Analytical Tools for Asset Management

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Analytical Tools for Asset Management

  1. 1. USING ANALYTICAL TOOLS TO IMPROVE ASSET MANAGEMENT FOR T&D May 5-7, 2004 Hyatt Regency Boston Boston Massachusetts Sponsored by EUCI S. Chapel Associates Lee Merkhofer Consulting VMN Group LLC 1
  2. 2. Outline Overview Purpose of Workshop Using Models • Introduction • T&D Project Prioritization Theory Data & Models • Managing Aging T&D Assets Organizational Issues Problem • T&D Strategic Reliability Decisions Analytic Tools Data • Summary Organizational Issues 2 2
  3. 3. Using Analytical Tools to Improve Asset Management for T&D INTRODUCTION Steve Chapel, S. Chapel Associates Lee Merkhofer, Lee Merkhofer Consulting Charles D. Feinstein and Peter A. Morris VMN Group LLC May 2004 1
  4. 4. Agenda • Overview – Some Asset Management Beliefs: fact or fallacy? – History of our Asset Management Research – T&D Asset Management Issues • Purpose of Seminar • Using Models 2 2
  5. 5. Some Asset Management Ideas – True or False? • Problems can be solved by organizational change and asset management teams • "Cost Benefit analysis, the "tried and true" method for ranking projects is a perfectly reasonable way to select projects to fund." • The first important step is to gather data • All projects can be valued using the same aggregate measures (i.e. $) • Projects are risky because of uncertain financial consequences • Beta is an appropriate way to measure project risk 3 3
  6. 6. Some Asset Management Ideas – True or False? • An important objective is near-term profitability • The biggest problem for asset management is insufficient data. • ROI is a good metric for evaluating investments. • Ranking is a good way to prioritize projects. • Strategic alignment is a good metric for prioritizing projects. • Balanced scorecards are a good way to prioritize projects. • Hurdle rates are a good way to account for risks. 4 4
  7. 7. Agenda • Overview – Some Asset Management Beliefs: fact or fallacy? – History of our Asset Management Research – T&D Asset Management Issues • Purpose of Seminar • Using Models 5 5
  8. 8. T&D Research 1997 – 2002 • December 1996 Chicago Focus Group • 1997 - 1998 – Create the portfolio – distribution planning – Produce V1.0 Area Investment Planning Tools • 1999 – Start work on Customer Needs & Reliability projects – V1.5 Strategy Model & V2.0 LoadDynamics – Methodology design for Project Prioritization (AEP) 6 6
  9. 9. T&D Research 1997 – 2002 cont. • 2000 – Aging Assets - Started – Project Prioritization – method & software designed – Customer Needs & Reliability – EPRI white papers – Area Investment Planning – tech transfer • 2001: Focus on Aging Assets and Project Prioritization • 2002: – Continued focus on Aging Assets and Project Prioritization – Some work on Measuring & Valuing Reliability • 2003: – Aging Assets – refine existing software & explore better ways to analytically address the problem – Project Prioritization: Refine existing software & continue improve methods for measuring T&D value 7 7
  10. 10. Utility Infrastructure Decision Making – The Focus of Our Work Utility Infrastructure Decision Tools & Supporting Decisions Information Research Managing Aging Managing Aging Measuring & Valuing Measuring & Valuing Assets Assets Reliability Reliability Managing existing assets Project Prioritization // Project Prioritization Capital Budgeting Capital Budgeting Assessing Assessing Customer Needs Customer Needs Expand distribution Area Infrastructure Area Infrastructure infrastructure to meet future load Planning Planning Investment Investment Economics Economics Underlying Objective: Minimize the lifecycle costs of distribution infrastructure while meeting customer needs for reliability & power quality 8 8
  11. 11. Our Focus • Analytical Tools & Information – Managing Distribution Aging Assets – Project Prioritization – Measuring & Valuing Reliability – Assessing Customer Needs – Infrastructure Investment Strategy • Supporting research: – Measuring & Valuing Reliability – Assessing Customer Needs – Investment Economics 9 9
  12. 12. Agenda • Overview – Some Asset Management Beliefs: fact or fallacy? – History of our Asset Management Research – T&D Asset Management Issues • Purpose of Seminar • Using Models 10 10
  13. 13. T&D Asset Management is Complex • What about reliability - how far can we push the system before falling off the edge? • How do we get the right-sized capacity when it is needed? • Can we save $ by deferring maintenance? • What risks are we taking by practicing “doing-less” decision making (do we really know how close we are to the edge)? 11 11
  14. 14. T&D Asset Management is Mostly About Solving Investment Problems Generation Generation GENERATION PLANNING • 40% to 50% of electric 230 KV utility net investment A Backbone Transmission Grid TRANSMISSION PLANNING • Business issues B 230/116 230/69 – Minimizing investment costs 115/12 115/12 69/12 69/4 – Having “right” infrastructure to C DISTRIBUTION PLANNING meet customer needs Distribution Planning Area 1 Distribution Planning Area 2 – Making money Net Invest. • Key strategic needs Gen. = $8.7B – Managing assets Tran. = $4.5B – Linking investment and O&M decisions to customer needs Dist. = $13.5B Total = $26.7B 12 12
  15. 15. T&D Asset Management • Two driving facts Generation Generation GENERATION PLANNING – Very low revenue to asset 230 KV ratio A Backbone Transmission Grid TRANSMISSION PLANNING – Large embedded asset base • Substantial care and 230/116 B 230/69 feeding is required 115/12 115/12 C 69/4 69/12 DISTRIBUTION – Repair / Replace Distribution Planning Distribution Planning PLANNING Area 1 Area 2 – Expand / Prepare for future – Reliability Net Invest. Gen. = $8.7B Tran. = $4.5B Dist. = $13.5B Total = $26.7B 13 13
