1. Estimating Project Costs

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Introduction

Project Cost Management is a set of activities for estimating costs of project, determining and approving a necessary budget, allocating financial resources and controlling spending for the purpose of ensuring that the project is performed under approved budget. Project cost management allows addressing the identification, development, allocation and management of the project budget. The given project cost management definition can be applied to most kinds of project.

In this article you will learn the following:

• Cost Estimating Principles
• Types of Project Cost
• Cost Estimates
• Cost Estimation Process
• Example of Cost Estimation Process

Project Cost Estimating Principles

The process of estimating costs is a methodological activity that complies with a set of cost estimating principles. Such principles act as a foundation for identifying and estimating project costs. Here is a list of the key project cost estimating principles:

• The Principle of Integrity. With reference to this cost estimation principle, any estimate should be produced with a high standard of ethical integrity and by following an open or transparent process. Any uncertainties and vagueness associated with estimates should be explained in an easy-to-understand manner and in laymen’s terms. The principle allows avoiding false precision and rash decisions on cost estimates by integrating all people involved in the cost estimation process into a team which works as a single mechanism operating the same information on project cost estimating.
• Cost Estimates Information. The development of cost estimates should be based only on the best information available. When cost estimators develop any estimate, engineering judgment and technical advice should be applied any assumption made at that estimate. By following this cost estimation principle, all information used for developing estimates can be thoroughly considered, filtered and refined in order to get the most accurate and relevant pieces of that information.
• Risk and Uncertainty. Any project cost should be identified and used within an estimate considering uncertainties and risks. A methodological and exhaustive method of assessing and reassessing project risk and uncertainty should be applied to estimating project costs. Cost estimation software can be used to associate each project cost with potential risks or uncertainties surrounding the project. Cost estimation software will also allow considering project risks by producing accurate contingencies in estimates that may be used later for developing a risk management plan.
• Expert Estimating Team. The principle assumes that only a skilled, interdisciplinary team of experts should produce estimates and make cost calculations. Project estimating sheets should be developed utilizing a clearly defined work statement. The team of experts should use methodological tools and cost estimating approaches to develop estimates. The estimating team can be composed of the project team members, experienced personnel of the performing organization, as well as experts from outside qualified agencies. Technical, managerial, and communication cost estimating skills are required for the members of the estimating team. They should also be able to identify and evaluate critical issues and risks.
• Validation of Estimates: An expert, unbiased estimating team should validate project cost estimates. The project manger should develop initial estimates of project costs and submit these estimated to the estimating team for validation. A second independent judgment will allow making estimates more correct and capturing a different perspective on the project cost estimating process. This cost estimation principle become more important to complex projects which require producing large estimates.
• Release and Use of Estimates. The principle assumes that while project cost estimates might have been developed for a specific goal, they can be used improperly by those people who do not understand the applicable context. Until the estimating team has been thoroughly reviewed cost estimates and validated their content, these cost estimates should not be released to the project team and stakeholders in order to avoid misuse and misunderstanding of cost estimations. Then cost estimates would be consistent with the project scope and accurate indicators of project costs.

Types of Project Costs

All the costs of a project can be broken down into three categories that include the following project cost types:

• Variable Cost and Fixed Cost. A Fixed Cost refers to a cost which is not to be changed throughout the project progress. Fixed cost does not change an increase or reduction of the project work amount. Examples of fixed project cost are setup cost, rental cost, cost for hiring of equipment, etc. A Variable Cost refers to any costs that can be changed with an amount of project work. An increase or reduction of project scope causes the respective change in variable costs. Examples of variable project cost are cost of production materials, remuneration of project team, cost of power and water.
• Direct Cost and Indirect Cost. A Direct Cost is a cost that is directly associated with particular tasks or/and activities of the project. Examples of direct project expense are team wages and expense on materials used during the project. An Indirect Cost refers to expenses on overhead items (overheads). Indirect cost does not refer to the project cost value. Examples of indirect project cost are: corporate tax, fringe benefit tax.
• Opportunity Cost. An Opportunity Cost is a cost associated with an opportunity of a choice for the project. When you select between two different projects, or activities within one project, you can consider opportunity expense of each project (activity) and then make your choice.

Project Cost Estimates

The major tools of project cost estimation are estimates which can be developed in a spreadsheet view. A cost estimate for a project is a calculation of all (monetary and time) resources necessary to perform and deliver the project. It is used to calculate and compare resources.

Project cost estimates generally show an amount of some currency units (e.g. USD, GBP, UAH) as well as an amount of working hours or total working time required to complete the project.

Sometime, project cost estimates include both currency units and working hours and show a comparison between both measures. Cost estimation software can be used to create cost estimates and define units per line and per column in the estimates.

Cost estimate spreadsheets are not static and to be continuously developed and modified throughout the course of the project in order to reflect additional details as project processes are being progressed. The accuracy plays the pivotal role in developing and managing cost estimates and spreadsheets. While project processes develop and change, project cost estimates should also be respectively changed and supplemented with new details. The matter of cost estimate accuracy is defined by cost estimation standards and requirements so that each organization can define the expected degree of accuracy. Cost estimation software allows creating cost estimate templates and sample cost spreadsheets that include specific accuracy degrees and possible deviations.

In project cost estimating spreadsheets, all information on the resources that can be changed throughout the project course is included and used. A typical project cost estimating spreadsheet includes information from such sources as labor, infrastructure, materials, financial resources, facilities, services, work time, etc. Cost estimating spreadsheets may also include special categories, such as contingency costs and inflation allowance.

