Cost
Before doing anything, the project manager must plan everything - this is the golden rule of successful project management. This of course also applies to budget planning. Generally, projects do not fit into the budget, which is due to insufficient planning. Everyone wants goods and services to be cheaper and of higher quality, certainly not the goods and services they provide themselves. There is such a saying - «Timid pays twice», since then it has been transformed and you can often hear such an interpretation «Timid pays twice, stupid three times, and the fool pays his whole life». This proverb fairly accurately shows the behavioral characteristics of sane people - if you buy a cheap thing or service, be prepared that it’s quality will be corresponding to the price. This fully applies to project management - it is not possible to execute a project several times below its real cost, provided that the quality level is adequate.
After Develop Schedule, PMI recommends to move on to Estimate Costs. Why right after the schedule? Because, only after the performed Develop Schedule process it becomes clear how long it will take to perform Activities, as well as what resources are needed for this. Okay, but what if the decision was made to change the Activity, thereby reducing its execution time (for example, applying a higher quality resource on the Activity)? Do not forget that project planning is an iterative process, i.e. it can be repeated countless times, which means that if you found the Activity or Work Package to be very expensive, you can always go back to the Define Scope, Estimate Activity Resources again, repeat Develop Schedule and Estimate Costs after that round. In principle, the complete planning process can run nonstop throughout the Project, but this technique is necessary in cases of extremely important projects.
So, the Cost Estimation consists of four processes:
7.1 Plan Cost Management
As in any other field of knowledge, the first step is to understand how planning will be carried out, what principles and rules will be used for it, etc. This is the purpose of the Cost Management Plan. It may include answers to the following questions:
- How will the evaluation be done. Who will evaluate? At what stage (when)?
- Which standards and norms will be used for this. Are there any corporate standards for Estimate Costs, or international financial reporting arrangements?
- What is the accuracy of the assessment? How important is accuracy in calculations? At what stage, what are the requirements for accuracy?
- What is the accuracy of rounding calculations? Perhaps the calculations will be very large, and taking into account every penny is very difficult and expensive. In these circumstances, it is easier to round the calculations to 1, 10, 100, 1000 etc.
- Which units of measurement will be used? Usually it is national currencies (rouble, ruppie, yen, US dollar, Euro, etc.), but can be in another currency, and sometimes, a man-hours unit.
- What are the control thresholds that will be applied? What are the acceptable deviations from the approved budget? What if the budget was exceeded by $130? What about $4 million?
- Is there a refund procedure for the Project and what does it mean? What if the project was done cheaper than planned (it is clear that this is almost fantastic, but still)?
- What are the project performance evaluation rules? Who will implement them? How often?
- What format will be used for financial reporting? Should it include a forecast? Who will perform it and how often?
Because for some products or services, the cost of creation or providing is not yet the full cost that will be spent on maintainign a product or service during a project, you should also consider the cost of the Product Lifecycle when drawing up a cost plan. For example, when building a house, in addition to spending on materials, there will be spending on electricity, because the drill consumes it?
The Project Manager and his Team should constantly try to find a way to conduce Activities cheaper. Naturally, this will entail Change Requests, which we already know must go through the process of Integrated Change Control.
Well, with the general part we’ve dealt. By the way, an example of the Cost Management Plan, you can see in the corresponding section. Now let’s look at further cost management processes.
7.2 Estimate Costs
In the process under consideration, it is clear that an assessment will be made for each Activity within the Scope declared in the Activities List. The sum of all Activities of the Project can be treated as the Cost of the project, or not? So what can be considered as the Cost of the project?
- The cost of tools, materials, team training, everything that will be involved in performing Activities. For example, to build a house you need to buy both materials (nails, boards, poles, etc.) and tools (hammer, saw, drill, etc.), and they must also be included in the cost of Activities;
- Cost of Quality provided for sufficient Activities execution. For example, in order to comply with all government standards, we would need to add verification operations. Since this is not a Deliverable, but only a requirement for Quality, it should be considered as the cost of Quality;
- The Cost of Risks. They are determined for each Activity separately. In more detail Risks are described in the corresponding section;
- Indirect costs such as rent, electricity, external services, etc. When building a house, the indirect costs will be consumed electricity for the installation of metal structures.
PMI distinguishes several types of cost:
- Variable Costs are all the forced costs for the direct implementation of the Project. For example, materials, wages, etc.;
- Fixed Costs are those costs that do not change during the course of a project. An example is the monthly rent.
