chapter it should be apparent that the determination of an appropriate discount rate (alternatively known as the cost of capital, or opportunity cost) is an important element of financial evaluation of projects. Choosing a rate that is either unrealistically high or low may result in poor management decisions; e.g., missed opportunities or poor returns on projects.

Determining the discount rate is not a precise science; rather, it is an excellent example of a manager’s use of reasoned judgment. As described, probably the most appropriate approach is to use the rate of return of an alternative investment. This is the opportunity cost.

In earlier examples, interest rates on bank passbook accounts and CDs were used. A bank account interest rate is an example of a relatively risk-free investment (assuming the amount of the account is less than the limit of federal deposit insurance). In the context of finance, risk refers to the probability that actual future returns will be less than expected returns. For a bank savings account, in most cases, the depositor is guaranteed the stated interest rate; i.e., the risk is low. Various investment offerings of the federal government are also examples of virtually risk-free investments; e.g., treasury bills, notes, and bonds. In fact, government treasury bonds (t-bonds), long-term investment vehicles requiring investments of over $1000, are often considered the benchmark for risk-free investments. Other investments are more risky, although all investments have some level of risk, however minimal.

Different types of risk exist; some are associated with business uncertainty (e.g., the level of variation between actual and forecast utilization levels of a new project), and some are associated with changes in the broader economy (e.g., the effect of inflation). Many theoretical approaches have been developed to attempt to estimate levels of risk. For a more thorough discussion of elements associated with risk and approaches to estimate it, the reader is encouraged to review any of the general finance texts cited in the list of suggested readings. For the purposes of this book, readers need to be aware that risk is a factor in all projects, levels of risk may vary among projects, and it is incumbent on the manager to take the relevant risk into account when evaluating projects.

EXERCISES

· 13-1 A representative of a reputable financial services company has approached you as manager of a four-person group of anesthesiologists with an opportunity to purchase a 10-year annuity due for each member of the group. The annuity due would pay $40,000 each year beginning 5 years from now (i.e., at time = 5). What is the most you would be willing to pay now, per each physician, for this investment? Assume an appropriate discount rate of 7%.

· 13-2 The hospital’s marketing and finance departments have just provided you, as chief financial officer, with pro forma income statements for your proposed sonogram center. These statements appear in the following.

Pro forma Income Statement

(000)

$ 35

Net Income

		Time			t + 1	t + 2	t + 3	t + 4
Service Revenues (net)	$425	$500	$580	$700
Expenses	$400	$450	$525	$600
Depreciation Expense				$ 35
($ 10)	$ 15	$ 20	$ 65

What is the project’s IRR? Assume an initial investment of $175,000 and an appropriate discount rate of 6%. The hospital is operated as a not-for-profit facility.

· 13-3 The chief operating officer (COO) of a small, not-for-profit community hospital has to make a recommendation to the board of trustees on choosing among three project options for an unrestricted gift of $250,000 that has just been received. The board has established a time horizon of 5 years on this project. The options are described in the following.

· a. Purchase a 5-year treasury note at an interest rate (annual) of 7%.

· b. Purchase the practice of a young physician (the hospital’s third highest admitter). Estimates of projected cash flows for the practice (post-purchase), are:

Probability of Cash Flow

Time

20%

t + 1

$20,000

t + 2

$ 60,000

t + 3

t + 4

$100,000

$50,000

$125,000

60%		20%
$ 40,000		$ 60,000
$30,000	$ 80,000
$ 75,000	$40,000		$100,000
			$50,000	$125,000
	t + 5

· c. Purchase an upgraded analyzer for the laboratory. Based on forecasts of laboratory utilization, the net cash flows for this project are:

Time

Net Cash Flow

t + 1

t + 2

$75,000

t + 3

$50,000

t + 4

$50,000

t + 5

$50,000

$75,000

· Which investment should the COO recommend and why?

· 13-4 What are some of the factors that can influence the riskiness of projects (investments) in healthcare organizations?

hapter

rogram

valuation

eview

echnique: PERT

ECTI

· 1. To define the scope and tools of project management.

· 2.

nderstanding the components of PERT analysis.

. To understand how to use PERT for project management.

