Project Cost Management

What Is Project Cost Management?

Project cost management

It includes the processes required to ensure that a project team completes a project
within an approved budget.

Cost
Costs are often measured in financial amounts, such as dollars, that must be paid to
acquire goods and services.

Different Cost Types

There are two cost types that concern project managers when they create budgets:
 Direct Cost
 Indirect costs.
Direct Costs
These costs can easily be attributed to the project and are charged to the project on an item-by-
item basis. Examples are:

 Labour (people)
 Consultant fees
 Raw materials
 Software licenses
 Travel

Indirect Costs
These costs are for items that benefit more than one project, and only a proportion of their total
cost is charged to the project. Examples are:

 Telephone charges
 Office space (rent)
 Office equipment
 General administration
 Company insurance

Importance and Principles of Project Cost Management

Project managers must make sure their projects are well defined, have accurate time and
cost estimates, and have a realistic budget that they were involved in approving. It is the project
manager’s job to satisfy project stakeholders while continuously striving to reduce and control
costs.
There are three process involved in project cost management:

Estimating costs 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 activity cost
estimates, basis of estimates, and project document updates.

Determining the budget involves allocating the overall cost estimate to individual work items to
establish a baseline for measuring performance. The main outputs of the cost budgeting process
are a cost performance baseline, project funding requirements, and project document updates.

Controlling costs involves controlling changes to the project budget. The main outputs of the
cost control process are work performance measurements, budget forecasts, organizational
process asset updates, change requests, project management plan updates, and project
document updates.

Principles of Cost Management

Information technology project managers need to be able to present and discuss project
information in financial terms as well as in technical terms. In addition to net present value
analysis, return on investment, and payback analysis, project managers must understand several
other cost management principles, concepts, and terms.

Profits are revenues minus expenditures. To increase profits, a company can increase revenues,
decrease expenses, or try to do both.
(Profit = revenues – expenditure)

Profit margin is the ratio of revenues to profits. If revenues of $100 generate $2 in profits, there
is a 2 percent profit margin.

Life cycle costing allows you to see a big-picture view of the cost of a project throughout its life
cycle. This helps you develop an accurate projection of a projects financial costs and benefits.
Life cycle costing considers the total cost of ownership, or development plus support costs, for a
project.

Cash flow analysis is a method for determining the estimated annual costs and benefits for a
project and the resulting annual cash flow. Project managers must conduct cash flow analysis to
determine net present value.

Direct costs are costs that can be directly related to producing the products and services
of the project. For example, the salaries of people working full time on the project and the cost
of hardware and software purchased specifically for the project are direct costs.

Indirect costs are costs that are not directly related to the products or services of the project,
but are indirectly related to performing the project. For example, the cost of electricity, paper
towels etc.,
Sunk cost is money that has been spent in the past. Consider it gone, like a sunken ship that can
never be returned. Sunk costs should be forgotten.

RESOURCE PLANNING

Before you can estimate the Cost for each activity, you must have a good idea of the
quantity and type of resources (people, equipment, and materials) that will be assigned to each
activity.

The nature of the project and the organization will affect resource estimating Expert judgment,
an analysis of alternatives, estimating data, and project management software are tools
available to assist in resource estimating. It is important that the people who help determine
what resources are necessary include people who have experience and expertise in similar
projects and with the organization performing the project.

Important questions to answer in activity resource estimating include:

 How difficult will it be to do specific activities on this project?
 Is there anything unique in the project s scope statement that will affect resources?
 What is the organization s history in doing similar activities?
 Has the organization done similar tasks before?
 What level of personnel did the work?
 Does the organization have people, equipment, and materials that are capable and
available for performing the work?
 Are there any organizational policies that might affect the availability of resources?
 Does the organization need to acquire more resources to accomplish the work?
 Would it make sense to outsource some of the work?
 Will outsourcing increase or decrease the amount of resources needed and when they
will be available?

This step involves making an estimate of the resources required to complete each activity.

Estimate Activity Resources: Inputs

There are eight inputs that are to be used in the process of activity resource estimating:

Schedule Management Plan

This identifies the level of accuracy and the units of measure for the resources to be used.
Schedule can be developed with the help of Gantt chart.

