Accurate Cost Estimates Allow Better Performance Measurements
“So how much will this project cost me,” says the corporation’s CEO, as she opens her purse. The project manager scratches his head and responds by asking, “How much do you have?” One of the cornerstones for every project is Cost: the others being Time and Scope. And. If you are teaching or writing on quality – Quality itself may be considered a cornerstone; however, for our purposes quality is an aspect of scope; since quality is measured by the achievement of scope objectives, design requirements, features and functions. In a previous article we covered the “what is” cost management; so now, we will spend a little time on cost estimates and how does it fit in project management?
Purpose of Cost Estimates are used to establish budget planning and performance data points. Projects start with estimates whether we are talking costs, time duration, even quantification of resources and risk probabilities. Our first major estimate related project activity is in regards to overall project cost. How much will it cost the organization to complete the project or provide a product or service?
Cost versus Price: Understand that estimated costs are not the same thing as actual costs or pricing. We will return to this actual versus estimate and cost versus prices again later.
Cost estimates serve two purposes:
- To identifying what the overall planned project cost to include variances; and
- Cost breakdown for work packages and deliverables for the purpose of tracking and predicting project performance.
Sources for Cost Estimating
There are several sources or resources used to develop project cost estimates. I’ve published articles on several of these tools that you might find helpful; they include, the Work Breakdown Structure (WBS), Project Breakdown Structure (PBS), Work Package (WP, and Work Package Authorization (WPA). These next few paragraphs will help to explain the various types of estimates.
Three Methods for Cost Estimating
Analogous Estimating: This is a top-down approach, whereby we use the actual cost of a previous similar project as the basis for estimating the cost of our current project. This is one of the reasons that we, PMs, should maintain good, complete, detailed records of our projects and have that information available for future project planning. This method is frequently used for estimating total costs when a detailed analysis has yet to be completed. This is often the method for initial project forecasts for project charter purposes. It is generally a less costly technique; however, it is also less accurate; and, can result in a significant underestimate of the actual needed budget. It’s most reliable when previous projects are very similar in content and proposed outcome.
- When using an analogous estimate consider and adjust projections for differences in work components. Hopefully, you will at least know the major deliverables that will be a part of the project that will allow you to improve the accuracy of the estimate.
Parametric Modeling: This method uses project characteristics in a mathematical model to predict project costs. An easy example is in a building project where the standard cost for new construction is, for an example, might be $100 per square foot. If the building plan calls for a 10,000 square foot facility, we can parametrically estimate the project at not less than $1,000,000. Although by definition, a project creates a unique output in the form of product or service, some project oriented organizations perform many similar projects. For these project oriented businesses, they may have cost estimate relationship templates, standard cost formularies or off-the-shelf packages that help create an overall project cost estimate.
Bottom-Up Estimating: Simply, this is an identification of, and estimates of, all the costs for individual elements, tasks, work packages, time and all resources both material and human resources (workers, team members, stakeholder costs) individual activities or work packages; then sum-up or rolling-up the individual estimates in order to get the total project cost estimate. This is the most accurate method; however, it is the most labor intensive and time consuming to perform.
- Bottom-up estimates use multiple sources for data to include, but not limited to: work breakdown structures, project breakdown structures, and resource assignment or allocation matrixes, project schedule, pay rates, material pricing lists, buy-rent-lease comparison pricing, old invoices, past projects, supplier quotes, and outsourced bids for WPs/SOW activities.
Cost and Price Considerations
Price versus Cost: Understand that there is a difference between cost and price: Cost is the dollar value of the resources you will need to complete the required work – while Price is what you will charge your customer. Price is a business decision and Cost is an input to that decision. Keep this difference in mind even when you are negation prices that vendors are quoting you on outsourced work.
Types of Costs
Projects can involve multiple types of costs:
Fixed Costs are those that do not vary with the number of units produced.
Variable costs vary with the number of units produced.
Burdened or Loaded Costs might look like this example: hourly costs plus benefits wage of $16.00 per hour, plus an incentive wage of $4.00 per hour equaling a burdened wage of $20.00 per hour.
Unburdened or Unloaded Costs are straight forward wages and salaries that have no benefits or incentives charged to the project. For example: an hourly employee paid at $16.00 per hour has an unburdened wage of $16.00 per hour – just that simple. In both cases, even salary employees might have an incentive bonus loaded into the contract for work finished on-time or early.
Note: You should consider these issues when estimating costs and include in your risk management and contingency planning. Having to build in overtime work is normal but must also be acknowledged in the cost management activities.
There are also costs that may have inherent overhead costs; this is especially true with labor costs. Overhead is generally shown as a percentage of the base cost and different for labor and material. Material overhead rates cover costs of purchasing, contracting, inspection and quality programs, inventory holding, and subcontractor labor. In many businesses contractors and subcontractors are classified as material since they are outsourced and are handled through a billing arrangement.
Direct and Indirect
Account for and verify both direct and indirect labor or material/equipment costs. Direct costs being those specifically assigned to the project; while indirect cost are those coming from the organization’s infrastructure supporting all business functions. Indirect labor may even include employee benefits costs. Whether or not the organization charges all indirect costs to the project is an internal business decision and one you, the PM, will need to find out; there is not universal practice on this issue. Example: for overhead rate, if for every $10 of direct labor you have an indirect labor of $2.50, along with another indirect equipment cost of $2.50; your total overhead cost is $5.00. Or is the overhead rate is charged by percentage, let’s say 25% for this example, a direct labor cost of $10 would have an indirect labor/equipment cost of $2.50; the total direct-indirect cost is $12.50. Let me remind you though that these are your cost estimates. They don’t become prices and realized costs until the project progress, work performed and resources used.
Project Performance and Cost Estimates
Most methods of quantifying and qualifying project performance involve measuring the burn-rate of costs and time/duration against the original estimates. Thus, if your cost estimates are poorly put together, a significant piece of your performance measurements will be woefully inadequate for the task. Work progress against time only tells us part of the project story; cost tells us whether we are in financial trouble or not.
As a final word on cost estimates, keep an eye on the causes of any variations from the estimates; these will help you determine the project’s health and identify potential or realized risk events. Check within your organization for any standard templates or cost and pricing tools. Some contracting offices have their own documents and tools to forecast costs and evaluate prices proposed by outsourced vendors. Maintain your own historical information from your past projects and those of other PMs that you can benefit from as part of your personal PM “tool-kit.”