  16. 16. Opposing Trends are Changing the Business • Increasing levels of key •Competition drivers •Customer Needs – Restructuring & deregulation •Technology – Regulatory & Corporate Level scrutiny – Customers demand for reliability and service quality – Technology change • Reduced budgets & increased corporate control •Budgets •Local Control • Together these are Time creating a collection of problems 14 14
  17. 17. Nature of Business Planning Problem Demand for Technology Services Local Area Local Area Req Existing Decisions Decisions ’ts Assets Budgets, Regulators Policy Alternatives, Consequences ts q’ Re Corporate Corporate Policy Policy 15 15
  18. 18. T&D Asset Management – Project Planning & Financial Planning • Fundamental engineering economic problems – Maintenance / Repair / Replace – Capacity expansion – System Risk Assessment & Mitigation • Financial planning problems – 3 to 5 year Capital Budgeting / Project Planning – Long-Term Financial Planning 16 16
  19. 19. In Summary T&D presents special challenges • Huge investment in assets • Regulations / Oversight • “Right” infrastructure for customer needs • Competitive pressures - extract maximum value from every asset • Performance vital to other industries & economy – Recent NE power blackout estimated to cost $7-10B – Loss of electric power to city of New York costs about $36m/hr 17 17
  20. 20. Agenda • Overview – Some Asset Management Beliefs: fact or fallacy? – T&D Asset Management Issues – History of our Research • Purpose of Seminar – What do you need to know? – What do you hope to get out of the seminar? – What are the main asset management problems? – What have we missed? • Using Models 18 18
  21. 21. Agenda • Overview – Some Asset Management Beliefs: fact or fallacy? – History of our Asset Management Research – T&D Asset Management Issues • Purpose of Seminar • Using Models 19 19
  22. 22. T&D Analytic Tools Workshop on Using Analytical Tools to Improve Asset Management for T&D May 5-7, 2004 Hyatt Regency Boston, Mass
  23. 23. Using Models Lee Merkhofer Lee Merkhofer Consulting 22706 Medina Court Cupertino, CA 95014 408 446 4105 www.prioritysystem.com
  24. 24. Fundamentally, good asset management is about making good decisions “Asset management is a business process that allows a utility to make the right decisions on the acquisition, maintenance, operation, rehabilitation, and disposal of assets.” (Stephen Kellogg, Vice President, CDM) c 2003, 2004 Lee Merkhofer Consulting 3
  25. 25. Fundamentally, good asset management is about making good decisions “Asset management is a business process that allows a utility to make the right decisions on the acquisition, maintenance, operation, rehabilitation, and disposal of assets.” (Stephen Kellogg, Vice President, CDM) • Asset management decisions are critical because: – The assets that are owned and how those assets are used strongly affects the revenues that are generated. – The costs of acquiring, installing, maintaining and retiring assets are typically large and directly affects the bottom line. – The capacity, reliability, and quality of the company’s assets strongly affect customer satisfaction along with the perceived and actual levels of service. c 2003, 2004 Lee Merkhofer Consulting 4
  26. 26. Numerous analytic tools are being promoted for asset management Examples: • Simulation models • Scoring tools • Executive dashboards • Narrow-focused applications • Enterprise-wide applications • Generic software • Custom software Do such tools really help? What characteristics does a good tool need to have? What type of tool is best? c 2003, 2004 Lee Merkhofer Consulting 5
  27. 27. The quality of a decision tool depends on the quality of its decision model • Tools rely on analytic models. • The model serves as a means for testing and evaluating alternatives. Decision Alternatives Model Value “All models are wrong, but some are useful.” (George E. P. Box, University of Wisconsin) c 2003, 2004 Lee Merkhofer Consulting 6
  28. 28. Models are cost-effective for complicated decisions Characteristics of Complex Decisions Power Delivery Asset Management Decisions More needs than resources Yes High stakes Yes Choices produce impacts over many years Yes Risk and uncertainty Yes Competing objectives Yes Multiple stakeholders Yes Interdependencies Yes Etc. c 2003, 2004 Lee Merkhofer Consulting 7
  29. 29. Models are useful because they address key limitations of human problem solving Empirical research shows people: - Have limited information processing skills Models allow… - Can be biased …computers to do the - Can be inconsistent at making choices things people have trouble doing. But people are good at: - Recognizing structure - Making “small,” well-defined judgments …people to do the things that they are good at. - Being creative c 2003, 2004 Lee Merkhofer Consulting 8
  30. 30. If well-designed, a decision model can provide 3 types of benefits 1. Use limited resources more effectively by – identifying value-maximizing choices – aligning decisions with corporate objectives – promoting better spending alternatives by clearly communicating performance metrics – clarifying sources of value c 2003, 2004 Lee Merkhofer Consulting 9
  31. 31. If well-designed, a decision model can provide 3 types of benefits 1. Use limited resources more effectively by – identifying value-maximizing choices – aligning decisions with corporate objectives – promoting better spending alternatives by clearly communicating performance metrics – clarifying sources of value 2. Improve the decision-making process by – providing a framework for collecting and incorporating relevant information into decision-making process – documenting performance goals and improving accountability – reducing opportunities for “gaming” – providing mechanisms for involving stakeholders in decision making – promoting consistent logic for valuing spending options and “leveling the playing field” – providing discipline for making tough decisions – controlling the role of politics c 2003, 2004 Lee Merkhofer Consulting 10