REAL WORL

SCENARIO

As the administrator of the Sunrise Care Center, a long-term care facility,

ichael Sharp is preparing to add on a new assisted living wing. The wing will be built as an addition to the existing facility. There are many steps involved with building the addition, and care must be taken to fully prepare for all of them.

urther, timing is vitally important, as units have already been sold to prospective patients. If the project takes longer than anticipated, there are financial implications. Mr. Sharp also needs to be aware of disruptions to ongoing care being provided in the facility. A project of this scope requires that each step be mapped out in detail and estimates be developed for completion time for each. Mr. Sharp has elected to use PERT analysis to manage the project.

This chapter presents Program Evaluation and Review Technique (PERT) and its application as a planning, scheduling, and control system to use with large scale projects. PERT was developed to support complex research and development projects. PERT provides the manager with a method to identify and sequence the many activities that comprise a complex project. It allows the manager an analytic tool to assess impacts when a change to the sequence or timing of required activities is needed. Such changes occur to finish the project by a specific date or as adjustments to changing circumstances once the project has begun.

ere we present single time estimate PERT, although other forms exist. Single time estimates create a “most probable” completion time when assessing proposed tasks. Other methods use multiple time estimates, such as optimistic and pessimistic time ranges. These may be desirable when project tasks are detailed, or when environmental factors could be an issue, such as cold weather or shipping time uncertainty. Here we examine single time estimate PERT to more easily develop the concept.

LEARNING OBJECTIVE 1: TO DEFINE THE SCOPE AND TOOLS OF PROJECT MANAGEMENT

A project is an activity done once. Building a new nursing home or modernizing a part of an existing hospital are examples of projects. Installing a new machine in a laboratory is a project. Developing a new capability, such as installing labor and delivery rooms in a hospital, is also a project. Installing a new computer system or a new computer capability to process patient accounts is a project. A project is a one-time activity intended to change the capabilities or capacity of the organization.

The antonym of a project is a program. A program is a repetitive activity. So while developing and installing a system for mothers to give birth in the same hospital room that they will use for the duration of their maternity stay is a project, using this new capability over and over again for many mothers is a program. Doing surgery in a newly renovated same day surgical suite is a program.

A project has defining attributes. It usually seeks to achieve a desired capability or capacity, and when that capability is achieved the project is, by definition, completed. As such, projects have formal beginning and ending points and do not continue past the point when the desired capability has been achieved.

Projects also evolve through many phases. Any project must move through at least three phases of development. The first is the concept phase. During this phase different ways to achieve the desired capabilities are considered and evaluated. Broadly defined project options are identified. Usually one or two of these conceptual options are taken further by gathering information and examining alternative methods to achieve the capability. Some projects spend hours or days in this phase, whereas others spend years depending on scope.

During the second, or definition phase, managers define exactly what resources are needed to achieve the desired capabilities associated with the specific project option chosen. These resources are defined in as much detail as possible. Usually a business plan or similar type of report is developed. At the completion of this phase, some type of organizational approval is sought to continue the project into its next phase. This approval may be based upon a detailed economic and/or financial analysis. In health care, some projects must also secure regulatory approvals, such as approval granted in the form of a Certificate of Need. If approvals are not received to move the project into the next phase—the project implementation phase—managers are expected to repeat the definition phase using different parameters, return to the concept phase, or are told that the organization no longer desires the capability.

The third phase is the implementation phase. During this phase of project management, resources and capabilities are installed in the organization in keeping with the intent of the overall project. It is during this phase that a project may involve new construction, buying new equipment, training staff, hiring new staff, revising job descriptions, and any other activities needed to implement the desired capability. This phase may also include an evaluation component to ensure the outcomes achieved were those planned, and if not, how the two differ and by how much. PERT is used in all phases of a project.

Projects typically involve altering existing capabilities as well as installing or implementing new capabilities. For example, expanding the capacity of a nursing home by 2

% will require more rooms, beds, and staff to administer to the needs of additional residents. However, such a project may also require altering the nursing home’s existing capacity to park cars (e.g., more visitors and staff), process laundry (e.g., increased amount), feed patients and staff (e.g., more meals), and store heating oil.