Activity List
This is a documented tabulation of schedule activities that shows the activity description.

Activity Attributes
These are the various attributes associated with each activity. The attributes can be codes,
predecessor and successor activities, logical and other relationships.
Resource Calendars
These provide information on the type of resource, its location and its availability. The accuracy
of this information depends on the length of the project.
Risk Register
Risk events may impact resource selection and availability.

Activity Cost Estimates

The cost of resources may impact resource selection.

Enterprise Environmental Factors

These include resource location, availability, and skills.

Organizational Process Assets

These include policies and procedures regarding staffing, policies and procedures relating to
rental and purchase of supplies and equipment, and historical information regarding types of
resources used for similar work on previous projects.

Outputs from Resource Planning

Resource requirements.
The output of the resource planning process is a description of what types of resources
are required and in what quantities for each element of the work breakdown structure.

COST ESTIMATING
Cost estimating involves developing an approximation (estimate) of the costs of the resources
needed to complete project activities.

Project managers must take cost estimates seriously if they want to complete projects within
budget constraints. After developing a good resource requirements list, project managers and
their project teams must develop several estimates of the costs for these resources. When a
project is performed under contract, care should be taken to distinguish cost estimating from
pricing.

Types of Cost Estimates

Three basic types of estimates include the following:

Rough order of magnitude (ROM) estimate

It provides an estimate of what a project will cost. This type of estimate is done very
early in a project or even before a project is officially started. Project managers and top
management use this estimate to help make project selection decisions. The timeframe for this
type of estimate is often three or more years prior to project completion. A ROM estimate s
accuracy is typically -50 percent to 100 percent, meaning the project s actual costs could be 50
percent below the ROM estimate or 100 percent above. For example, the actual cost for a
project with a ROM estimate of $100,000 could range between $50,000 to $200,000. For
information technology project estimates, this accuracy range is often much wider.
Budgetary estimate
It is used to allocate money into an organization s budget. Many organizations develop
budgets at least two years into the future. The accuracy of budgetary estimates is typically -10
percent to 25 percent, meaning the actual costs could be 10 percent less or 25 percent more
than the budgetary estimate. For example, the actual cost for a project with a budgetary
estimate
of $100,000 could range between $90,000 to $125,000.

Definitive estimate
It provides an accurate estimate of project costs. Definitive estimates are used for making many
purchasing decisions for which accurate estimates are required and for estimating final project
costs. For example, if a project involves purchasing 1,000 personal computers from an outside
supplier in the next three months, a definitive estimate would be required to aid in evaluating
supplier proposals and allocating the funds to pay the chosen supplier. The accuracy of this type
of estimate is normally -5 percent to 10 percent, meaning the actual costs could be 5 percent
less or 10 percent more than the definitive estimate. For example, the actual cost for a project
with a definitive estimate of $100,000 could range between $95,000 to $110,000.

Inputs to Cost Estimating

Work breakdown structure. It will be used to organize the cost estimates and to ensure that all
identified work has been estimated.

Resource requirements.
It is the output from resource planning..

Resource rates. The individual or group preparing the estimates must know the unit rates (e.g.,
staff cost per hour, bulk material cost per cubic yard) for each resource in order to calculate
project costs. If actual rates are not known, the rates themselves may have to be estimated.
Activity duration estimates. Activity duration estimates
Historical information. Information on the cost of many categories of resources is often
available from one or more of the following sources:

• Project files—one or more of the organizations involved in the project may maintain records of
previous project results that are detailed enough to aid in developing cost estimates. In some
application areas, individual team members may maintain such records.

• Commercial cost estimating databases—historical information is often available commercially.

• Project team knowledge—the individual members of the project team may remember
previous actual or estimates. While such recollections may be useful, they are generally far less
reliable than documented results.

Chart of accounts. A chart of accounts describes the coding structure used by the performing
organization to report financial information.

Outputs from Cost Estimating

Cost estimates Costs must be estimated for all resources that will be charged to the project. This
includes, but is not limited to, labor, materials, supplies, and special categories such as an
inflation allowance or cost reserve.