  32. 32. If well-designed, a decision model can provide 3 types of benefits 1. Use limited resources more effectively by – identifying value-maximizing choices – aligning decisions with corporate objectives – promoting better spending alternatives by clearly communicating performance metrics – clarifying sources of value 2. Improve the decision-making process by – providing a framework for collecting and incorporating relevant information into decision-making process – documenting performance goals and improving accountability – reducing opportunities for “gaming” – providing mechanisms for involving stakeholders in decision making – promoting consistent logic for valuing spending options and “leveling the playing field” – providing discipline for making tough decisions – controlling the role of politics 3. Improve decision-making defensibility by – documenting underlying assumptions and decision logic – promoting consensus over spending decisions – answering “what if” questions c 2003, 2004 Lee Merkhofer Consulting 11
  33. 33. The dilemma: Complex decisions require sophisticated models “There is a simple solution to every complex problem. Unfortunately, it is wrong.” (H. L. Mencken) An inadequate tool can mislead decision makers, resulting in poorer decisions than those that would be made without it. How can users be assured that analytic tools are adequate decision aids? The workshop addresses this question. c 2003, 2004 Lee Merkhofer Consulting 12
  34. 34. T&D Project Prioritization Lee Merkhofer Lee Merkhofer Consulting 22706 Medina Court Cupertino, CA 95014 408 446 4105 www.prioritysystem.com
  35. 35. Topics • Project prioritization and T&D asset management • Introduction to priority systems • Mathematics of project prioritization • Valuing projects and project portfolios • Creating a priority system • Accounting for risk • Organizing for project portfolio management • Selecting project prioritization tools • Case study examples – O&M resource allocation – Risk management – T&D project prioritization c 2003, 2004 Lee Merkhofer Consulting 2
  36. 36. Topics • Project prioritization and T&D asset management • Introduction to priority systems • Mathematics of project prioritization • Valuing projects and project portfolios • Creating a priority system • Accounting for risk • Organizing for project portfolio management • Selecting project prioritization tools • Case study examples – O&M resource allocation – Risk management – T&D project prioritization c 2003, 2004 Lee Merkhofer Consulting 3
  37. 37. Prioritization is an important concept for asset management • Because resources are limited, not all asset investments can be made now – Prioritization is needed to determine which projects to do now, and which should be postponed, scaled back, or eliminated. Assets Asset Investment “Projects” • Infrastructure • Rehabilitate/repair • Property • Replace/improve • Buildings • Dispose • Equipment • Create/acquire • Vehicles • People • Intellectual assets c 2003, 2004 Lee Merkhofer Consulting 4
  38. 38. Project prioritization guides asset management • The goal of project prioritization is to select the set of projects that create maximum value. c 2003, 2004 Lee Merkhofer Consulting 5
  39. 39. Project prioritization guides asset management • The goal of project prioritization is to select the set of projects that create maximum value. • A “project” is any investment of organizational resources. c 2003, 2004 Lee Merkhofer Consulting 6
  40. 40. Project prioritization guides asset management • The goal of project prioritization is to select the set of projects that create maximum value. • A “project” is any investment of organizational resources. • The goal of asset management is to manage assets to create maximum value. c 2003, 2004 Lee Merkhofer Consulting 7
  41. 41. Project prioritization guides asset management • The goal of project prioritization is to select the set of projects that create maximum value. • A “project” is any investment of organizational resources. • The goal of asset management is to manage assets to create maximum value. • Thus, a priority system can be used to guide investments for asset management. PRIORITY LIST PROJECT CUM. COSTS 1. PROJ. W $1M 2. PROJ. X $5M 3. PROJ. K $8M 4. PROJ. G $12M 27. PROJ. H $37M ------------------------------------------ 28. PROJ. M $43M c 2003, 2004 Lee Merkhofer Consulting 8
  42. 42. Project prioritization fits the modern view of asset management • Technical Old philosophy – Asset management is assuring high reliability and quality service through adequately building and maintaining poles, wires, transformers, turbines, etc. c 2003, 2004 Lee Merkhofer Consulting 9
  43. 43. Project prioritization fits the modern view of asset management • Technical Old philosophy – Asset management is building and maintaining poles, wires, transformers, turbines, etc., to ensure high reliability and quality of service. • Economic Recent philosophy – Asset management is efficient capital rationing (using hurdle rates, NPV, ROA, etc.). c 2003, 2004 Lee Merkhofer Consulting 10
  44. 44. Project prioritization fits the modern view of asset management • Technical Old philosophy – Asset management is building and maintaining poles, wires, transformers, turbines, etc., to ensure high reliability and quality of service. • Economic Recent philosophy – Asset management is capital rationing through financial evaluation of options (hurdle rates, NPV, ROA, etc.). • Strategic New philosophy – Asset management is about obtaining maximum value from assets, which requires integrating policy (strategic-level) information, systems-network understanding, and operations-management knowledge. c 2003, 2004 Lee Merkhofer Consulting 11
  45. 45. The “paradigm” of modern asset management • Organizations exist because they create value – For owners (who provide investment capital). – For customers (who purchase products and services at a price they are willing to pay) c 2003, 2004 Lee Merkhofer Consulting 12