As a project manager, you will have total system (or subsystem) performance responsibility (TSPR). TSPR characterizes all project management activities. As the project manager, you will be expected to install the “total package” of capabilities necessary to complete the project. Installing a new computer system that exceeds the capability of existing electrical circuits violates TSPR. Installing the equipment to do laser surgery without training the operating room staff to use the equipment violates TSPR. Consider the following example: An organization that specializes in eye and ear sub specialties contracts to provide those services to another major hospital’s emergency department. A cart containing all of the necessary equipment is installed in that hospital’s ED with the appropriate security measures (locks, etc…) and the key locations are known by all staff who would need access to the cart. Upon first use, the cart is wheeled to the hospital’s sanitation room for sterilizing which is required after each use. There it is found that the existing sterilization service volume does not accommodate a new cart and because the cart originates from an outside facility, the staff are even more reluctant to attempt to rework the schedule. In this instance the manager with project responsibility at the eye and ear facility violated TSPR by failing to consider the need for sterilization of the cart. As a result, the cart had to be transported back to the eye and ear facility after each use, which carried added cost and potential quality issues if during that time, other patients were in need of the cart. Having total system performance responsibility means defining the project to include all the capabilities needed to fully complete the project, which in turn also entails the effective integration of the project into existing work flows and capacity of the organization, or in the above example, the contracted organization.

Some projects are complex, involving many action steps, significant resources, and a number of people. However, the definition of complex is often situational. What may be complex to one organization may not be to another. Complex can also refer to the duration of a project. A project that will require 2 years to complete may be complex; a project that takes 1 day may not be considered complex.

Formal project management methods, such as PERT, are reserved for complex projects. Often these projects have significant financial implications created by the expenses associated with installing the new capability as well as the expense (e.g., lost revenue) associated with any delay in achieving the capability. Using PERT to meet the deadline to submit a Certificate of Need application may be justified by the implications associated with being late or unprepared.

Generally project activities are performed in a predetermined sequence. Some steps must occur before others can begin. For example, the framing of an addition must be complete before electrical work can begin. Further, some sequences are more efficient than others. In other instances, the timing of activities is also very important. For a project that requires a significant amount of time, it may be inappropriate to train staff as an initial step. Training needs may change over the course of the project. Some trained staff may leave before the project comes on-line. Staff may forget their training given the long gap between when training occurred and when they begin to use the skills acquired. Similarly it would be inappropriate to hire new staff for an expanded nursing home months before the staff was actually needed. PERT assists managers in identifying and sequencing all the activities that must be completed to complete the project.

Consider the project to expand a nursing home by 20%. The initial list of the needed activities or steps could include the following:

· 1. Get Certificate of Need (CON) approval.

· 2. Get zoning approval.

· 3. Hire an architect and approve plans.

. Get the necessary construction financing.

. Hire a construction company.

. Build it.

. Advertise for staff.

. Interview staff.

. Select staff and train.

. Revise existing insurance policies.

. Change the operating budget to reflect the project.

. Determine the necessary new equipment, issue bids, and select the equipment.

· 13. Get the equipment delivered, unpack it, and set it up. Test equipment and secure replacements for any defective equipment.

When the steps necessary to implement project capabilities are defined, they should be listed in sequential order to the extent possible. For example, for this project we would seek CON approval before obtaining construction financing, etc. However, although some activities must be accomplished in a sequential order, other activities can be accomplished simultaneously or in parallel with others. Accomplishing activities in parallel can shorten the total time between when a project is begun and when it is completed. By authorizing and managing activities to proceed in parallel, projects can become more efficient, but also more difficult to manage and coordinate. PERT facilitates managing parallel activities, especially when the order of activities influences the overall time a project will take.