Also the costs can be:
- Direct Costs. Costs directly aimed on project execution. For example, these are the same materials, salaries, travel of team members etc.;
- Indirect Costs. Costs related to the project only indirectly. For example, it can be taxes, duties and fees etc.
For a successful evaluation of the project cost, we will need:
- Scope Baseline. As mentioned earlier, without it nothing will be possible in project management (how can you accomplish something if you don’t understand what it is?). It’s a key tool at the beginning of the process, helps to understand what resources are needed (and therefore explain their cost), understand the relationship between resources etc;
- Project Schedule. Used as another key input tool of the process. The Schedule is needed as a tool to plan the price relative to the time period and establish a project financing calendar. For the first case, let’s suppose that if we know that building materials are cheaper in winter, then their purchase can be carried out precisely during this period, which will reduce the cost of the Project as a whole. Secondally, we need to indicate in what time period we will need financial resources (thus, we will need a Scope Baseline to justify these costs);
- HR Management Plan. Although we have not yet touched on this area of knowledge, it should nevertheless be addressed as a tool for estimating the cost of a Project. Although this tool is not as important as the previous two, but it will be just as useful in estimating the cost and here’s why: when estimating the cost we should take into account the system of rewards for team members. In more detail, this is described in the relevant section, just remember that the costs of performing the Activities also includes this item of expenses;
- Risk Register. In the Risk Register we can find ways to save money on the Project, and there is also indicated the monetary mass required as a Reserves. Again, in more detail in the corresponding section;
- Lessons Learned. Perhaps we have already done evaluation of similar Activities, then we can use them as an example;
- Procedures adopted by the company. May contain evaluation standards for particular Activities;
- Corporate culture (in particular, market situation). As an example, we will not produce building materials ourselves, but buy them on the public market, the price of which will depend on market prices.
As you may have noticed, almost all areas of project management knowledge are used in evaluations, if not directly, then indirectly.
How to estimate?
In principle, cost estimation methods are identical to Estimate Activity Durations. These include well-known One-point Estimating, Analogous Estimating (Top-down), Parametric Estimating, Three-point Estimating (PERT Analysis), as well as additional methodology - Bottom-up Estimation.
The principle of this new method (Bottom-up Estimation) is based on the estimation of the cost of each Activity for each Work Package mentioned in WBS.
The calculation starts from the lowest level of the Work Package, summing up the costs of all Activities at this level - the result will be the total cost of that level. Passing through every level of the WBS the total sum of the Project will be at the last level. To estimate the cost of an Operation Activity, you can use one of the tools that we are already familiar with by Estimate Activity Durations process. Remember that the evaluation should be linked to each Activity, but not to the Work Package or WBS - this will be done later in the Determine Budget process. Of course, this method has both positive and negative sides: pros - the evaluation accuracy is quite high, based on detailed analysis of the Project Scope; cons - takes a lot of time, requires clear definition of the Project Scope.
Iterativity and estimation
In the Estimate Costs process, iterativity is fully illustrative because some inputs to the process, as you have already noted, are results of a couple of next processes. For example, if Quality Assurance requires additional Activities, they should be added during the next iteration, and their cost should also be calculated in the next iteration in the Planning Process Group.
Reserve Analysis
As already mentioned, Reserve Analysis carried out in the process of analysis of Plan Risk Responses. Here it can only be noted that the Project Manager must evaluate the Reserves, expressed in a financial indicator, for each operation of the Project (i.e. Contingency Reserves).
Cost of Quality
In essence, it is sufficient to evaluate the Activities that must be performed for Quality Assurance, as discussed above.
Accuracy of Estimates
The accuracy of the assessment may depend on several factors - the importance of the Project to the company, the competence and skills of the Project Manager and Team, the requirements of the Project and others. But the following standards of accuracy for assessments are generally accepted:
- Rought Order of Magnitude Estimate - this is the initial estimate of the Project, announced in the group of processes of Initiation of the Project; accuracy may vary +/-50% from the final;
- Budget Estimate - is given in the Planning Process Group. It varies from -10% to +25% against to the final cost of the Project;
- Definitive Estimate - an assessment during the Execution Process Group, i.e. after the start of the Project. The accuracy is +/-10% of total.
7.3 Determine Budget
So, once we have determined the cost of each Activity, you can estimate the cost of the whole project, which in turn is the Project Budget. The Project Budget is one of the three Baseline of the Project - the Cost Baseline - i.e. the criterion by which we will evaluate project performance (implemented in the Control Costs process).