  46. 46. The “paradigm” of modern asset management • Organizations exist because they create value – For owners (who provide investment capital). – For customers (who purchase products and services at a price they are willing to pay) • The capacity to produce outputs of value to the customer and, thereby, to create value for owners is directly related to the performance of the company’s production assets. c 2003, 2004 Lee Merkhofer Consulting 13
  47. 47. The “paradigm” of modern asset management • Organizations exist because they create value – For owners (who provide investment capital). – For customers (who purchase products and services at a price they are willing to pay) • The capacity to produce outputs of value to the customer and, thereby, to create value for owners is directly related to the performance of the company’s production assets. • Investments in the asset base (capital acquisition, operation, maintenance and renewal “projects”) should, therefore, be chosen with the goal of maximizing value. c 2003, 2004 Lee Merkhofer Consulting 14
  48. 48. Similarities between asset management and project prioritization Asset Management Project Prioritization Value- • “… should not just create ..seeks “value-maximizing” maximizing value, it should create the project portfolios. goal greatest possible value.” • “…requires seeing the …evaluates projects based Strategic on their impact on the value of managing assets perspective fundamental objectives of from a strategic the organization. perspective.” Importance of • “…is largely about ..uses rigorous techniques to obtain and analyze information information management.” information. management Search for • “…involves seeking ..seeks accurate, logically common solutions and defensible, and consistent consistent solutions approaches/ practices across different solutions lines of business and classes of asset types. c 2003, 2004 Lee Merkhofer Consulting 15
  49. 49. However, formal project prioritization is a big step for most T&D companies In most cases, companies: • Do not quantitatively evaluate and compare all distribution projects. • The value of doing a particular project is not compared with the values of competing projects. • Ignore uncertainty, project interdependencies, and the strategic “option value” of investments. • Inadequately address process issues--including information quality, credibility, and trust. c 2003, 2004 Lee Merkhofer Consulting 16
  50. 50. Topics • Project prioritization and T&D asset management • Introduction to priority systems • Mathematics of project prioritization • Valuing projects and project portfolios • Creating a priority system • Accounting for risk • Organizing for project portfolio management • Selecting project prioritization tools • Case study examples – O&M resource allocation – Risk management – T&D project prioritization c 2003, 2004 Lee Merkhofer Consulting 17
  51. 51. A priority system is a decision support tool Data Evaluation collection processes Software Decision Support processes Rank Project Total Benefit | Total Benefit | TECHNICAL DATA | | | | 7 ~~~~~ scoresform | | | 8 ~~~~~ 9 ~~~~~ | Total Cost Total Budget 10 ~~~~~ scoresform Used to Also known as tools for – Collect and consolidate project – Resource allocation data – Multi-project management – Evaluate and compare project alternatives – Project portfolio management – Provide decision – Capital allocation recommendations – Enterprise asset management – Explain and defend choices – Create a level playing field for the competition for resources c 2003, 2004 Lee Merkhofer Consulting 18
  52. 52. Priority systems are popular because many managers view prioritization as a top challenge What is your biggest challenge? Prioritizing which 40% projects to do Coordinating efforts 36% across the company Moving at the speed of 30% the market Finding qualified 22% people Insufficient resources 20% (PricewaterhouseCoopers survey of managers, Convincing executives 20% 10/00) of importance Identifying strategy 16% c 2003, 2004 Lee Merkhofer Consulting 19
  53. 53. Project prioritization is increasingly being recognized as a key component of business success Choosing “Of all the things a manager can do, figuring out the best way to projects is of allocate capital is probably the most important.” critical (Fortune Magazine). importance… c 2003, 2004 Lee Merkhofer Consulting 20
  54. 54. Project prioritization is increasingly being recognized as a key component of business success Choosing “Of all the things a manager can do, figuring out the best way to projects is of allocate capital is probably the most important.” critical (Fortune Magazine). importance… …as is “Regardless of industry, people are asking for more rigorous justifying the cases that illustrate both the short-term impact and the long- resources term benefits of projects.” required. (Randy Hancock, Senior VP of strategy at Mainspring Inc.) c 2003, 2004 Lee Merkhofer Consulting 21
  55. 55. Project prioritization is increasingly being recognized as a key component of business success Choosing “Of all the things a manager can do, figuring out the best way to projects is of allocate capital is probably the most important.” critical (Fortune Magazine). importance… …as is “Regardless of industry, people are asking for more rigorous justifying the cases that illustrate both the short-term impact and the long- resources term benefits of projects.” required. (Randy Hancock, Senior VP of strategy at Mainspring Inc.) Thus, “Overwhelmingly, enterprises that regularly prioritize projects project and services by their business impact are increasing prioritization shareholder value.” is key. (Doug Lynn, MetaGroup) c 2003, 2004 Lee Merkhofer Consulting 22
  56. 56. Priority systems address important questions for asset management How should we spend our resources? • What total budget should be sought from funding sources? • How should funds be allocated across organizational units? • What level of funding should be provided for each project? c 2003, 2004 Lee Merkhofer Consulting 23