The Work Breakdown Structure

Before using PERT, any complex project must be first broken down into its component parts. Each piece of the project must be identified. A Work Breakdown Structure (WBS) is used to divide the project into appropriate and logical components and then subdivide each component of the project into even more specific parts. The WBS is a comprehensive listing of the components of the project listed in outline form. Some use a numbering system to ensure that macro as well as micro components of the project are identified and ordered. For example, the project to increase the capacity of the nursing home by 20% could be broken down into the following work breakdown structure:

· 1.0 Regulatory Approvals

· 1.1 Certificate of Need

· 1.2 Zoning

· 1.3 Fire Department

· 1.4 Highway Department

· 1.5 Building Inspection

· 1.6 Certificate of Occupancy

· 2.0 Physical Addition

· 2.1 Design

· 2.1.1 Building Design—New Space

· 2.1.1.1 Resident Rooms and Baths

· 2.1.1.2 Hallways and Storage

· 2.1.1.3 Work Stations

· 2.1.1.4 Common Areas

· 2.1.1.5 Other New Space

· 2.1.2 Changes to Existing Mechanical Systems

· 2.1.2.1 Heat

· 2.1.2.2 Fire Alarm

· 2.1.2.3 Electric

· 2.1.2.4 Telephone

· 2.1.2.5 Water

· 2.1.2.6 Air

· 2.1.2.7 Other Mechanical Systems

· 2.2 Build

· 3.0 Staff

· 3.1 Professional Staff

· 3.1.1 Registered Nurses

· 3.1.2 Licensed Practical Nurses

· 3.1.3 Social Workers

· 3.1.4 Therapists

· 3.2 Nonprofessional Staff

· 3.3 Consultants

This example only begins to illustrate the concept of a work breakdown structure. It is not the comprehensive WBS for this specific project.

Project managers, with input from many sources, create a WBS to define the project in terms of its scope and detail. A comprehensive WBS insures a comprehensive project. To create the comprehensive WBS, project managers ask what is necessary to achieve the desired project capability, categorize their answers into logical top level tasks (e.g., regulatory approvals, building design, staff, financing, etc.), and then continue to define subcomponents of each task until they feel that the project has been adequately defined in scope and detail. For example, building design could be further broken down into the subtasks of architect plans and contractor schedule. The latter could be further broken down into the subtasks of framing, plumbing needs, electrical work, dry walling, etc.

How much detail is included in the WBS is a product of managerial judgment. The WBS must be sufficiently comprehensive to include all necessary components and contain sufficient detail to guide the continued definition, implementation, and management of the project. In short, a good WBS lists all the pieces of the project.

Before the advent of PERT and similar methods in the 1960s, project managers used such a list of project activities to schedule activities. Gantt Charts, for example, listed all the activities associated with a project (i.e., WBS) on the vertical axis of a chart and used lines across a horizontal time axis to indicate when the specific activity was to begin and end.

Figure 12-1

is one simplified form of a Gantt chart.

Gantt charts provide the manager with a list of project activities and the estimated duration of each activity. These charts also provide the estimated start date as well as completion date for each activity. From a project management perspective, these charts have one serious flaw—they do not represent the relationship between and among activities. A Gantt chart does not indicate—although it does imply—which activities must precede other activities. Although these types of chart do indicate which activities can precede other activities, they fail to indicate which activities must precede other activities. PERT was developed to overcome this shortcoming.

Figure 12-1 Gantt Chart for Expansion Project

Gantt charts nonetheless remain an effective project planning and control approach for relatively simple projects. These charts provide the manager with appropriate scheduling information and a yardstick to use to compare actual experience with planned actions. Although easily created in any spreadsheet program, Gantt charts have been included in many specialized project management software packages available today.

LEARNING OBJECTIVE 2: UNDERSTANDING THE COMPONENTS OF PERT ANAL

SIS

Although misnamed a “Program Evaluation Review Technique,” when it actually deals with projects, PERT is a formal method to define projects and support project management. Specifically it helps project managers to determine:

· 1. When the project will be completed.

· 2. What the scheduled start and completion date for each specific activity included in the project will be.

· 3. What activities are “critical” and must be completed exactly as scheduled to keep the project on schedule. This feature of PERT makes PERT a much more robust project planning and control system than Gantt charts.

· 4. How long “noncritical activities” can be delayed before they cause a delay in the total project.

Based upon timing and the specific activities, PERT segregates all activities into critical and noncritical activities. By definition, if the completion date of a critical activity is delayed, the completion date for the overall project will be delayed. If the completion date of a critical activity is earlier than estimated, the date for the completion of the overall project may be earlier than originally planned. Noncritical activities, by definition, do not affect the scheduled completion date of the overall project. As projects evolve and circumstances change, noncritical activities can become critical activities and vice versa.

