Project Cost Management

Understanding cost
management
Budgeting
Cost estimation
Project cost management

 Includes the processes required to ensure that

the project is completed within an approved
budget
 Thus, you have to make sure the project is well
defined, have accurate time and cost
estimations, and has a realistic budget
Importance of Cost Management

 Projects typically have cost overruns

– Building a house—generally ALWAYS cost overruns
– Research has shown that the average cost overrun
of an information technology project is 189%
Importance of Cost Management

 3/5 to 5/6 of all projects fail to meet their time,

cost and specification objectives
 Most commonly used solution is to increase
estimates
 Often people forget to factor in waste and
spoilage
Project cost management

 The project cost management process include:

– Resource planning
– Cost estimating
– Cost budgeting
– Cost controlling
Project Cost Management Processes

 Resource planning: determining what resources and

quantities of them should be used
 Cost estimating: developing an estimate of the costs and
resources needed to complete a project
 Cost budgeting: allocating the overall cost estimate to
individual work items to establish a baseline for
measuring performance
 Cost control: controlling changes to the project budget
Resource Planning

 Involves determining what resources (people,

equipment, materials) and what quantities of
each should be used to perform the project
activities.
 The output of the resource planning process is
the list of resource requirements
Resource Planning

 The nature of the project and the organization will affect

resource planning
 Some questions to consider:
– How difficult will it be to do specific tasks on the project
– Is there anything unique in this project’s scope statement that
will affect resources?
– What is the organization’s history in doing similar tasks?
– Does the organization have or can they acquire the people,
equipment, and materials that are capable and available for
performing the work?
Cost Estimating

 Involves developing an approximation or

estimate of the costs of the resources needed
to complete a project.
 The main outputs of the cost estimating
process are cost estimates, supporting detail,
and a cost management plan
 The cost management plan describes how cost
variances will be managed on the project
Cost Budgeting

 Cost budget involves allocating the project cost

estimate to individual work items and providing a
cost baseline
Cost Control

 Project cost control includes

– monitoring cost performance
– ensuring that only appropriate project changes are
included in a revised cost baseline
– informing project stakeholders of authorized
changes to the project that will affect costs
 Earned value analysis is an important tool for
cost control
Earned Value Analysis

 Best way to measure project process is

through variance or earned value analysis
 A variance is an deviation from the plan of the
project
 Variance analysis allows you to find trouble
spots and take corrective action
Four areas of control

 Performance
 Cost
 Time
 Scope Objectives
 Cost is the easiest to measure—generally
refers to labor costs
Variance or Earned Value Analysis

 Cost Variance: Compares deviations only from

budget and provides no comparisons of work
scheduled and work accomplished--$$$ only
 Schedule variance: Compares planned versus
actual work completed—Labor only
BCWS

 BCWS:Budgeted cost of work scheduled

 The budgeted cost of work to be done in a
given time period or the level of effort budgeted
to be performed in that period.
 This is target toward which the project is
headed—in terms of cost target.
BCWS

 It is basically product of labor- hours and the

loaded labor rate that is paid during a given
period of time (usually a day or a week at a
time )
 Loaded labor means that direct pay has added
to it the overhead rates that are used to cover
heat,water,lights,rent and so on.Loaded labor
is the actual cost to do project work
Example BCWS

 Two people…40hours..loaded labor rate $30

per hour
 One person…30 hours..loaded labor rate

$50 per hour

40 hours x $30/hour x 2 = $2400
30 hours x $50/hour x1 = $1500
Total BCWS = $2400 + $1500 =$3900
BCWP and ACWP

 BCWP-The budgeted cost of work actually

performed in a given period . Also called
earned value.It is a measure of how much of
work has been accomplished
 ACWP-Actual cost of work performed is the
amount of money actually spent in completing
work in a given period.
Example

 2 workers work for a full 40 hours each put in

that amount of effort
 One gets her work complete,the other
completes only 80% of the work supposed to
be done
 Third assigned worker completes as planned
Example