  57. 57. Priority systems address important questions for asset management (continued) Where should we be headed? • Is the current set of projects the best way to accomplish our mission? • To improve alignment with strategy, which projects should be accelerated and expanded, and which should be slowed, scaled back, or eliminated? c 2003, 2004 Lee Merkhofer Consulting 24
  58. 58. Priority systems address important questions for asset management (continued) What is the right project mix? • Balance between – Low-payoff “sure things” versus high-payoff “gambles”? – Near-term versus long-term payoffs? – Maintenance versus growth? – Risk versus return? c 2003, 2004 Lee Merkhofer Consulting 25
  59. 59. Priority systems are intended to support the on- going process of project portfolio management ds n ee De fy pr fine nti oje Ide cts ess Moni tiveness Continual pr ogr improvement po jects lio s c tor rtfo & effe ro roj e p & p al u at ec t Implement Ev selected projects c 2003, 2004 Lee Merkhofer Consulting 26
  60. 60. Priority systems address key challenges Numerous needs, Dispersed information/ Biases/Gaming limited resources Multiple stakeholders/ Differing opinions Competing objectives Customer service Risk/Uncertainty Critical review Financial Market performance share ? D ecisions Reputation Regulatory compliance Health, safety & environment c 2003, 2004 Lee Merkhofer Consulting 27
  61. 61. …and overcome common problems of project portfolio management Project mix inconsistent Over-emphasis on with strategy Poor-performing portfolios “low-hanging fruit” ≠ “Fair-share” Allocations Insufficient Resources spread over understanding too many projects of risk Projects that won’t die RISK c 2003, 2004 Lee Merkhofer Consulting 28
  62. 62. The computational goal of a priority system is to identify the “efficient frontier” of project portfolios • Concept: Some project portfolio (e.g., Portfolio D) are undeniably better than others. c 2003, 2004 Lee Merkhofer Consulting 29
  63. 63. The efficient frontier identifies the project portfolios that create the most value for the least cost c 2003, 2004 Lee Merkhofer Consulting 30
  64. 64. There are 4 basic types of priority systems 1. Project ranking systems 2. Budget-allocation systems 3. Combined (tiered) systems 4. Problem/opportunity ranking systems c 2003, 2004 Lee Merkhofer Consulting 31
  65. 65. Project ranking system • Projects ranked according to benefit/cost • Typically used with an all-or-nothing, fund-from-the-top-down decision rule Ranking produces total benefit versus total cost curve (efficient frontier) Project costs and Projects ranked based on B/C Total value benefits evaluated Total Benefit PROJECT CUM. COSTS 1. PROJ. W $1M 2. PROJ. X $5M Added value Funded 3. PROJ. K $8M 4. PROJ. G $12M Added cost TECHNICAL DATA scoresform 27. PROJ. H $37M ------------------------------------------ 28. PROJ. M $43M scoresform Total cost Organizational element funding • Produce a funding curve (efficient frontier) showing which activities to cut (add) and specific benefits lost (gained) if budget is decreased (increased). c 2003, 2004 Lee Merkhofer Consulting 32
  66. 66. Advantages and disadvantages of project ranking systems • Ranking activities is a relatively simple, easy to understand concept • Enables the organization and project proponents to defend individual project choices • Most appropriate for organization with centralized decision making • Ranking logic can be extended to handle project interdependencies • All-or-nothing funding is unrealistic—may need to define and evaluate alternative “versions” of activities (e.g., base- case and reduced scope). c 2003, 2004 Lee Merkhofer Consulting 33
  67. 67. Budget allocation system • Provides an optimal allocation of a fixed budget among competing organizational units • Each organizational unit proposes activities to be conducted under several different, pre-specified funding cases (e.g., base-case funding, reduced funding, enhanced funding, etc.). • Each funding case is evaluated (based on the activities to be funded). • “Bang for the buck” used to allocate Scores used to determine optimal funds across sites allocation of total funds Budget Allocation Each unit prioritizes activities, indicates Funds Unit A Unit B Unit C Unit D funding under alternative unit funding $15M $16M 2 3 3 3 5 5 5 5 cases, and scores funding cases $17M $18M 3 3 4 4 5 6 5 5 $19M 4 4 6 5 $20M 4 4 6 6 Unit A (E-bus) Funding Cases $21M 4 5 6 6 Funding Case $22M 5 5 6 6 Activity Min Reduced Base Max $23M 5 5 6 7 $24M 5 5 6 8 B2B site $1M $2M $2M $2M $25M 5 5 7 8 Web store $1M $1M $2M $2M $26M 5 6 7 8 Kid’s lifestyle portal 0 0 $1M $1M $27M 5 7 7 8 Recruiting site 0 0 0 $1M : : Total $2M $3M $4M $5M c 2003, 2004 Lee Merkhofer Consulting 34
  68. 68. Advantages and disadvantages of budget allocation systems • Not as intuitive. • Allows organizational unit to retain authority for choosing which activities to conduct—most appropriate for decentralized decision making • Interdependencies among activities do not create a problem (since groups of activities are scored). • Allows consideration of partial funding of activities (doesn’t assume all-or-nothing decisions). • Doesn’t provide benefit estimates at the level of individual activities. c 2003, 2004 Lee Merkhofer Consulting 35
  69. 69. Combined (tiered) system • Individual organizational units use a common ranking tool to evaluate and prioritize projects while upper organizational levels use a budget allocation system to allocate resource across the organizational units. Integrated Budget Allocation/Activity Ranking System Enterprise level Budget allocation system • Funding case guidance • Project priorities Budget allocation criteria/weights Total benefit vs. total funding curves Individual Project Project Project organizational ranking ranking ranking elements tool tool tool • The value-maximizing allocation matches slopes: Element 1 Benefit Element 2 Benefit Element 1 funding Element 2 funding Cost Cost c 2003, 2004 Lee Merkhofer Consulting 36