Developing the Network Table and Diagram

When completed, a PERT network table and diagram are tabular and graphical representations that show the relationships between project activities and the time estimated for individual activities as well as for the total project.

Step 1. List All Project Activities Using the Work Breakdown Structure

Each activity should be expressed using an action verb, such as “secure a Certificate of Need,” “build the new addition,” or “train new staff.” The list needs to be comprehensive and indicate all the activities needed to complete the project. In

Table 12-1

each project activity has been modified by the addition of an action verb. Using this approach, the work breakdown structure becomes an activity list that includes all the activities that must be completed.

Table 12-1

Activity

List for Project of Opening a New Clinic

Office:
	Identify site and lease
	Make modifications to site
	Install equipment
Aquire supplies
Staff:
	Hire staff
		Train staff

Step 2. For Each Activity, Indicate Its Immediate

Predecessor

Activity

In this step, the order of activities is determined. Each activity should be considered separately to determine which activity or activities must occur immediately before the next. This step begins to identify the essential sequence of activities of the project. The immediate predecessor for each activity is then listed (

Table 12-2

). For example, it is essential that the organization hires staff (E) before it trains staff (F). It is also possible that a step will have more than one immediate predecessor, such as with step D in
Table 12-2
,

Acquire supplies

Table 12-2 Activity List with Immediate Predecessors

Identify site and lease

Make modifications to site

Install equipment

Hire staff

Train staff

Activity

Predecessor

–

Acquire supplies

A, C

E, D

Table 12-3 Activity List with Immediate Predecessors and Time Estimates

Identify site and lease

–

Make modifications to site

Install equipment

Acquire supplies

A, C

Hire staff

Train staff

E, D

Activity	Predecessor	Time estimate (weeks)
			3
			2
				1

Step 3. Estimate the Time It Will Take to Complete Each Activity

When estimating the time each activity will take a common unit of time such as days, weeks, or years should be used. The estimate should be a reasonable estimate and not based on “best-case” or “worst-case” scenarios (

Table 12-3

Step 4. Create a Network Diagram That Includes Time Estimates

Table 12-4 PERT Project Paths and Times

Path	Path Time
A-B-C-D-F	11
A-E-F		7
A-D-F			6

After identifying the immediate predecessor activities, project “paths” can be determined. Because some activities have more than one predecessor, separate paths must be mapped out. An example of this from
Table 12-2
would be the following. All paths start at the beginning or at activity A. Activity A must precede activity B, thus a path would start A to B. However, activity A also precedes activities D and E. Here, two other paths must be started, one that runs from A to D, and one that runs from A to E. Following the A to B path, we look for activities that require B as a predecessor. We see that step C lists step B as a predecessor. This path now reads A to B to C. We continue down each path in this way until step F is reached, which is the end of the project.

Table 12-4

lists out all the paths for this project. A PERT network diagram considers each path separately and places them visually in one diagram.

Figure 12-2

shows the components of a PERT network diagram. PERT requires the use of specific symbols. Circles indicate the completion of a predecessor activity and the beginning of the next activity and lines are used to indicate relationships between activities. These are shown in
Figure 12-2
.

Figure 12-3

shows the completed network diagram for this project. The activities are labeled using their designated letter between the activity completion nodes. The time estimates for each activity are placed below. It is important that each project, and thus network diagram, have only one start and one end. Visually, all paths lead to these two nodes.

The critical path is the longest time path through the network and is determined by adding all of the individual project step time estimates for each path. From
Table 12-4
, we find that the critical path is the pathway represented by activities A, B, C, D, and F. Adding the times for each of these activities yields a total minimum project time of 11 weeks. The path containing activities A, E, and F has a total minimum completion time of 7 weeks, and the path with activities A, D, and F has a total minimum completion time of 6 weeks. The critical path is thus 11 weeks, or the longest. This means that given the time estimates of the various activities, the project cannot be done in any less than 11 weeks. If any of the activities on the critical path becomes delayed, or take longer than anticipated, the overall time of completion for the entire project will also be delayed.