 40 hours x $30/hour = $1200

 0.8 x 40 hours x $30/hour = $ 960
 30 hours x $50/hour =$1500
 Total BCWP $3600
Example

 Cost Variance = BCWP – ACWP

 = $3660 - $3900 = -$240
– Taken from our earlier slide:
 Schedule Variance = BCWP – BCWS
 = $3660 -$3900 = -$240
 Negative cost variance is unfavorable
 Negative schedule variance is also unfavorable
Earned Value Calculations for One Activity
After Week One

Activity Week 1 Week 2 Total % Complete EarnedValue

after Week 1 after Week 1
(BCWP)
Purchase web server 10,000 0 10,000 75% 7,500

Weekly Plan (BCWS) 10,000 0 10,000

Weekly Actual (ACWP) 15,000 5,000 20,000
Cost Variance (CV) -7,500
Schedule Variance (SV) -2,500
Cost Performance 50%
Index (CPI)
Schedule Performance 75%
Index (SPI)
Earned Value Formulas

Term Formula
Earned Value Budgeted Cost of Work Performed (BCWP) =
budgeted cost to date X % complete
Cost Variance CV=BCWP-ACWP (actual cost of work performed)
Schedule Variance SV=BCWP-BCWS (budgeted cost of work
scheduled)
Cost Performance Index CPI=BCWP/ACWP
Schedule Performance Index SPI = BCWP/BCWS
Example

 Back to our other example:

 CPI=BCWP($3600)/ACWP($3900), therefore
 CPI=.92—you are nearly 10% over budget

 SPI=BCWP($3600)/BCWS($3900), therefore
 SPI=.92—you are nearly 10% behind in
schedule
Rules of Thumb for EVA Numbers

 Negative numbers for cost and schedule

variance indicate problems in those areas. The
project is costing more than planned or taking
longer than planned
 If CPI and SPI less than 100% indicate
problems
EAC and ETAC

 Want to find out the estimated actual cost at

completion based on the problems you have
had thus far in the project (EAC)
 First look at BAC – Original budget at
completion which is Time/Cost
 To get your EAC
– BAC (original budget at completion)/CPI (cost
performance index)
EAC

 Example
– Say your BAC (budget at completion) is $120,000
and your CPI is (as before) .92,
 BAC/CPI = $130,434.78

 So, instead of costing you $120,000 it will cost you

approximately $130,435
ETAC

 Want to find out the estimated actual time to

complete the project based on the problems
you have had thus far in the project (EATC)
 You look at your budgeted actual time…let’s
say 12 months (BAT)/SPI (Your schedule
variance index) which was .92
 12/.92 = 13.04, you are looking at a scheduled
completion of roughly 13 months rather than 12
Cost control-conclusion

 Involves controlling changes to the project

budget.
 The main outputs of the cost control process
are revised cost estimates, budget updates,
corrective action, estimate at completion, and
lessons learned
Estimating Project costs
Basic Principles

 Lifecycle Costing: Allows you to take a big

picture view of the cost of a project over its
entire life
 It helps you to better determine the
project’s financial benefits
Lifecycle costing

 Total cost of ownership or development and

support costs
– Example: Million dollar investment in equipment but
no money for training
Lifecycle costing

 Project managers should create estimates of

the costs and benefits of the project for its
entire life or at least a reasonable period, eg.
10 years.
Cash Flow Analysis

 Needs to be done in order to determine the

estimated annual costs and benefits of a
project
 Companies may have several projects with
high cash flow needs--important to show
exactly what years the expenditures will occur
Tangible and Intangible costs

 Tangible costs can be easily measured in

dollars--in a development project you might
need to get the land surveyed before go
forward with the project , that is a tangible cost
Intangible costs

 Difficult to measure in monetary terms. The

hours that you are spending on these projects
are intangible costs to your clients--they are
not being billed to the client, but it is money
spent on the project
Tangible and intangible costs

 These categories are important because they

help in determining how definable the
estimated costs are for the project, as well as
the estimated benefits
Direct Costs

 Costs related to a project that can be traced

back in a cost-effective way--this would include
salaries, purchases etc.
Indirect costs

 Cannot be traced back to the project in a cost-

effective way. Cost of electricity etc.
 Most projects have indirect costs allocated to
them and the project manager has little control
over these costs
Sunk cost

 This is money that has been spent in the past.