When drawing up the Project Budget, only the Scope Baseline and the Schedule Baseline are not sufficient. You will also need a list of treats and opportunities - the Risk Register; an understanding of the hiring and personel policy - HR Management Plan; quality assurance and control principles - Quality Management Plan; the resolution of questions regarding purchases and external contractors - the Procurement Management Plan; definition of methods and rules of communication - the Communication Management Plan. Therefore, the Budget can be considered to have been done only with several iterations of the Planning Process Group.
How is the budget drawn up? The calculation is carried out according to a similar method already familiar to us - Bottom-up Estimating. After all, we already have the cost of each Activity produced as a result of performing the Estimate Costs process, so now we can calculate the value of each Work Package in WBS! So, moving again from the bottom up, we calculate the cost of performing each level of WBS, this process is called Cost Aggregation. Having counted them all, we will get the project execution cost, BUT this is not yet a Project Budget! We need to account for the cost of the project’s Reserves (see Risk Response Planning), both Contingency Reserves and Management Reserves. And only after that, the Budget can be considered established. Naturally, the initial Budget of the Project will not coincide with the opinion of the management and the customer, but if properly planned, you can argue it.
According to the above diagram, a few comments should be given. The calculation is carried out from the bottom up, first of all by counting the cost of each Activity. On the second level, the cost of execution of Work Package is considered to be the sum of the cost of all Activities included in it. At the third level, the cost of Control Account is considered (checkpoints used to evaluate the execution of Activity, see the WBS), the sum of which gives the project cost (fourth level). To the Cost of the project should be added Contingency Reserves - those reserves that are determined for each Activity in accordance with known Risks. As a result, the Cost Baseline is obtained, on the basis of which the performance of the Project will be evaluated. But on those Risks that are initially impossible to determine, as a rule, is allocated a certain percentage of the cost of the Cost Baseline, equal to 5% - named as Management Reserves. After their adding, the calculation of the Project Budget can be considered done!
Project Funding Requirements
Together with the creation of the Project Budget, the result of this process can be a replenishment schedule for the project balance. What is it? Everything is quite simple - we will not introduce all the necessary resources (financial, primarily) to the Project at once, but we will do it gradually according to the requirements of the resources in the schedule. If you put it schematically, you could get something like this.
In addition to the required financing of the project (Planned Investments), this diagram shows the use of the reserve, as well as changes made to the Project due to exceeding the Cost Baseline. This chart also shows how, despite some delay in the changes, the Project Manager was able to adjust the situation.
7.4 Control Costs
Along with the Control Schedule process, it is one of the most important processes in project management. Both of these processes have the main responsibility for monitoring the status of the Project, assessing the performance of the Project Manager and team. Of course, for any evaluation we need to know the criteria. This is a big problem for many project managers. While most deadlines are controlled, the concept of Control Costs is known only to those who are experienced with encountering hurdles or studied corresponding management techniques. So what is the criteria? The Baseline. In the case of Control Costs, it is a Budget, the one we designed in the Determine Budget process.
Okay, but most project managers make a Budget for the Project. Yes, it is, but it is not (or rarely) used as a tool to track project progress. Note that time management and cost management often run simultaneously because they use the same inputs.
Before we move to the tools review, let’s deal with some terms that will help us.
Progress Estimation
As mentioned earlier, PMI recommends decomposing Activities in the Work Package according to the Rule 8/80 - each Activity should be in range of 8 to 80 hours. This will allow the Project Manager and Team Members to more accurately estimate the amount of Activities that are being performed. For example, during the estimation the volume of work completed, they may be guided by one of the following methodologies:
- 50/50 Rule. When you start the execution, it is assumed that 50% of the Activity has already been completed. Activity is considered fully completed only when it is actually done. For example, the fence we are just going to paint, but already noted that 50% is done, the remaining 50% count only when finishing the painting of the fence;
- 20/80 Rule. When the Activity is started, 20% is completed; when the Activity is completely finished - 100%. For example, at the beginning of the foundation building, when estimating that 20% of the work is done, the remaining 80% are considered only after the foundation is done;
- 0/100 Rule. Classical evaluation - only the completed Activities are considered.
Also, it is worth to remember that PMI says that each Activity or Work Package should have a description of the state of completion (under which condition, Activity can be considered as done). For example, the description of the completion of painting Activity - «painted fence» - sounds vague, because for each person «painted fence» can represent something of his own. Better description of the given example might sound like: «painted fence with external and internal sides over the entire height and width of boards, with maximum allowable cracks in the paint overlay, in 2% of the total area of the fence». You can read more about the acceptance criteria here.