Given the sequence of activities included in a PERT network, each activity has an earliest start date, which is simply the earliest time the activity can start after the project has begun. For example, activity B has an earliest start of 3 weeks and can only start after activity A has completed. Activity A is estimated to take 3 weeks to complete. Activity A, the first step in any project, by definition always has a start time of zero. The latest start time is the latest time the activity can begin without jeopardizing the total time estimated for the project. For activities on the critical path, the latest start time and the earliest start time are always the same. There is no flexibility in these start times, as any delay would delay the entire project. For activities not on the critical path, however, there may be flexibility in start times, and the earliest start time and latest start time can differ. For example, Activity E could begin as late as the seventh week without jeopardizing the 11 weeks estimated for the entire project. To calculate the latest start time for noncritical path activities, it is often easier to work backward from the end of the project. To stay within the estimated project time of 11 weeks, we would calculate the time needed to complete those steps to the end of the project, including the activity we are estimating. To do this we select the path the activity is on, because it is not on the critical path. Activity E is followed by activity F, which ends this project. Activity F takes 1 week to complete. This means that it must start at week 10 to stay on time. Activity E takes 3 weeks to complete. Therefore, the latest it can start and still end by the tenth week would be week 7.

The difference between the earliest and latest start times is called a slack time. Slack is the amount of timing flexibility that exists within an activity. It conveys the amount of time that an activity can increase without changing the estimated completion date of the overall project. Along the critical path slack equals zero. When slack is greater than zero, the activity is not on the critical path.

Table 12-5

has been updated to show slack time as well as a column designating whether the activity is on the critical path or not, a helpful, but not necessary, convention.

Table 12-5 Activity Times and Slack

Activity

Critical path?	Earliest start time (EST)	Latest start time (LST)	Slack
				Y	0		0
		3
						8
			N				4
	10

Pert establishes the sequential schedule of activities that constitute the overall project. By sequencing the activities in an appropriate order and adding time estimates, the overall time necessary to complete the project can be estimated. Equally important is the identification of those activities that must be monitored to complete the overall project on schedule—activities on the critical path.

LEARNING OBJECTIVE 3: TO UNDERSTAND HOW TO USE PERT FOR PROJECT MANAGEMENT

Once developed as a project planning technique, PERT provides the manager the ability to evaluate and control the project. In projects with many activities and paths, PERT focuses the attention of the manager on those activities on the critical path. Although all activities are important and essential for the completion of the project, PERT indicates those special or critical activities that the manager must monitor and manage to complete the project within the original time estimate. If the manager can shorten the time associated with these critical activities, the completion date of the project can be shortened.

Once a project is begun, managers monitor all activities by comparing the estimated time for each activity with the actual time taken to complete an activity. The difference between the time estimated and the actual time is the variance. When the actual time is less than the original time estimate, a positive variance occurs. When the actual time is more than the original time estimates, a negative variance occurs.

Negative variances on the critical path delay the overall project. A delay is referred to as a slip or slippage. Managers must evaluate any negative variance to determine if it is associated with a critical or noncritical path activity. If slippage is related to a critical activity, the overall completion date of the project will be affected as will the date subsequent activities begin. If it is not on the critical path, then the manager must determine the impact of the activity slippage. It is important to remember that extreme slippage of an activity from the original critical path sifts the entire critical path of the network.

Some managers use “rolling wave” PERT for projects that involve long time durations. Under this approach, managers continue to update and change the original network based upon project experience (what actually happens) and new information about completion times and estimates. For example, if a snowstorm delays lumber shipments from Canada early in the project, all subsequent activities must be adjusted accordingly. Rolling wave estimates add more detail than was originally included in the network. To ensure appropriate project management, it breaks macro activities into many micro activities and monitors adherence to the revised schedule of activities.

PERT networks and charts can be cumbersome. For large projects, these charts can fill walls. To assist managers with the size of charts, some prepare PERT networks in levels. They use a master network to show large activities and individual charts to plan and control smaller or subactivities. Some organize their charts based upon the categories used in the WBS. Others are organized by scope. “Higher level” activities are those activities expressed in larger time durations, whereas “lower level” activities show the detail associated with one or more “higher level” activities.

As an evaluation and control system, PERT provides the manager the ability to monitor project activity and assess the impact of project accomplishments. It facilitates timely planning of subsequent activities and provides the manager the dual ability to monitor the micro as well as macro elements of a project.