  70. 70. Advantages and disadvantages • Automatically provides the necessary activity ranking information in the form needed for the budget allocation system • More complex than either of the individual systems • Usually results as an expansion from a project ranking or budget allocation system c 2003, 2004 Lee Merkhofer Consulting 37
  71. 71. Problem/opportunity ranking systems • Rank problems or opportunities, not projects or investments • Tell you where you should be focusing your attention, not what you should be doing • Simpler and less constraining than other approaches – No inputs required on costs or effectiveness of investments – Defends decision makers without constraining them—decision makers decide how much to spend on top-ranked items • Typically used as “screening” systems Scores used to rank problems/opportunities Each problem/opportunity is scored PROBLEMS 1. PROBLEM W 2. PROBLEM J Funded 3. PROBLEM K TECHNICAL DATA 4. PROBLEM G scoresform 27. PROBLEM. H scoresform c 2003, 2004 Lee Merkhofer Consulting 38
  72. 72. Topics • Project prioritization and T&D asset management • Introduction to priority systems • Mathematics of project prioritization • Valuing projects and project portfolios • Creating a priority system • Accounting for risk • Organizing for project portfolio management • Selecting project prioritization tools • Case study examples – O&M resource allocation – Risk management – T&D project prioritization c 2003, 2004 Lee Merkhofer Consulting 39
  73. 73. The project prioritization problem Find the set of projects that • Produces the greatest possible value (benefit) • Without exceeding the available budget c 2003, 2004 Lee Merkhofer Consulting 40
  74. 74. The project prioritization problem Find the set of projects that • Produces the greatest possible value (benefit) • Without exceeding the available budget Mathematicians refer to this a the “knapsack problem” c 2003, 2004 Lee Merkhofer Consulting 41
  75. 75. Mathematical formulation of the basic project prioritization problem N = number of project opportunities 0 if the i’th project is not funded xi = 1 if the i’th project is funded bi = benefit obtained if i’th project is funded C = total available budget N Maximize Σ1 bixi i= This is known as a “zero-one N Σ1 cixi < integer Subject to C programming i= problem” c 2003, 2004 Lee Merkhofer Consulting 42
  76. 76. Prioritization is surprisingly difficult to solve mathematically • The problem is the number of alternative project combinations. – If there are N possible projects, there are 2N possible project portfolios – E.g., with 30 projects there are roughly 1 billion alternative project portfolios! • Most software packages for integer programming use the “branch and bound” solution technique. • The solution is time consuming, even with modern computers. • If there are more than about 200 possible projects, even the fastest computers may not be able to find the solution. • Thus, most priority systems do not use branch-and-bound c 2003, 2004 Lee Merkhofer Consulting 43
  77. 77. Fortunately, a theorem from economics often applies • Suppose the projects are independent – Any combination of projects can be selected – Neither the costs nor benefits of any project depend on what other projects are funded c 2003, 2004 Lee Merkhofer Consulting 44
  78. 78. Fortunately, a theorem from economics often applies • Suppose the projects are independent – Any combination of projects can be selected – Neither the costs nor benefits of any project depend on what other projects are funded • Then, ranking projects by the ratio of benefit-to-cost and funding from the top down approximately gives the value-maximizing project portfolio Rank Project Cost Benefit B/C Cumulative Cumulative benefit cost 1 w 2 12 6 12 2 2 X 5 25 5 37 7 3 K 1 4.5 4.5 41.5 8 4 G 7 21 3 62.5 15 5 H 3 6 2 68.5 18 6 J 1 1 1 69.5 19 7 M 4 2 0.5 71.5 23 c 2003, 2004 Lee Merkhofer Consulting 45
  79. 79. Fortunately, a theorem from economics often applies • Suppose the projects are independent – Any combination of projects can be selected – Neither the costs nor benefits of any project depend on what other projects are funded • Then, ranking projects by the ratio of benefit-to-cost and funding from the top down approximately gives the value-maximizing project portfolio Rank Project Cost Benefit B/C Cumulative Cumulative benefit cost 1 w 2 12 ts 6 12 2 2 X 5 25c e 5 37 7 oj 3 K 1 pr 4.5 4.5 41.5 8 4 G 7 ed 21 3 62.5 15 5 H nd u 3 6 2 68.5 18 Budget 6 J F 1 1 1 69.5 19 constraint: 7 M 4 2 0.5 71.5 23 $20 million c 2003, 2004 Lee Merkhofer Consulting 46
  80. 80. The project ranking shows the order in which projects are added Rank Project B/C Cumulative Cumulative benefit cost 1 w 6 12 2 2 X 5 37 7 3 K 4.5 41.5 8 4 G 3 62.5 15 5 H 2 68.5 18 6 J 1 69.5 19 $20 M 7 M 0.5 71.5 23 80 70 Added value Cumulative benefit 60 Added cost 50 …which can be plotted to 40 show the “Efficient 30 Frontier” 20 10 0 5 10 15 20 25 Cumulative cost Budget constraint c 2003, 2004 Lee Merkhofer Consulting 47
  81. 81. Important considerations Note that: • the proper ranking metric is “bang-for-the-buck.” – Not “bang” – Not “alignment with strategy” – Not “balance” – Not “points” c 2003, 2004 Lee Merkhofer Consulting 48
  82. 82. Important considerations Note that: • the proper ranking metric is “bang-for-the-buck.” – Not “bang” – Not “alignment with strategy” – Not “balance” – Not “points” • ranking gives and approximate solution, not an exact one. c 2003, 2004 Lee Merkhofer Consulting 49
  83. 83. Important considerations Note that: • the proper ranking metric is “bang-for-the-buck.” – Not “bang” – Not “alignment with strategy” – Not “balance” – Not “points” • ranking gives and approximate solution, not an exact one. • ranking will give the wrong answer if there are interdependencies c 2003, 2004 Lee Merkhofer Consulting 50