 One pitfall of project management is that if a
project is failing and a lot of money has been
spent on it in the past…some people hate to
quit spending money
 It’s like gambling---sunk cost is lost money and
should be forgotten
Project cost management

 Problems can occur if the project manager is

not involved in the creation of the budget
 It is the project manager’s job to satisfy the
client and that includes controlling costs
Learning Curve Theory

 When human performance is involved and

many items are produced repetitively, the per
unit cost decreases in a regular pattern as
more units are produced.
 The cost of the first item would be considerably
more than the cost of the last item
Learning Curve Theory

 For any task where labor is a significant cost

and the production run is reasonably short,
learning curve should be taken into account in
cost estimates.
Budgeting and Cost Estimation

 As noted previously, in order to develop a

budget you must forecast what resources
are required, quantity of resources, and
how much they will cost
– Human, Equipment and Material resources
Budgeting resources

 Actual use may differ from “accounting” use

 If budget is not detailed out as to when
materials will be used it could affect the cash
flow because accountants will generally spread
the expenditures evenly.
Top-down budgeting

 Based on collecting the judgments and

experiences of top and middle managers.
 Management estimates overall project cost
and these costs are then given to lower-
level managers who break down the budget
into specific tasks
Benefits or Cautions
 Management generally has experience at
budgeting and base on previous projects
 Budgets are generally stable
 If something is left out, often it has been
accounted for since the budget isn’t down to
the last penny
 If everything is new….might not be a good
method
Bottom-up Budgeting

 Estimating individual work items and summing

them to get a project total
 The size of the individual work items and the
experience of the estimators drives the
accuracy
Bottom-up Budgeting

 All of the estimates would then be added to

create estimates for each level WBS and finally
for the whole project
 Using smaller work items adds to the accuracy
Benefits or Cautions

 More accurate on the details but

EVERYTHING must be included
 More difficult to get a complete list
 Generally it is associated with participative
management--must be a team effort
Comparison

 Top down budgeting is common

 Bottom up is considered risky
Other methods of costing

 Parametric Modeling uses project

characteristics in a mathematical model to
estimate project costs
 These are reliable when historical information
used to create the model is accurate and
parameters are readily quantifiable
Work Element Costing

 Each element on the WBS is evaluated for its

resource requirements and the cost of each
resource
 Direct costs for resources and machinery are
charged directly to the project without
overhead (generally)
Work Element Costing

 Use of general office equipment such as copy

machines etc. are generally calculated in
overhead costs
 General and Administrative costs are also
assigned--includes things like cost of senior
management and staff functions--not included
in overhead
Work Element Costing

 A fully costed budget would include:

– Direct costs (labor, resources, special machinery)
– Overhead
– G&A charges
Cost Problems