The Time and Cost Tradeoff

Typically, but not always, a project can be shortened by adding more resources. Embedded in every time estimate is an implicit resource statement. For example, if the activity to modify the clinic site (activity B) is estimated to take 3 weeks, this could imply that it will take 3 weeks with a crew of four working 8 hours per weekday.

4 workers × 8 hours per day = 32 worker hours per day

32 worker hours per day × 15 work days = 480 worker hours

At $14 per hour, this would equal $6720 for staff time. Consider alternative ways to schedule 480 worker hours, which is the estimated amount of work that must occur regardless of how many workers or days are allotted.

If two workers were scheduled to work the 480 hours, the activity could be completed in 30 work days or 6 weeks (480 hours/2 workers × 8 hours per day = 30 days).

If six workers were scheduled to work the 480 worker hours, the activity could be completed in 10 days or 2 weeks (480 hours/6 workers × 8 hours per day = 10 days).

If four workers were used and required to work 12, in contrast to 8 hours per day, the activity could also be completed in 10 days or 2 weeks.

Requiring workers to work 12 hours per day, in contrast to 8 hours per day, would, however, change the expenses related to this activity. Mandatory overtime would have to be paid, usually at a pay rate 50% higher than the base hourly rate (i.e., 480 hours/four workers × 12 hours per day = 10 days). In this last scenario, the tradeoff between time and cost is very evident. As originally scheduled using four workers at 8 hours per day for 480 hours (15 days), the staff cost was estimated to be $6720. This is found by multiplying 480 worker hours by $14 per hour. Using four workers, 12 hours a day for 480 hours requires some calculation. Having the extra time shortens the number of days needed to 10. This means that for 10 days the four workers will receive $14 per hour for 8 hours and $21 per hour for 4 hours. In total, 320 worker hours are paid at the base rate and 160 worker hours are paid at the overtime rate. The base rate cost is now $4480 and the overtime rate cost is now $3360 for a total of $7840, an increase in our budget of $1120. In fact there are many possible tradeoffs that can occur here relative to the number of workers and the number of hours.

Table 12-6

shows the options for some of them.

Inherent in each of these alternatives are key assumptions. One is that each worker contributes equally to project tasks, e.g., that there is enough work to go around infinitely. It is the converse of the law of diminishing returns, which states that as more workers are added, the output provided by each marginal worker decreases, a more likely reality. It is unlikely that an unlimited number of workers could be added to a project, and so estimations need to consider the scope of what is needed. The second is that additional resources are available. Although more workers or equipment could help to move a project time forward, these things are not always available, and so projections again need to be made realistic.

The project manager understands the tradeoff between project time and project cost, and that there are many strategies available to complete specific project activities. Some of these options take more or less time than the time chosen for project planning. Some options involve higher costs. If cost concerns are not a factor, a project can be rescheduled using crash times, which are the quickest time that an activity can be completed given any amount of resources.

Table 12-6 Resource/Cost Tradeoffs

$ 6720

$ 7840

20.0

$ 6720

$ 7840

$ 6720

$ 7840

$ 6720

$ 7840

10.0

$ 6720

$ 7840

$ 6720

$ 7840

$ 6720

$ 7840

6.7

$ 6720

$ 7840

For a project with 480 total worker-hours
Workers	Hours per day	Days	Total cost
60.0					$ 6720
				12	40.0	$ 7840
30.0
	20.0
13.3
1 5.0
	10.0
	5	12.0
8.0
		6
	6.7
	7	8.6
5.7
	8	7.5
5.0
		9
4.4

assumes $14 per hour and $ 21 per hour OT

Conversely, to lower project and activity costs, activities and projects can sometimes be lengthened. This will delay project completion. Even though such an action may have a system cost impact (e.g., the cost impact of a delayed opening of a new clinic), it may also lower the cost of the project. Delays may be caused by using fewer workers or less skilled workers who are paid less but require more time to complete the project. Delay may mean using manual labor to accomplish a task, even though the task could be done quicker, albeit more expensively, using an automated process with specific equipment.

The central point is to acknowledge the fundamental relationship between time and costs in project management. Within boundaries, the project manager is able to trade off one against the other.

