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Learning Objectives
 Understand the importance of project cost management.

Chapter-3  Discuss different types of cost estimates and methods for

preparing them.

Project Cost Estimation and  Understand the processes involved in cost budgeting and
preparing a cost estimate and budget for an information
Budgeting technology project.

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Introduction
 To answer these questions, as discussed in
previous chapter, we have to do
• Three basic questions to be answered in project
Technical analysis
analysis activities. These are:
Market and demand analysis
1. Can we produce the goods or services?
Financial analysis
2. Can we sell the goods or services? Socio-economic analysis

3. Can we earn a satisfactory return on the investment Institutional analysis

made in the project?

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Basics components of project Financial Analysis What is cost and project cost management?
 Cost of the project • Cost is a resource sacrificed or foregone to achieve a
specific objective or something given up in exchange
 Production cost
• Primarily concerned with the cost of the resources needed to
 Means of finance complete project activities
 Profitability projection • Costs are usually measured in monetary units like Birr,

• Result - financially viable i.e. being able to meet Dollar, Euro etc…

• Project cost management includes the processes required to

 burden of servicing debt
ensure that the project is completed within an approved
 return expectations budget – one of key issues in a project

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Project Cost Management Processes Resource planning

• Resource planning: determining what resources and • The nature of the project and the organization will affect

quantities of them should be used (next chapter) resource planning

• Cost estimating: developing an estimate of the costs • Some questions to consider:

– How difficult will it be to do specific tasks on the project?
and resources needed to complete a project
– Is there anything unique in this project’s scope statement that
• Cost budgeting: allocating the overall cost estimate to
will affect resources?
individual work items to establish a baseline for
– Does the organization have or can it acquire the people,
measuring performance equipment, and materials that are capable and available for
• Cost control: controlling changes to the project budget performing the work?

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Cost estimation Classification of project cost

• Clear definition of project costs at the beginning decreases the • Based on Project Life Cycle

possibility of estimation errors. • Based on purpose

• With greater initial accuracy the likelihood of completing within  Investment cost
budget estimates is greater.  Production cost
• To be able to create good estimations the project must be broken
down by deliverables, work packages and tasks.

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Life cycle costing (LCC) LCC Cont…

• Life cycle costing is the total cost of ownership of a
• The need for life cycle costing arises because
product, structure, or system over its useful life.
decisions made during the early stages of a project
• For products purchased off the shelf, the major factors are
inevitably have an impact on future outlay.
the cost of acquisition, operation, service, and disposal
• The trade off between current objectives and long
• For a system or product it is necessary to include the costs
term consequences of each decision is a strategic
associated with conceptual analysis, feasibility studies,
aspect of a project management that should be
development design, logistics support analysis,
integrated into the project management
manufacturing/erection, testing and commissioning.

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LCC Cont… Main components of project life cycle costs:

I. Pre- investment costs: costs incurred in developing the
• The five life cycle phases of a system or product project concept and preliminary project design.

1. Conceptual design phase
2. Advanced development and detail design phase
3. Production/construction/realization phase
4. Project termination and system operation and
maintenance phase
5. System disinvestment
II. Bidding and procurement-related costs: design and
analysis work to prepare bids .
III. Project development costs: further development/refinement
of the project scheme during the bid and post concession.
IV. Construction cost: Includes the construction of the entire
facility, including the purchase and installation of equipment.
V. Termination cost

VI. Operating costs

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LCC Cont…

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Purpose – Investment cost Investment cost items Cont…

 Land and site preparation
• Investment cost identification is the most difficult
 Technology (lump sum and initial payments)
and at the same time the most important function
 Equipment
of a project cost analysis
• Production
• Like any forecast, cost estimation includes some
• Auxiliary
uncertainty
• Costs for environmental protection technology,
– There is uncertainty regarding usage and price
waste disposal, internal infrastructural services

• Spare parts, wear-and tear-parts, tools

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Investment cost items Cont… Investment cost items Cont…