Earned Value Method
When evaluating the performance of the Project using the Earned Value Method, the Manager has several advantages over the «classic» evaluation - comparing the completed work volume with the planned:
- The Earned Value Method allows to evaluate project execution in three dimensions - Scope, Schedule and Cost Cost;
- The Earned Value Method makes it possible to make predictions on the future development of the Project;
- Reporting based on Earned Value is a recognized practice in project management;
- This method also provides both quantitative and percentage measures.
Used measures
Below are the baselines used to calculate the entire Earned Value Method:
| Indicator | Description |
|---|---|
| Planned Value (PV) | Current planned cost of Activities |
| Earned Value (EV) | Currently completed (relative to planned) cost of Activities |
| Actual Cost (AC) | Currently completed (actual spent) cost of Activities |
| Budget At Completion (BAC) | The planned budget for all Activities in the work package/project/group of Activities under review. Roughly speaking, this is the sum of their costs |
Before we go any further, let’s take a look at each of these indicators by example. Measurements for the Earned Value, will be considered on the example of building a house wall. Let’s assume that we have determined that the construction of the house walls is one Work Package and the cost of each Activity within it (the construction of single wall of the house) is $100US, and its overall time is 24 hours (3 working days).
| Indicator | Example |
|---|---|
| PV | The Planned Value this time is $100US * 4 = $400US |
| EV | If we finished building one wall and 50 percent of the second, then that means we have $150US of Earned Value |
| AC | Let’s suppose, that during the construction of the second wall, 50% of the wall collapsed and we had to rebuild it at our own expense. Then, if we built a third wall, the Actual Cost will be equal to $350US (1st wall + 2nd wall + restoration of 2nd wall + 3rd wall) |
| BAC | The budget of the Work Package for the construction of 4 walls will be the cost of all Activities, equal to $400US ($100US + $100US + $100US + $100US) |
If these three indicators are clear, let’s move on. All subsequent values are derived from these three and are calculated according to the formulas:
| Indicator | Formula | Description |
|---|---|---|
| Cost Variance (CV) | CV = EV - AC | The difference between the completed cost and the actual cost. Value less then 0 means budget overrun |
| Schedule Variance (SV) | SV = EV - PV | The difference between the completed cost and the planned cost. Value less than 0 means that the Activity/Work Package/Project is delayed |
| Cost Performance Index (CPI) | The ratio of completed cost to actually spent. A value less than 1 (100%) indicates that the execution is more expensive than planned | |
| Schedule Performance Index (SPI) | The ratio of the completed cost to the planned cost. If a value less than 1 (100%), that means that the project works are tardy |
As before, let’s consider each indicator by example. When the second wall was built, half of it collapsed and we had to rebuild it at our own expense. We finished the construction of the 2nd wall and clearly do not fit into the schedule - we have to complete the 3rd wall at the moment:
| Indicator | Example |
|---|---|
| CV | CV = $200US - $250US = -$50US |
| SV | SV = $200US - $300US = -$100US |
| CPI | |
| SPI |
Let us now consider the following group of calculations, which are more related to forecasting:
| Indicator | Formula | Description |
|---|---|---|
| Estimate at Completion (EAC) | EAC = AC + BAC - EV | This method is used when it is assumed that the development of the Project will go according to plan until the end of the Project, but the actual costs will be treated as the current cost |
| The calculation is based on the assumption that the Project will proceed according to the current progress. CPI |
||
| This method takes into account both the schdule index and the cost index. It is effective if deadlines have a high impact. | ||
| To Complete Performance Index (TCPI) | Shows the projected cost performance index that must be achieved to complete the project’s management objectives. Calculated as the ratio of remaining work to remaining project funds. | |
| Estimate to Complete (ETC) | ETC = EAC - AC | Shows how much more will be spent on the project. The result depends on EAC calculation method |
| Variance at Completion (VAC) | VAC = BAC - EAC | Shows what would be the difference with the originally planned budget |
So, now let’s consider all this by examples. For each indicator we will describe the situation separately:
| Indicator | Example |
|---|---|
| EAC | |
| TCPI | |
| ETC | ETC = $500US - $250US = $250US |
| VAC | VAC = $400US - $500US = -$100US |
To simplify the understanding of Earned Value indicators, let’s review a diagram bellow:
This is how the analysis of Earned Value is done. It can be practiced on the example of almost any life situation, in the section Documentation, you can find examples for self-checking.
The Earned Value Method is a powerful tool that helps not only to assess the performance of Activities, but also to build forecasts, which is essential for management. Naturally, calculations are not calculate in purpose of «just so they are» - as a result of the Control Costs process Corrective and Preventive Change Requests can be created, which can affect almost any area of the Project.