OTHER PERT METHODS

Multiple Time Estimate Pert

Multiple time estimate PERT provides the project manager with a probabilistic range of estimates of the time required to complete project activities, or the overall project. Using multiple time estimate PERT, the manager can trade off different levels of probability (i.e., the probability of completing an activity in a specified amount of time), which is sometimes referred to as a time/probability tradeoff. Because multiple time estimate PERT utilizes optimistic, pessimistic, and most probable time estimates, there becomes a need for assessing the probabilities that are associated with each time estimate. Given the probabilistic nature of the time estimates used in PERT, other versions of PERT incorporate more formal methods for the project manager to assess time tradeoffs, cost, and the probability of completion success or failure. For most projects, however, the use of multiple time estimate PERT is overly complex and unnecessary.

PERT COST

PERT COST was developed as a companion to PERT. It adds the ability to assess and trade off time and cost at the activity level. It requires each activity to have three costs estimates: an estimate associated with the optimistic time, pessimistic time, and most probable time. Other versions use boundary limits (e.g., crash time cost estimates) as a basis for these multiple cost estimates. PERT COST is a complex system best used in very specific settings. Project managers of major construction and research and development projects use PERT COST to plan, evaluate, and control project activity. By comparing the planned value of work scheduled with the planned value of work accomplished, the project manager is able to extend the use of variance analysis to manage project costs as well as project times. Computer programs exist to develop PERT networks and support a project manager’s use of multiple time estimate PERT and PERT COST. The application of these more advanced versions of PERT is usually restricted to large-scale, highly complex projects.

CONCLUSION

PERT remains the premier method to define, plan, schedule, and control a project. It provides the manager with the ability to consider alternative plans and change plans once a project has begun.

The PERT network is the outcome of the combined insight of many. Groups of managers and experts are typically used to construct the WBS for PERT analysis. PERT also provides the ability to do “what if,” or sensitivity analyses; for example, what if the project had to be completed in 8 weeks instead of 12? “What ifs” are common questions that project managers consider.

PERT requires comprehensive project planning. During the concept and definition phase of a project, project managers construct and consider many different project approaches using PERT as a basis for moving forward. As circumstances change or develop, the project may need to be adjusted to accomplish its objectives. PERT provides the tools to do this by stressing the interrelation of project activities. It further provides an explicit tool for measuring the time/cost tradeoff inherent in any large-scale project.

EXERCISES

· 12-1 Using the information in

Table 12-7

, construct a PERT network and answer each of the following questions:

· a. What is the expected project completion data?

· b. What is the scheduled start and completion date for each activity?

· c. Which activities are on the critical path?

· d. How long can noncritical path activities be delayed without jeopardizing the overall completion date for this project?

· 12-2 Assess the impact of the following changes to the time estimates provided in question 12-1. Individually, what is the impact if:

Activity

Predecessor

New Time Estimate
O. Advertise for new staff
P. Interview for new staff			O
Q . Select new staff			P
Collectively, what is the impact of these changes?

· 12-3 As project manager for the example included in question 12-1, what would you recommend to preserve the original project completion date if activity A was reestimated to take 8 weeks, not the original 4 weeks? Provide details.

· 12-4 Develop a WBS and PERT network with no more than 20 activities for each of the following projects.

· a. Buying a car

· b. Screening 1000 school-age children for high blood pressure and reporting the results to the child’s physician

Table 12-7 Project to Convert a 20-Bed Unit in a Nursing Home to Accommodate Patients with Dementia

Activity

Predecessor

Time estimate (weeks)

–

Train staff

Secure state approval
Identify 20-bed unit to be used
Move existing residents
Clean space
Develop architectural plans
Install new heating and ventilation systems
G	Install security systems
H	Move walls; renovate
	I	Identify new equipment
	J	Order new equipment
K	Unpack and inspect new equipment
L	Install new equipment	D, K, H
		M	Reassign staff
Identify new staffing needs
Advertise for new staff
Interview for new staff
Q	Select new hires
R	Develop care plan protocols
	S	R, Q, M, L
	T	Modify quality assurance plans
U	Coordinate with hospital discharge planners
V	Complete internal audit	U, G

Figure 12-2 PERT Diagram Components

Figure 12-3 PERT Network Diagram for New Clinic Project

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