  84. 84. Case study: Getting the concepts right is critical Example—Suspiciously performing priority system – Company was using a scoring approach recommended by consultants: » Candidate projects were awarded points based on performance in several dimensions (financial reward, strategic fit, leverage, probability of success) » Points were added and results used to rank projects – Something was wrong » Large project nearly always ranked near the top c 2003, 2004 Lee Merkhofer Consulting 51
  85. 85. Case study: Getting the concepts right is critical Example—Suspiciously performing priority system – Company was using a scoring approach recommended by consultants: » Candidate projects were awarded points based on performance in several dimensions (financial reward, strategic fit, leverage, probability of success) » Points were added and results used to rank projects – Something was wrong » Large project nearly always ranked near the top – Approach had numerous “fatal flaws” » Most notably, failing to divide by cost (to get bang-for-the-buck) meant that the logic was wrong. The system was biased toward large projects. c 2003, 2004 Lee Merkhofer Consulting 52
  86. 86. Topics • Project prioritization and T&D asset management • Introduction to priority systems • Mathematics of project prioritization • Valuing projects and project portfolios • Creating a priority system • Accounting for risk • Organizing for project portfolio management • Selecting project prioritization tools • Case study examples – O&M resource allocation – Risk management – T&D project prioritization c 2003, 2004 Lee Merkhofer Consulting 53
  87. 87. What exactly is “value” “Asset management should not just create value, it should create the greatest possible value” (Asset Management Software Vendor) c 2003, 2004 Lee Merkhofer Consulting 54
  88. 88. What exactly is “value”? “Asset management should not just create value, it should create the greatest possible value” (Asset Management Software Vendor) • Value is NOT – ROI, – ROA, – IRR, – NPV, – pay-back period, – etc. • Such financial metrics fail to Two views on value: capture the true objectives of - shareholder value organizations - stakeholder value c 2003, 2004 Lee Merkhofer Consulting 55
  89. 89. Many US business leaders and management scientists believe the one and only goal of business is to create value for shareholders “Maximizing shareholder value is becoming the number one priority for most publicly listed corporations.” CFO, Price Waterhouse, 1997. c 2003, 2004 Lee Merkhofer Consulting 56
  90. 90. Many US business leaders and management scientists believe the one and only goal of business is to create value for shareholders “Maximizing shareholder value is becoming the number one priority for most publicly listed corporations.” CFO, Price Waterhouse, 1997. “Maximizing shareholder value is now embraced as the “politically correct” stance by corporate board members and top management in the United States.” Alfred Rappaport, Creating Shareholder Value, 1998. c 2003, 2004 Lee Merkhofer Consulting 57
  91. 91. Many US business leaders and management scientists believe the one and only goal of business is to create value for shareholders “Maximizing shareholder value is becoming the number one priority for most publicly listed corporations.” CFO, Price Waterhouse, 1997. “Maximizing shareholder value is now embraced as the “politically correct” stance by corporate board members and top management in the United States.” Alfred Rappaport, Creating Shareholder Value, 1998. "Managing for shareholder value...pays off... We refined the goal over the years, constantly trying to come up with measures that better reflected the intrinsic value of the company and each of the businesses. But we always maintained a single overall objective: generating greater value for the shareholder" Brian Pitman, CEO of Lloyds Bank, HBR, April 2003. c 2003, 2004 Lee Merkhofer Consulting 58
  92. 92. Arguments for adopting shareholder value as the ultimate metric • For publicly held companies, the value assigned by markets is, arguably, the final measure of business success c 2003, 2004 Lee Merkhofer Consulting 59
  93. 93. Arguments for adopting shareholder value as the ultimate metric • For publicly held companies, the value assigned by markets is, arguably, the final measure of business success • Market valuations are objective and applied consistently across all publicly held companies and markets – Assured by principle of no arbitrage c 2003, 2004 Lee Merkhofer Consulting 60
  94. 94. Arguments for adopting shareholder value as the ultimate metric • For publicly held companies, the value assigned by markets is, arguably, the final measure of business success • Market valuations are objective and applied consistently across all publicly held companies and markets – Assured by principle of no arbitrage • Companies not managing for shareholder value are candidates for investor takeover c 2003, 2004 Lee Merkhofer Consulting 61
  95. 95. Managing for shareholder value and managing for profitable cash flows are two, very different things • Shareholder value is NOT the risk-adjusted, discounted value of projected future cash flows. c 2003, 2004 Lee Merkhofer Consulting 62
  96. 96. Managing for shareholder value and managing for profitable cash flows are two, very different things • Shareholder value is NOT the risk-adjusted, discounted value of projected future cash flows. • Example (4 power delivery companies): Gap (=“option value”) NPV of projected earnings (discounted at WACC) c 2003, 2004 Lee Merkhofer Consulting 63
  97. 97. Managing for shareholder value and managing for profitable cash flows are two, very different things • Shareholder value is NOT the risk-adjusted, discounted value of projected future cash flows. • Example (4 power delivery companies): Gap (=“option value”) NPV of projected earnings (discounted at WACC) • What causes these differences? c 2003, 2004 Lee Merkhofer Consulting 64
