Tuesday, January 20, 2015

Understanding the Efficient Frontier

The Efficient Frontier is a concept defined by the Nobel Prize winner HarryMarkowitz as part of an article published in 1952 named “Portfolio Selection”. He stated that an optimal portfolio is the one that delivers the best possible return for a given level of risk or investment. Applied to portfolio analysis, the Efficient Frontier is represented as a curve, and plots strategic value (as a percentage) against Portfolio Cost. It might happen, often when you choose to force-out some projects, that the portfolio selection scenarios is plotted under the curve, which mean that the portfolio is not optimal.

Nice introduction isn’t itJ, yes. But let see how it works in Microsoft Project Server 2013.
The efficient frontier is part of a portfolio analysis. The creation of a portfolio analysis is done in 3 steps:
  • Definition of business drivers
  • Prioritization of business drivers
  • Portfolio analysis itself

OK, let’s get started. I will first create the following business drivers:
  • Expand revenue of the Bobby Brown product line
  •  Increase product awareness among people between 13 and 18
  •  Increase the number of members of the VIP club
  • Introduction of new premium products
  • Reduce employee turn over
  • Reduction of support call waiting time

Drivers are then prioritized. Without going too much into details, here is the result:

The consistency ratio is > 80%, which is a best practice, that’s a good prioritization.
I have also created the following projects, and define the estimated cost for each of them (note: as the portfolio analysis is done on the cost axis only, there is no resources assigned nor planning defined for those projects):
  • Travelling Up Europe ($100,000.00)
  • Mountain Lake Park city council ($200,000.00)
  • Colthan Metalhead adventure game ($200,000.00)
  • Bamsolcare service desk reorganization ($300,000.00)

The project prioritization is calculated and the result is the following:

We can now start our portfolio analysis. Including all the projects, the baseline is given for $800,000.00, with 4 projects and 100% of the strategic value delivered.

We now do several “what if” scenarios to simulate various cost restriction, and save them. The last scenario defines a cost limit of $300.000.00, but because some projects cannot be done today, we finally manually force in the “Bamsolcare service desk reorganization” and exclude all others. The portfolio is then the following:

Zooming on the efficient frontier curve:

What we can say:
  • The 3 scenarios “Baseline”, “600k” and “300K” are plotted on the efficient frontier curve meaning that for the given cost, each scenario brings the maximum strategic value. They are optimal.
  • Opposed to those, the scenario “300k restricted” is plotted below the efficient frontier. This scenario does not give the maximum strategic value for given cost constraint. It is not optimal.

The efficient frontier chart will help you identify optimal portfolios.

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