 Pre-production expenditures
 Civil works
• Cost of previous studies
• Buildings • Preliminary and capital issue
• Outdoor works • Project and site management
• Engineering and design costs (unless included in equipment). • Pre-production marketing costs
• Project design costs (engineering etc.) • Pre-production implementation costs
• Transport, handling costs and charges • Personnel recruitment, training, administration & overheads.
• Insurance, duties, taxes • Trial runs, start-up and commissioning

• Interests on loan accrued during construction

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Investment Cost Estimation Cont’d…

Investment Cost Estimation
 Factors in cost estimates adjustments
 Calling tenders (specifications, BOQs)
o Location factor
 Prices from similar projects to calculate costs (based on o Scope of project - ancillaries
 Accessibility to construction site
specs, BOQs) o Annual inflation rates
 Local conditions e.g. Climate

 Unit cost parameters o Changes in FOREX rates (heating, air conditioning etc.)

o Errors in data, physical  Laws and regulations e.g. safety,

 Lump sum totals of functional project parts of an labour
contingencies
existing project.  Level of infrastructural and HR
development

 Percentage of local inputs for project

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Problems with Cost Estimation the challenge …

 Low initial estimates • Even with careful planning, estimates are wrong

 Unexpected technical difficulties  Escalation

 Waste
 Lack of definition
 Bad Luck
 Specification changes
• Mitigation approach:
 External factors
– Making better/systematic estimates

– most firms add 5-10 percent for contingencies

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Making Better Estimates Types of Costs

• Projects are known for being over budget  Direct Vs. Indirect
o Unlikely that this is due to deliberate underestimating  Recurring Vs. Nonrecurring
• There are two types of errors  Fixed Vs. Variable
Cost Classifications
o Random  Normal Vs. Expedited
o Systematic

• There is nothing we can do about random errors

• Focus – eliminating systematic errors by proper

resource planning

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Elements and Classification of Costs Indirect Costs

• Broadly classified as direct and indirect costs • Many costs are of indirect nature and are not easily
associated/related with the output of a particular project;

Direct Costs • But it does not mean it is unproductive, useless, or

• Direct costs consist of two elements, unbeneficial.

• Direct material: The quantity (usage) and the price. • Indirect costs consist of three elements:

• Direct labor: Time (usage or efficiency) and rates (price or wage)

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Overhead Costs Elements

Feasibility Cost
 Factory Expenses: costs include salaries of project foremen and
expenses of maintenance staff; depreciation of project equipment
• The total cost of a project in feasibility analysis
and buildings; payment for power, water, etc.
may be calculated in at least two different ways:
 Administrative Expenses: salaries of administrative personnel;
1. Total cost is the sum of manufacturing cost and selling
office supplies, telephone, telex and postage; office equipment
expenses.
depreciation and buildings; and insurance fee, etc.
2. Total cost as the sum of fixed cost and variable costs
 Selling Expenses: include salaries and commissions of salesmen;
and advertising and traveling expenses for sales promotion.

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Fixed costs and variable costs

• Total Cost = Fixed Cost + Variable cost TC  FC  VC
• Fixed costs: expenses which are independent of the volume of
output (i.e. constant for any level of production output)

Examples of the fixed costs include cost of factory building,

insurance, lighting expenses, the cost of production
Finally total cost is the sum of direct labor, direct material, equipment, property taxes, salaries of administrative staff,
factory expense, administrative expense and selling expenses. etc.

All of these fixed costs can be expressed as annual costs.

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Fixed costs and variable costs Project feasibility decision

• Variable costs: expenses which vary or change proportionally • Decision on whether to proceed with the project
with the level of output (i.e. increases as the level of use
implementation or not – financial perspective needed;
increases).
• Profitability or financial attractiveness needs
 E.g. – Direct labor costs, expenses of raw material, electrical
evaluation with due project total cost analysis;
power to operate the production machines, packing material,
chemical input, etc., • Considers
 When fixed and variable costs are combined, we get the total – pre-operating cost,
cost in a feasibility study of the project – project implementation cost and

– operational cost
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Project Cost Estimation – Example

A good cost estimate

• Complete

• Reasonable

• Credible

• Analytically defensible

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Break - Even Analysis Total Project cost

(pre-operating + investment + operation)
• Business enterprises face problems of selection in
which profit maximization is assumed to be the
governing factor.