  98. 98. Stakeholder Value represents the alternative view “It is probably safe to say there remains, worldwide, a large segment of the people that highly doubts the business goal of maximizing shareholder value is aligned with the interests of society at large.” Bartley Madden, CFROI Valuation, 2000. c 2003, 2004 Lee Merkhofer Consulting 65
  99. 99. Stakeholder Value represents the alternative view “It is probably safe to say there remains, worldwide, a large segment of the people that highly doubts the business goal of maximizing shareholder value is aligned with the interests of society at large.” Bartley Madden, CFROI Valuation, 2000. The alternative view is that businesses have obligations to other stakeholders as well: • customers • employees Company leaders must decide whether stakeholder • the community values matter and what • suppliers weight (if any) to assign to • business partners each stakeholder. • etc. c 2003, 2004 Lee Merkhofer Consulting 66
  100. 100. What kind of metrics reflect impact on value? • Most organizations take the wrong approach. They measure what is easy to measure, not what is important. c 2003, 2004 Lee Merkhofer Consulting 67
  101. 101. What kind of metrics reflect impact on value? • Most organizations take the wrong approach. They measure what is easy to measure, not what is important. • They take a bottom-up approach—they define interesting metrics, but then can’t come up with algorithms for computing value based on those metrics. c 2003, 2004 Lee Merkhofer Consulting 68
  102. 102. What kind of metrics reflect impact on value? • Most organizations take the wrong approach. They measure what is easy to measure, not what is important. • They take a bottom-up approach—they define interesting metrics, but then can’t come up with algorithms for computing value based on those metrics. • Unless there is a way to logically combine the metrics to determine the value added by projects, the metrics will not be of much use for prioritizing projects. c 2003, 2004 Lee Merkhofer Consulting 69
  103. 103. Use “value modeling” to define metrics Value modeling • Subject of numerous books and articles, taught any many graduate school business and engineering programs. System System Performance Performance • Also called Power − “multiattribute utility analysis” Safety Safety Power Quality Quality Reliability Reliability − “multicriteria decision making” Net Revenue Net Revenue Environment Environment − “multi-objective decision analysis” • Goal is to construct the most accurate and objective measure of value possible c 2003, 2004 Lee Merkhofer Consulting 70
  104. 104. Topics • Project prioritization and T&D asset management • Introduction to priority systems • Mathematics of project prioritization • Valuing projects and project portfolios • Creating a priority system • Accounting for risk • Organizing for project portfolio management • Selecting project prioritization tools • Case study examples – O&M resource allocation – Risk management – T&D project prioritization c 2003, 2004 Lee Merkhofer Consulting 71
  105. 105. The philosophy underlying the decision analysis approach to prioritization • Resources are insufficient to do everything at once. • Things that are most valuable and most urgent should be done first. • The value of an investment or other alternative is determined by the degree to which it contributes to the achievement of objectives. • Objectives and the weights to be assigned to them should be established by policy makers. • In the absence of hard data and reliable models, estimates of the ability of alternatives to achieve objectives should be provided by those most knowledgeable about the alternatives and the needs that they will address. • Techniques should be used to reduce biases and discourage gaming. c 2003, 2004 Lee Merkhofer Consulting 72
  106. 106. Basic steps for developing a priority system 1. Identify and structure the objectives – Specify what you want 2. Define performance measures – Specify how you will measure the degree to which an alternative would achieve each objective 3. Derive the aggregation equation and decision rule – Specify how you will combine the performance measures – Specify relative importance or weights – Equation may be linear or non-linear and is derived using value modelling principles – Define how projects will be prioritized c 2003, 2004 Lee Merkhofer Consulting 73
  107. 107. A simple example What to pack for Limited resource: Alternatives vacation? space in suitcase (5,000 cubic inches) c 2003, 2004 Lee Merkhofer Consulting 74
  108. 108. Step 1: Identify and structure objectives Structuring objectives as a hierarchy shows how achieving lower-level objectives (that are impacted by choices) enable higher-level objectives to be achieved. Maximize enjoyment of vacation Maximize fun Minimize work Bring items Bring items Avoid bringing Avoid bringing likely to whose use big items heavy items be used enhances enjoyment c 2003, 2004 Lee Merkhofer Consulting 75
  109. 109. Step 2: Define performance measures Objectives Performance Measures Required Estimates Bring items likely to be Frequency of use Estimated number of times used item would be used Bring items whose use Benefit per use Benefit score: enhances enjoyment 4 = Major benefit added 3 = Significant benefit added 2 = Moderate benefit added (about ½ that judged “major”) 1 = Minor benefit added 0 = No benefit added Avoid bringing heavy Item weight Estimated weight in pounds items Avoid bringing items big Item size Estimated volume (length x items width x height, in inches) c 2003, 2004 Lee Merkhofer Consulting 76
  110. 110. Step 3: Derive the aggregation equation and corresponding decision rule Example equation: Ranking Measure = [ 80 x (Frequency of Use x Benefit per Use) - 20 x Weight ] / Size c 2003, 2004 Lee Merkhofer Consulting 77
  111. 111. Desired characteristics • Logically sound (defensible) and accurate • Complete c 2003, 2004 Lee Merkhofer Consulting 78

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