Cost estimates are generally expressed in units of currency

COST BUDGETING

Budgeting Basics

There are two main approaches you can take when creating a budget:

1. Top-down approach: deciding how much the project will cost and dividing the amount
between the work packages.
2. Bottom-up approach: estimating the total cost of the project by costing the lowest-level
work packages and rolling up.

Both approaches have their advantages and disadvantages and as a project manager, you will be
faced with both at some time in your career. Let's take a look at each approach in more detail:

Top-Down Budgeting Approach

The decision is made, often by senior management, about how much the project should cost.
This amount is divided between the work packages. Keep in mind that this approach is more
than guessing; you need to explain how you will do the work within the allocated amount of
budget on each work package. Prior experience from other projects will play a part in validating
the budget allocation for work packages. It should be asked whether the budget looks realistic
based on experience from past projects.

The advantage of the top-down budgeting approach is that it focuses on achieving the project
within the budget allocated and leads to efficiencies and reduction in wasteful practices.

A disadvantage of the top-down budgeting approach is that it assumes that the person creating
the budget has enough knowledge and expertise to make a reasonable cost estimate. If they do
not, conflict may occur when a person required to execute the project is given an unrealistic
budget that is insufficient to deliver the project. There is a risk of deliberately low budgets
created with the belief that it will encourage cost savings.

Bottom-Up Budgeting Approach

The team, often involving the final budget holder, identify the tasks and activities needed to
complete the project. The project is based on the lowest-level work packages and rolled up to
arrive at the total project cost. The direct and indirect costs are calculated for each work
package.

The advantage of the bottom-up budgeting approach is its accuracy (as long as you have not
missed any task or activity). It is good for team morale because the project manager involves the
team in budget creation. This approach is sometimes called participative budgeting for this
reason.

A disadvantage of the bottom-up budgeting approach is the difficulty in getting a full list of tasks
and activities needed to complete the project. It is easy to miss some that will be needed and
that will later throw the budget out.

CONTROLLING COSTS
Controlling project costs includes monitoring cost performance, ensuring that only
appropriate project changes are included in a revised cost baseline, and informing project
stakeholders of authorized changes to the project that will affect costs. The project management
plan, project funding requirements, work performance data, and organizational process assets
are inputs for controlling costs. Outputs of this process are work performance measurements,
budget forecasts, organizational process asset updates, change requests, project management
plan updates, and product document updates.

One of the powerful cost control technique is Earned Value Management (EVM).

Earned Value Management

Earned value management (EVM) is a project performance measurement technique that
integrates scope, time, and cost data.
In earned value management, it has three elements:
1. Planned Value (PV)
2. Actual Cost (AC)
3. Earned Value (EV)
The calculations for finding Planned Value, Earned Value, and Actual Cost are very simple.

Planned Value (PV)

This is the first element of earned value management. Planned Value is the approved value of
the work to be completed in a given time, or you can say that it is the money that you should
have spent as per the schedule.

You calculate Planned Value before actually doing the work, which also serves as a baseline.
Total Planned Value for the project is known as Budget at Completion (BAC).

Formula for Planned Value (PV)

Take the planned percentage of the completed work and multiply it by the project budget and
you will get Planned Value.

Planned Value = (Planned % Complete) * (BAC)

Actual Cost (AC)

This is the second element of earned value management. Actual Cost is the total cost incurred
for the actual work completed; or simply put; it is the amount of money you have spent for each
activity.
Formula for Actual Cost (AC)

Finding Actual Cost is simplest of all.

There is no special formula to calculate Actual Cost. It is an amount that has been spent and you
can find it very easily in the question.

Earned Value (EV)

This is the last and third element of earned value management. Earned Value is the value of the
work actually completed to date, or you can say that if the project is terminated today, Earned
Value will show you the value that the project has produced.
There is a difference between Planned Value and Earned Value. Planned Value shows you how
much money you have planned to complete the work in a given time, while Earned Value shows
you how much work you have actually completed or earned on the project.
Formula for Earned Value (EV)

The formula to calculate Earned Value is also very simple. Take the actual percentage of the
completed work and multiply it by the project budget and you will get the Earned Value.