 Poor estimating techniques and/or standards,

resulting in unrealistic budgets
 Out-of-sequence starting and completion of
activities and events
 Inadequate work breakdown structure
 No management policy on reporting and control
practices
 Poor work definition at the lower levels of the
organization
Cost Problems (Continued)
 Management reducing budgets or bids to be
competitive or to eliminate “fat”
 Inadequate formal planning that results in
unnoticed, or often uncontrolled, increases in
scope of effort
 Poor comparison of actual and planned costs
 Comparison of actual and planned costs at the
wrong level of management
 Unforeseen technical problems
Cost Problems (Continued)
 Schedule delays that require overtime or
idle time costing
 Material escalation factors that are
unrealistic
Cost Problems Per Phase
 Proposal Phase
– Failure to understand customer requirements
– Unrealistic appraisal of in-house capabilities
– Underestimating time requirements
Cost Problems Per Phase
 Planning phase
– Omissions
– Inaccuracy of the work breakdown structure
– Misinterpretation of information
– Use of wrong estimating techniques
– Failure to identify and concentrate on major cost
elements
– Failure to assess and provide for risks
Cost Problems Per Phase
 Negotiation phase
– Forcing a speedy compromise
– Procurement ceiling costs
– Negotiation team that must “win this one”
Cost Problems Per Phase
 Contractual phase
– Contractual discrepancies
– SOW different from RFP requirements
– Proposal team different from project team
Cost Problems Per Phase
 Design phase
– Accepting customer requests without
management approval
– Problems in customer communications
channels and data items
– Problems in design review meetings
Cost Problems Per Phase
 Production phase
– Excessive material costs
– Specifications that are not acceptable
– Manufacturing and engineering disagreement
Trade off analysis in a project
environment
Tradeoff Questions
 Is the information pertinent?
 Is the information current?
 Are the data complete?
 Who has determined that this situation exists?
 How does he know this information is correct?
 If this information is true, what are the implications
for the project?
Unexpected Problems
 Human errors/failures
– Impossible schedule commitments
– Poor control of design changes
– Poor project cost accounting
– Machine failures
– Failure to receive a critical input
– Failure to receive anticipated approvals
Unexpected Problems
 Uncertain Problems
– Too many concurrent projects
– Labor contract expiration
– Change in project leadership
– Possibility of project cancellation
Unexpected Problems
 Unexpected Problems
– Over-committed company resources
– Conflicting project priorities
– Cash flow problems
– Labor contract disputes
– Delay in material shipment
– “Fast-track” people having been promoted off of the
project
– Temporary employees having to be returned to their home
base
Unexpected Problems
(Continued)

– Inaccurate original forecast

– Change in market conditions
– New standards having been developed
Risk Analysis in Project
Management
RISK MANAGEMENT
The alternative to proactive
management is reactive
management, also called crisis
management. This requires
significantly more resources and
takes longer for problems to
surface.
RISK MANAGEMENT

 RISK MANAGEMENT FOCUSES ON THE

FUTURE

 RISK AND INFORMATION ARE INVERSELY

RELATED
RISK MANAGEMENT (CONT.)

 HISTORICALLY, WE FOCUSED OUR

ATTENTIONS ON SCHEDULE AND COST
RISK MANAGEMENT.

 TODAY, OUR PRIMARY EMPHASIS IS ON

TECHNOLOGICAL RISK MANAGEMENT:
– CAN WE DESIGN IT AND BUILD IT?
– WHAT IS THE RISK OF OBSOLESCENCE?
Risk Management
– RiskManagement is a measure
of the probability and
consequence of not achieving a
project goal
 Definition Of Risk

Riskevent= f(Likelihood, Impact)

•Likelihood is the probability of occurrence
•Impact is the amount at stake
Tolerance For Risk
 Risk averter-Greater $$, Less
Tolerance—prefers certain outcomes
 Risk neutral-no real change
 Risk lover-Greater $$, Greater
tolerance-prefers uncertainty
Decision-Making Categories
 Complete uncertainty
 Relative uncertainty (partial information)
 Complete certainty
 FIVE STEPS TO ASSESSING RISK

 List all the alternatives.

 List the future consequences of each
alternative.
 Identify the payoffs associated with each
combination.
 Assess the degree of certainty that these
combinations will materialize
 Decide on a decision criterion.
Risk Management Processes
 Risk planning
 Risk assessment
– Risk identification
– Risk analysis/quantification
 Risk handling
 Risk monitoring
Inclusion of “protect the plan” forces to
look at risk early in planning stage
Project Selection and Planning
 Strategic Planning for Project
Management

 The first step in initiating projects is to look at

the big picture or strategic plan of an
organization
 Strategic planning involves determining long-
term business objectives
What is Project Strategy:

 The overall approach to the project

 The game plan
Example

 When the Chunnel was built to connect

England to France options were evaluated
 Result…dig from both ends and meet in the
middle
 Resulted in a much shorter process
 Important point: They did their homework and
planned ahead
What is corporate strategy

 Strategy that helps to determine the broad and

long term direction of a company

 Most companies have determined a strategic

direction—necessary for long term survival
What are the issues?