Project Cost Estimation Process

Estimating costs (cost estimation) is a process of determining an amount of monetary resources required to accomplish project activities. The process of project cost estimating involves the approximation and development of costing alternatives to plan, perform and deliver the project. The process focuses on finding and allocating optimal costs for the project.

The process is vital to determining whether the project will be successful, all its goals and objectives will be achieved and its deliverables will be produced. Considering this statement, the following definition of a successful project can be made: the project becomes successful if it meets the four success criteria:

• the scope is developed and produced on schedule;
• the scope is delivered within budget;
• the quality expectation are met; and
• the expected benefits are receive by stakeholders

The cost estimation process influences all the items of the project success criteria so the project manager should understand all the importance of the process.

The process of estimating project costs involves applying several specific techniques, in combination or separately. Here a list of the key project cost estimation techniques and tools:

• Analogous Cost Estimating. This technique is also known as “Historical Data Analysis” and it assumes applying the actual cost of previous or analogues projects as the foundation for estimating the cost of the current project. This cost estimation technique is usually applied to separate segments of the project and in combination with other techniques and tools.
• Parametric Cost Estimating. It is an effective method that allows using historical and statistical data on the project to make an estimate for activity parameters (like scope, budget and duration). It may provide a higher degree of estimation accuracy depending on the data included in the parametric model. The technique can be used separately as well as in combination with other cost estimation techniques and tools.
• Bottom-up Cost Estimating. This method supports the idea that the individual activity cost (or work package cost) consciousness is of prime importance. It assumes estimating cost of a smaller work unit. By using the method, individual scheduled activities, or a work package, can be estimated to the smallest detail. Then all estimated costs are grouped and sorted by cost categories, and then gathered into the summary table that is used for tracking, control and reporting purposes.
• Top-down Cost Estimating. This technique is opposite to Bottom-up Cost Estimating method. The technique assumes that the total project budget is determined at the project’s beginning and the estimating team needs to identify the costs of each project work item (task or job). The method of Top-down Cost Estimating allows determining the number of required activities and tasks referring to the WBS which reflects the necessary work items and work packages. By using the WBS, the team can determine the quantity of the work items that can be delivered within the fix project budget. The team may decide to add or remove certain items in the WBS in order to fit the fix project budget.
• Reserve Analysis. Since Quality Assurance and Quality Control are integrated parts of the cost estimate process, the technique is used to deal with uncertainties that may overstate or understate project costs by making cost estimate reviews. It assumes that costs may include reserves (or contingency allowances) which can be used for mitigating risks and responding to threats. Reserves should be estimated and then added to cost estimated in order to allow applying the critical chain method and risk mitigation strategies.
• Cost of Quality. The method of estimating quality cost allows develop the schedule activity cost estimate and estimate how many resources it is required to achieve the expected quality.

By using project estimation software (like MS Project, VIP Task Manager Pro), all the listed tools and techniques can be managed and applied. Advanced examples of project estimation software allow managing project tasks, making billing and payment activities, documenting transactions and resource transfers, communicating with project participants, customers and vendors, planning meetings and events, and sharing cost estimating information.

Example of the Cost Estimating Process

Most projects face the same or similar problems related to estimating costs and managing financial resources. New technologies, teams unfamiliar with these technologies, or unclear project work statements are most frequent problems. Here is probably one of the best ways to estimate and calculate costs for your project. The given example of cost estimate process is most applicable to IT projects and software development projects.

• Step #1. Breaking project work down into smaller tasks. You need to decompose your project work into as many work items (tasks and jobs) as possible. A convenient way to break down your tasks is to consider typical activities appropriate to your project, and then see whether they can be divided into tasks and todo lists. For example, a software development project involves such typical activities as such Analysis, Designing, Developing, Demo, Testing, Bug Fixing, Documenting, Deploying, and Supporting. Now having these activities, you can divide each of the activities into a number of smaller tasks and actions. The Analysis activity can be divided into several tasks, like “Collecting Necessary Info”, “Examining Collected Info”, “Creating a software development plan”, etc.
• Step #2. Evaluating tasks. Once you have specified tasks and jobs for each typical process/activity in your project, now it is time to evaluate the tasks considering two scales: Complexity (high, medium, low) and Work Size (large, medium, small). Note that less complex tasks may still require a large amount of work, so for example Low Complexity does not necessary involves Small Work Size. For example, you run an IT project, and you need to load a database that contains information taken from paper documents. Loading may take several weeks which means that a very complex task (“Loading Database”) may not involve much actual work of people but can still take much time, as in configuring the database for optimum performance. Evaluating tasks can be a complicated matter because complex tasks are usually hard to allocate between team members, while large-sized yet less complex tasks can usually be shared between team members.
• Step #3. Regarding to the previous step, all project tasks can be effectively broken down into nine combinations of complexity and size (3×3 – high, medium, low versus large, medium, low). Therefore, each task can fall into one of the combinations. For each combination, you need to estimate an expected amount of resources (time, people, money) required. For example, you have evaluated tasks and now you can state that high-complexity and small-sized tasks take three weeks at most, medium-complexity and small-size tasks take one week, and so on. All possible combinations of tasks should be reviewed and evaluated, so that your will define better values for your project. By combing all defined values for each task, you can obtain a cost estimate of resources (time, people, money) required.