Earned Value = % of completed work * BAC

Example problem for Planned Value (PV), Actual Cost (AC) & Earned Value (EV)
In the below given Table 1,

[Link] Time duration Activity % of money allocated

for each activity
1 January Requirement gathering related to project 10%
2 February Resource planning 5%
3 March Designing Phases 15%
4 April Web server purchase implementation 20%
5 May Configuration & Installation 10%
6 June Coding Phase 25%

7 July Testing 5%
8 August Quality checking, Shipping & Delivery 10%

You have a project to be completed in 8 months and the total cost of the project is 100,000 USD.
A. Find Planned value for each activity
B .Estimate Actual Cost
C. Find earned value upto the month of May.
Answer
A. What is the project’s Planned Value (PV)?
Let’s see what we have been given in this question.
Project duration: 8 months
Project cost (BAC): 100,000 USD
Activity1 - Requirement gathering related to project takes 10% (as per the schedule)
Planned Value is the value of the work that should have been completed in the month of january
(as per the schedule).
Therefore, in this case we should have completed 10% of the total budget allcated.
Hence,
Planned Value for activity 1 = 10% of the value of the total allocated budget
= 10% of BAC
= 10% of 100,000
= (10/100) * 100,000
= 10,000
Therefore, the project’s Planned Value (PV) for activity 1 is 10,000 USD.

Similarly for remaining activity 2, 3, 4, 5, 6, 7 & 8

[Link] Activity Planned Value
1 Requirement gathering related to project 10,000
2 Resource planning 5,000
3 Designing Phases 15,000
4 Web server purchase implementation 20,000
5 Configuration & Installation 10,000
6 Coding Phase 25,000
7 Testing 5,000
8 Quality checking, Shipping & Delivery 10,000
Total 1,00,000

B. Estimate Actual Cost (AC)

Actual Cost is the amount of money that you have spent for each activity.
[Link] Activity Actual Value
1 Requirement gathering related to project 8,000
2 Resource planning 6,000
3 Designing Phases 14,000
4 Web server purchase implementation 20,000
5 Configuration & Installation 10,000
6 Coding Phase 24,000
7 Testing 5,000
8 Quality checking, Shipping & Delivery 9,000
Total 96,000

C. Earned Value (EV)

What is the project’s Earned Value (EV)?
From the question, it shows up to the month of May.
% of money allocated for each activity up to month of May is 60%.
Earned Value = 60% of the value of total budget for project
= 60% of BAC
= 60% of 100,000
= 0.6 * 100,000 = 60,000
Therefore, the project’s Earned Value (EV) is 60,000 USD.
Cost variance (CV) is the earned value minus the actual cost. If cost variance is a negative
number, it means that performing the work cost more than planned. If cost variance is a positive
number, it means that performing the work cost less than planned.

Cost variance (CV), CV = EV - AC

Schedule variance (SV) is the earned value minus the planned value. A negative schedule
variance means that it took longer than planned to perform the work, and a positive schedule
variance means that it took less time than planned to perform the work.

Schedule variance (SV), SV = EV – PV

The cost performance index (CPI) is the ratio of earned value to actual cost and can be used to
estimate the projected cost of completing the project. If the cost performance index is less than
one or less than 100 percent, the project is over budget. If the cost performance index is greater
than one or more than 100 percent, the project is under budget.

Cost performance index (CPI), CPI = EV/AC

The schedule performance index (SPI) is the ratio of earned value to planned value and can be
used to estimate the projected time to complete the project. Similar to the cost performance
index, a schedule performance index of one, or 100 percent, means the project is on schedule. If
the schedule performance index is greater than one or 100 percent, then the project is ahead of
schedule.

Schedule performance index (SPI), SPI = EV/PV

Example Problem:
In a project, Earned Value (EV) 5,000$, Planned Value (PV) 10,000$ & Actual cost (AC) 15,000&.
Find CV, SV, CPI & SPI.

Answer