 What do you agree are the basic

element of this organization
 Now, how do you define this
business?
 Do you have any competitors?
Other issues...
 What are the important trends in your
environment and your industry?
 How do these trends affect your
organization?
 What strategic and business
opportunities face your organization?
Other issues….
 What constraints will inhibit you from
exploring these opportunities (eg:
lack of financial resources etc…)

 What are the objectives of your

constituents?
In making strategic decisions…

 You must rely on informed judgments

 Sometimes the more important the

decision, the less quantifiable it is and the
more you have to rely on the opinions of
others and your own best judgment
Formalizing strategy..

 Some businesses grow and prosper with no

apparent strategy or rudimentary strategic
systems
– Is this due to pure luck?
– Is it easier to do in non-competitive markets (but you
have to find that market!)?
Formalizing strategy..

 The more complex the market, the greater the

need for a formal approach to ensure that as
many aspects of the market as possible are
considered.
More formalized strategic management
process

 More important for organizations that deal with

large fixed-asset investments than with
expense investments (increased advertising)
 The same is true when you are strategically
planning for your project
Other important issues:

 When the rate of market growth declines there

is a greater need for formal planning
 When there is an increase in the level of
competition, the organization has greater need
for a formal planning approach
Other important issues

 When the rate of change in the environmental

such as legal, regulatory, economic,
demographic, social increases, a systematic
method is needed to cope with the change
needed.
The Mission

 And the mission of your organization is

important in determining potential projects

 The mission is how you see this company now

and in the future
The Objectives

 The objectives are important because they give

you quantitative mile markers of where you
expect the company to go within a given period
of time
The Strategy

 Strategy is the means to meeting your

objectives
 Sometimes the projects that you are
undertaking could be the actual strategic
process
 You will have a more detailed lecture on
strategically planning in a few weeks
Project strategy verses technical
strategy

 Example: You have to feed a large group

 You have three alternatives: cook, take
everyone out to a restaurant, have it catered
 You evaluate all the alternatives and you
decide on your project strategy
– You will cook
Technical strategy

 You have your project strategy but the

technical strategy is HOW are you going to
cook
– In the oven
– In the microwave
– On the grill
General guideline on technical
strategies

 It is best NOT to employ cutting edge

technology in a project with a tight deadline

 Let’s not get ahead…let’s talk about selecting

your project
Identifying Potential Projects

 Many organizations follow a planning process

for selecting projects
 First develop a strategic plan based on the
organization’s overall strategic plan
 Then perform a business area analysis
 Then define potential projects
 Then select projects and assign resources
Business area analysis

 This analysis dissects your organization into

processes to see where you are strong, weak,
have special competencies or constraints
 Selecting a project would be contingent on the
ability to actually carry out that project
Methods for Selecting Projects

 There are usually more projects than available

time and resources to implement them
 It is important to follow a logical process for
selecting projects to work on
Financial Analysis of Projects

 Financial considerations are often an important

consideration in selecting projects
 Three primary methods for determining the
projected financial value of projects:
– Net present value (NPV) analysis
– Return on investment (ROI)
– Payback analysis
Return on Investment
 Return on investment (ROI) is income divided by
investment
ROI = (total discounted benefits - total discounted costs) /
discounted costs
Discounted against any increase revenue/costs)
 The higher the ROI, the better
 Many organizations have a required rate of return or
minimum acceptable rate of return on investment for
projects
Net Present Value Analysis

 Net present value (NPV) analysis is a method of

calculating the expected net monetary gain or
loss from a project by discounting all expected
future cash inflows and outflows to the present
point in time
 Projects with a positive NPV should be
considered if financial value is a key criterion
 The higher the NPV, the better
Figure 4-2. Net Present Value Example

