Applying the Efficient Frontier to Portfolio Selection

The Efficient Frontier curve shows all of the best possible combinations of project portfolios and the value that can be created with available capital resources in an unconstrained mode. In the example in Figure 4.4-1, the cumulative business value or discounted cash flows are on the vertical axis and available budgets are on the horizontal axis. The vertical value measures the value of the opportunity based on the impact and alignment with business drivers.

As we move from left to right, the quantity of cost increases while the value increases. This illustrates an important point: when a company is employing all available resources, it faces a trade-off. The only way it can have more value is by using capital.

Any point above the Efficient Frontier is not possible. The company can select a portfolio of projects on or under the Efficient Frontier. Portfolios along the curve are said to be efficient because the company is getting the maximum value from the available budget. Points under the Efficient Frontier curve represent inefficient portfolios. Many reasons cause a portfolio to be under the curve, including forcing in too many low-value projects or a significant mismatch between supply and demand of skill competencies, leaving the portfolio

Figure 4.4-1 Efficient Frontier Curve

Figure 4.4-1 Efficient Frontier Curve

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to yield less than it could have from the available budget. This brings us to an important lesson: any factor that moves the portfolio's position away from the Efficient Frontier should be challenged.

Another important outcome from Efficient Frontier modeling is the opportunity cost. The Efficient Frontier shows the opportunity cost of investing an additional dollar versus the additional value received. When the company is discovering the most valuable projects for the in-vestment—those with the highest value/cost. ratios—the Efficient Frontier is quite steep (for example, when the company plotted in Figure 4.4-1 uses $15 million, which is 21 percent of the budget, and gets 70 percent of the possible value). In contrast, when there are very few valuable projects left—those with the worst value-to-cost relations—the

The Efficient Frontier allows us to understand the value that is destroyed by each constraint (for example, labor demand versus supply, lack of efficient alternatives, or lack of consensus).

Efficient Frontier curve is quite flat (for example, when the company plotted in Figure 4.4-1 invests from $35 million until $70 million, 50 percent of the budget, yields only an additional 15 percent of the possible value). So we see in this case that investing the first 21 percent of the available budget on the projects with the highest value-to-cost ratio provides 70 percent of the possible business value, whereas spending the last 50 percent of the available budget on projects with a lower value-to-cost ratio can only deliver an additional 15 percent of value.

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Project Management Made Easy

Project Management Made Easy

What you need to know about… Project Management Made Easy! Project management consists of more than just a large building project and can encompass small projects as well. No matter what the size of your project, you need to have some sort of project management. How you manage your project has everything to do with its outcome.

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