• Project client will be concerned only with revenues/

benefits , costs and the consequent profits or losses
associated with the possible alternatives.

• Income depends on both income generated (benefit

obtained) and capacity of delivery.

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The break-even point can be determined from a graphical presentation

Break - Even Analysis…Cont’d or can be computed using a mathematical formula.
• Point in the operation of an enterprise where revenue/sales Total Cost = Fixed Cost + Variable Cost
and total cost are exactly equal – the break-even point. Income  Price  Quantity
• At this point of operation an enterprise will, neither realize
At break-even sales,
an operating income, nor incur an operating loss.
Total Cost = Income
Price  Quantity = Fixed Cost + Variable Cost
Variable cost = Quantity * Variable unit cost
Let P = Price/unit
F
Q = break-even quantity Q
P V
F = fixed costs, and
V= variable costs/unit
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Net Present Value (NPV) Internal Rate of Return (IRR)

• The sum of the present values (PVs) of incoming and outgoing
• The discount rate at which the total PV of the cash flows into a
cash flows over a period of time.
business arising from an investment precisely equals the initial
• Difference between the present value of cash inflows and the
outlay.
present value of cash outflows over a period of time
• IRR is the discount rate that would result in NPV of zero for the
• Adjusting, or discounting them to get their present value
investment.
means working out how much money would have to be
• In general, the higher the IRR, the more attractive the project.
invested now in order to generate that specific amount at
that time in the future. Rt = net cash inflow-outflows during a
single period t
i = discount rate or return that could be
earned in alternative investments
t = number of time periods

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Project Budget Project Cost Budgeting

• The budget of any specific project is tied to the
• Cost budgeting involves allocating the project cost estimate
organizational/client budget.
to individual work items and providing a cost baseline
• A budget implies constraints in a project and implies that
• Needs to be linked to the work breakdown structure (WBS)
managers will not get everything they want/need
and the schedule for each activity
• A well designed budget is an efficient communication channel
for management
• How should the estimated cost be distributed through the
project works and time schedule
• A successful project manger is one who can achieve the
budget goals with the resources allocated to his or her project. • Example …

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Budgeting…Cont’d Project Cost Budgeting

• The budget for an activity also implies management support
for that activity

• The higher the budget, relative to cost, the higher the

managerial support

• The budget is also a control mechanism

 Many organizations have controls in place that prohibit exceeding the
budget

 Comparisons are against the budget

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Budgeting Methods Advantages

• Overall project budgets can be set/controlled very
1. Top-down accurately
• Top managers estimate/decide on the overall budget for the
• Management has more control over budgets
project

• These trickle down through the organization where the Disadvantages

estimates are broken down into greater detail at each lower
• More difficult to get buy in
level
• Leads to lower level competition for larger shares of
• The process continues to the bottom level
budget

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Bottom-Up Budgeting Negotiated Budgeting

• Project is broken down into work packages
• Mixes top down and bottom up approaches;
• Low level managers price out each work package

• Overhead and profits are added to develop the budget • Experts develop cost estimates and request budget

Advantages where negotiation yields the final agreed cost

• Greater buy in by low level managers estimate;
• More likely to catch unusual expenses • Offers sense of ownership, agreed control variables
Disadvantages and accountability
• People tend to overstate their budget requirement.

• Management tends to cut the budget 50

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Outputs of project budgeting Project Budget Components

• Cost baseline: approved version of The Time-phased Project
Budget, excluding any management reserves, which can only be
changed through formal change control procedures and is used as
a basis for comparison to actual results;

• This is developed as a summation of the approved budgets for the

different schedule activities aggregated into work packages.

• Project funding requirements: Total funding requirements and

periodic funding requirements (E.g., Quarterly, annually) are
derived from the cost baseline.
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End of Chapter

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