Excel file
NPV example

 Looking at the example, if you discount your

stream of income over years 1-5, the sum of
those discounted values is your NPV
 Since you start out in the hole by so much in
year 1 of project one, your NPV is lower than
project 2
Return on Investment

 Return on investment (ROI) is income divided

by investment
ROI = (total discounted benefits - total discounted
costs) / discounted costs
 The higher the ROI, the better
 Many organizations have a required rate of
return or minimum acceptable rate of return on
investment for projects
Payback Analysis
 Another important financial consideration is payback
analysis
 The payback period is the amount of time it will take to
recoup, in the form of net cash inflows, the net dollars
invested in a project
 Payback occurs when the cumulative discounted
benefits and costs are greater than zero
 Many organizations want IT projects to have a fairly
short payback period
Weighted Scoring Model/Decision
Criteria
 A weighted scoring model is a tool that provides a
systematic process for selecting projects based on many
criteria
– First identify criteria important to the project selection process
– Then assign weights (percentages) to each criterion so they add
up to 100%
– Then assign scores to each criterion for each project
– Multiply the scores by the weights and get the total weighted
scores
Using Decision Criteria (example)
 Criteria  Weighted Criteria
– Supports objectives – 10
– Good rate of return
– 10
– 20
– Good net present value
– 30
– Meets budgetary
constraints
– 10
– High probability of
completing project
– 20
– Good profitability potential
– 100
Using Decision Criteria (example)
Given project 1 verse 2
 Score criteria 1(low)-5(high)  Scoring
P1 P2
– Supports objectives 2 3
– Good rate of return 3 3
– Good net present value 2 4
– Meets budgetary constraints 1 3
– High probability of completing 3 3
project
– Good profitability potential 3 3
Using Decision Criteria (example)
Given project 1 verse 2
 Criteria Weight x Rate  Weighted Ratings
P1 P2 P1 P2
10 x 2 3 20 30
10 x 3 3 30 30
40 80
20 x 2 4
30 90
30 x 1 3
30 30
10 x 3 3 60 60
20 x 3 3 180 320***
Project Implementation and
Control
Implementation Phase
– Monitor Project
– Modify Project
– Closeout and Evaluate
Monitor the Project

 This is where you begin to put in your actual

time and actual costs—in MS projects
 There are some control mechanisms that can
be used to help monitor the project
 PROGRESS REPORTING

Progress reporting needs to answer four fundamental

questions:
1. Where are we today (time and cost)?
2. Where will we end up (time and cost)?
3. What are the present and future risks?
4. Are there any special problems that need to be
addressed and what can management do to help?
Steering Controls
– Sensors are put into place that measure one or
more aspects of the output
– Measurements are taken to determine if there is a
deviation between expected and actual
– Decision maker decides if great enough to need
correction
– Goal is to get things back on target before it is too
late
Go/No-go controls
 Looks to see if some specific precondition has been
met.
 Most projects fall into this category
 You must have predetermined limits
 Often revolves around cost and time--sometimes early
delivery carries a penalty (eg: JIT)
 The number of go/no-go controls on a project is limited
only by the imagination
Modify the Project

 Based on the results of your controls,

modifications may or may not occur
– Modifications could cost more money
– Take more time
Closeout and Evaluation

 A post control is often used as a form of

closeout and evaluation
Postcontrols

 Postcontrol is generally a formal document with

four sections
– Project Objectives: Compares with actual objectives
 Generally it is important to include all the assumptions that
were made
 Important because “acts of God” could have altered
Postcontrols
– Milestones, Checkpoints, Budget: Provides a full
report of the project performance against the
planned schedule and budget. Significant
deviations should be highlighted.
– Final Report on Project Results: This section
chronicles the reasons behind both favorable and
unfavorable deviations
Postcontrols
 Recommendations for Performance and Process
Improvements: Includes a set of recommendations
covering ways that future projects can be improved.